Fears over slowing economic growth have caused traders to sell the oil and gas sector in recent weeks. However, that has likely opened up some opportunities. Many U.S. shale producers can profit with oil prices over $50, so given that oil prices are still over $100 per barrel despite the recent sell-off, there could be some bargains out there, especially if we don't have the recession some think we will.
One interesting subsector is the midstream segment, which offers high yields, and whose revenues are largely tied to oil and gas volumes irrespective of price. So if long-term bond yields go down on an economic downturn but oil and gas prices remain high enough for U.S. producers to drill, the high yields paid by midstream operators could find favor with investors. And master limited partnership Crestwood Equity Partners (CEQP) sticks out even amid this attractive group.
Where Crestwood's cash comes from
While most midstream operators deal in pipelines, Crestwood's operations are concentrated in natural gas gathering systems and processing facilities near the drillers themselves, and they are primarily concentrated in the Williston Basin of the Bakken Shale in North Dakota. Crestwood also owns storage and logistics facilities, along with assets in other basins, but the vast majority of its cash flow -- nearly 70% up until recently -- comes from its Williston assets.
Crestwood's assets reliably threw off cash flow even through the pandemic, and 83% of its revenue is in the form of take-or-pay fixed-rate contracts, with a majority of contracts including inflation escalators or annualized increases. Just for extra safety, the company also hedges a portion of its commodity price exposure.
But concentration in just one basin could be why the market gives Crestwood such a low valuation. Just how low? Well, the company's 10.8% distribution yield is covered two times over by its current distributable cash flow (DCF). That means the company trades at less than five times its distributable cash flow. While Crestwood has a high yield, it still has cash left over every quarter, allowing Crestwood to continue improving its balance sheet or invest in growth. In fact, Crestwood even increased its already-high payout by 5% earlier this year, to $2.62 annually.
Crestwood's 3.5 times leverage ratio is also quite reasonable by midstream standards, and its credit rating was recently upgraded by Standard & Poor's from BB- to BB.
Natural gas prices have risen this year, and gas has become a geopolitical flash point, with Russia now threatening Germany's natural gas supply. The U.S. continues to build more LNG export facilities in order to help Europe wean itself off of Russian supplies, so it seems as though U.S. natural gas has a very bright future.
But Crestwood isn't standing still
In May, Crestwood announced three simultaneous transactions that will transform the company. These include the purchase of privately held Sendero Midstream for $600 million in cash and debt, the buyout of Crestwood's 50% Permian joint venture partner First Reserve for $320 million in equity units, and the sale of its legacy Barnett Shale operations for $275 million in cash. That cash will be used to help finance the Sendero acquisition.
The acquisitions will greatly expand Crestwood's operations in the Delaware Basin of the Permian Shale, increasing its Permian exposure from 7% to 20% of cash flow, while lowering its Williston exposure from 68% to 61%. That's important because the Delaware Basin is the most attractive of all the U.S. basins, with break-even oil prices of just $35 per barrel, as opposed to $45 per barrel in Crestwood's home Bakken Shale. So in executing this deal, Crestwood de-risks its portfolio and enhances the growth profile.
Meanwhile, the deal doesn't overburden the company's balance sheet. While leverage will initially go up to 3.8 times earnings before interest, taxes, depreciation and amortization (EBITDA), the projected $50 million-plus in deal synergies is expected to bring Crestwood's leverage down to less than 3.5 times in 2023.
An attractive high-yield play
Crestwood's stock has sold off with the rest of the oil and gas sector recently, but its assets probably won't see the types of fluctuations in results that will come with owning an exploration and production company, which are reliant on the price of oil and gas to determine their financial results.
For pipelines and other midstream assets, such as Crestwood's gathering and processing assets, it only really matters that the price of oil and gas is high enough to warrant more drilling volumes. With oil still at $100 per barrel and natural gas prices still above $6 per mmBtu even after their sell-offs, there is room for prices to come down while still allowing Crestwood to rake in ample profits.
Given its recent credit upgrade, high coverage ratio, and the recent transactions giving it greater exposure to the Permian Shale, yield-seeking investors should look into this midstream play after the recent oil and gas sell-off.
