Interest in the oil and gas industry has quickly grabbed Wall Street's attention. Even before the recent geopolitical turmoil in Europe, energy prices were on the rise, with some long-term factors suggesting a period of high energy prices for some time.
One place that investors immediately turn to in times like this are high-yield dividend stocks. While a high yield can sometimes mean a company is in trouble, it could also be a sign that the stock is undervalued. One such high-yield stock in the oil and gas industry is Crestwood Equity Partners (CEQP), with a distribution yield of 8.2% as of this writing.
Is Crestwood a safe stock trading at a discount, or a high-yield stock at risk of a cut to its payout? Let's look at the business to find out.
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Not all pipeline companies are the same
The oil and gas industry breaks down into roughly four categories: exploration and production, pipelines and midstream, refining and marketing, and equipment and services. A heuristic investors can use to gauge risk in these segments is that pipelines and midstream tend to be some of the less volatile investments in the sector. That's because midstream tends to be the least exposed to commodity prices and tends to work on contracts that earn fees for use of a pipe, a storage tank, or a processing facility.
Digging a little deeper, though, there is another heuristic for evaluating midstream businesses: The closer to the actual well these assets are, the riskier they become.
Think of it this way. A pipeline or storage facility that takes oil and gas from thousands of wells from across the country isn't worried if a single well is out. If a company owns a pipe that originates at a well, though, any disruption at that well will be significant. Also, when that well is no longer producing, that pipe's economic value is exhausted, too. This is a more pressing issue with shale wells, as production rates are high early but taper off quickly.
That's where Crestwood operates. Its assets are primarily gathering and processing infrastructure designed to take product from individual wells and aggregate them to a central location. It does this for oil, gas, and water produced from fracking. If, for example, a shale basin where Crestwood operates is too expensive to drill at a certain price point, then its gathering and processing assets aren't likely get used to their full capacity. Probably not a problem at today's oil prices, but certainly something to keep in the back of your mind when investing in this part of the industry.
Fixing flaws with good management
Fortunately for Crestwood investors, management has done a good job of mitigating much of the risk associated with this particular part of the midstream business. There are three things management does, in particular, that stand out here:
- The contracts it uses to ensure more stable revenue.
- Higher credit-quality customers.
- A conservative approach to managing cash flow and leverage.
For a midstream company to ensure stable, predictable revenue, contracts and how they are structured is key. In Crestwood's case, the company mostly signs up producers to what are called take-or-pay contracts with dedicated acreage. Take-or-pay means that a producer has to pay for the use of a pipeline or facility regardless of whether it's physically being used. Dedicated acreage means that should a producer drill a new well within the boundaries of this contract, then that producer has to use Crestwood's assets. As of its most recent investor presentation, 83% of Crestwood's contracts were take-or-pay and it had 1.7 million acres under dedicated acreage contracts.
Management also reduces its risks by working primarily with higher-credit-quality companies. The last thing you need after spending tens of millions on assets for a client is to have that client be unable to pay the bills. Crestwood's clients are a combination of some of the largest oil and gas producers, other midstream companies, and refiners, most of which have investment-grade credit ratings.
Finally, just in case the oil and gas market doesn't work in Crestwood's favor, management takes a conservative approach to how much it pays out to investors and keeping its debt levels in check. As of the most recent quarter, its distribution coverage ratio -- a measure of how much cash is available to pay a distribution divided by how much is actually paid -- for 2021 was 2.4, and management is projecting its 2022 payout to be in the range of 2.0 to 2.2. For reference, a ratio above 1.5 is considered a pretty healthy payout cushion in this business. Management is also targeting keeping its leverage -- measured as debt to adjusted EBITDA -- between 3.25 and 3.75.
Is it undervalued?
"Undervalued" and "overvalued" in high-dividend companies can be tricky concepts. If you're looking for a stock that's going to see significant price appreciation over a relatively short term, then Crestwood Equity Partners is probably not the stock you're looking for. Crestwood is going to be a company that grows slowly and returns a lot of cash to shareholders. If you're looking for a company that will pay you a solid dividend that can either be reinvested or used to supplement your income, then there aren't a lot of companies out there that can beat Crestwood in terms of its current yield, the relative safety of the payout, and some modest price upside.
