The U.S. has the largest energy pipeline network in the world. In 2019, more than 2.4 million miles of pipeline crisscrossed the country, bringing natural gas, oil, natural gas liquids (NGLs), refined petroleum products, and petrochemicals from production centers to end users.

These pipelines play a vital role in fueling the U.S. economy. Because of that, the companies that operate pipelines can be an excellent investment. This guide will help investors understand how to invest in the companies focused on this sector.

Pipelines heading toward the bright sun.

Image source: Getty Images.

How the pipeline industry works

Pipeline companies operate three main types of pipeline systems. These network of pipes help move gasses (such as natural gas and carbon dioxide) and liquids (like water, oil, NGLs, and refined petroleum products) from wells to end users.

Gathering pipelines

Gathering pipelines collect the output from a group of wells (oil, natural gas, NGLs, and water) and transport it to central processing locations. They move crude oil to treating facilities, the liquids-rich natural gas to processing plants, and the water to recycling or disposal locations. Many oil and gas exploration and production (E&P) companies build and operate gathering systems to support their operations. Others will hire midstream companies to construct these assets and will pay them a fee for this service.

Transmission pipelines

Transmission pipelines ship oil, natural gas, and NGLs over long distances, usually from a central treating or processing facility to a market hub. There are two types of transmission pipeline systems: intrastate and interstate.

Intrastate pipelines, as the name implies, are systems that transport oil, natural gas, and NGLs within state lines. Pipeline companies typically charge shippers a fee for capacity on their intrastate networks.

Interstate pipelines cross state lines. Consequently, the Federal Energy Regulatory Commission (FERC) regulates these systems by setting the rates that pipeline companies can charge shippers. While some E&P companies own stakes in interstate pipelines, pipeline companies, as well as some natural gas distribution utilities, typically operate these pipelines.

Distribution pipelines

Distribution pipelines distribute natural gas into homes and businesses. Natural gas utilities primarily operate these networks.

Other midstream infrastructure

Many pipeline companies will also operate related midstream assets such as:

  • Natural gas processing plants: These facilities separate NGLs from raw liquids-rich natural gas.
  • NGL fractionation complexes: These plants spilt the raw NGL stream from a processing plant into its various components (ethane, propane, butane, and natural gasoline).
  • Storage terminals: These locations typically consist of a group of liquids storage tanks or underground natural gas storage wells or caverns.
  • Export facilities: These port operations consist of oil, NGL, and refined products export docks or liquefaction terminals that make liquefied natural gas (LNG).

Types of pipeline companies

Investors will find two types of companies operating in the pipeline industry: corporations and master limited partnerships (MLPs).

Pipeline corporations

Many large pipeline companies are a corporation for tax purposes, which is the chosen structure of most publicly traded companies. These entities pay tax at the corporate level. However, most pipeline companies can minimize their tax liability by taking depreciation and interest expenses to reduce their taxable income. While paying some corporate tax is a drawback, the benefits are that pipeline corporations pay dividends and thus send their investors a 1099-DIV form for tax filing purposes. Investors can hold shares of these pipeline companies in tax-deferred retirement accounts like an IRA and 401(k).

Pipeline MLPs

MLPs are very common in the pipeline industry. In 2018, 80% of MLPs as measured by their market capitalization were in the energy sector, with 90% of those entities focused on operating midstream assets. This structure has many benefits for pipeline companies. For starters, pipeline assets owned in an MLP are exempt from corporate income tax. That enables MLP investors to keep a higher percentage of a pipeline's earnings since they're not paying taxes twice, once at the corporate level and again at the individual level. However, MLPs do have some drawbacks. Since they're already tax-exempt, investors who hold them in an IRA or 401(k) could be liable for Unrelated Business Taxable Income (UBTI). Another issue with MLPs is that they issue a Schedule K-1 for tax purposes, which can complicate tax filing.

Several pipelines with storage tanks in the background.

Image source: Getty Images.

Key metrics for the pipeline industry

The pipeline industry, like many others, has sector-specific terms that investors need to know. Here are the five most important:

Distributable cash flow (DCF)

This metric measures the amount of cash flow a pipeline company produces in a period that it could distribute to investors via a dividend or MLP distribution. It's similar to free cash flow. This metric is commonly used by MLPs, though many pipeline-focused corporations also use it so that investors can see how much money they could pay out in dividends.

Earnings before taxes, interest, depreciation, and amortization (EBITDA)

This non-GAAP metric measures an asset's underlying earnings. It's an important metric for pipeline companies because pipeline systems are expensive to build and maintain. Thus, they not only borrow heavily (and therefore pay interest) but also take large depreciation deductions against their income. Those factors reduce a pipeline company's net income to such a degree that they suppress its real underlying earnings.

Distribution coverage ratio

This metric measures how many times a pipeline company can cover its distribution to investors with cash flow -- it's the inverse of the dividend payout ratio. A distribution coverage ratio of 1.0 times means a pipeline company generated enough cash to cover its distribution. Most, however, aim to have a coverage ratio of at least 1.2 times, which gives them a cushion that they can use to invest in expansion projects.

Debt-to-EBITDA ratio

This metric measures how much debt a pipeline company has compared to its underlying earnings. It gives investors a sense of the company's leverage. Credit rating agencies often require pipeline companies to have a debt-to-EBITDA ratio of less than 5.5 times to maintain an investment-grade credit rating. Many pipeline companies, however, aim to keep this metric below 4.0 times.

Enterprise value

The enterprise value metric adds a company's current market capitalization to its net debt. It helps provide a clearer picture of a pipeline company's size. That's because it includes debt, which is often significant given the amount of money that companies typically borrow to fund pipeline projects.

Headwinds facing the pipeline industry

Energy price volatility is a significant headwind in the pipeline sector. When oil and gas prices decline, it leads E&P companies to cut spending and reduce their drilling activities. That causes their oil and gas production to drop as output from wells naturally declines. As a result, fewer volumes flow through pipelines. These declines have the most significant impact on gathering pipelines since pipeline companies get paid fees on the amount of oil and gas that flows through their systems. Transmission pipelines, on the other hand, usually have a minimum volume commitment, making them less susceptible to volatility in the energy market.

Growing climate change worries are causing more opposition to new oil and gas pipelines. That's delaying projects as well as increasing costs. One of the biggest pipeline projects impacted by these concerns is TC Energy's (NYSE:TRP) Keystone XL. The pipeline would transport 830,000 barrels of oil per day (BPD) from oil sands production facilities in Western Canada as well as North Dakota's Bakken shale to refineries along the U.S. Gulf Coast. TC Energy initially proposed the pipeline in 2008. After many delays, the Obama administration rejected it in 2015 because of concerns that it would increase greenhouse-gas emissions. The Trump administration, however, took executive actions to revive the project in 2017. TC Energy continued to face opposition to the project and hadn't begun construction as of the middle of 2019. Those delays drove the project's estimated cost up from $5.4 billion when first proposed to $8 billion as of the middle of 2019.

Changes in interest rates can have a big impact on pipeline stocks. Because they borrow lots of money to fund new projects, they're highly sensitive to interest rates. When they rise, it increases their borrowing costs.

Since most pipeline stocks pay high dividend yields, they compete with other income investments such as bank CDs and bonds. When interest rates rise, rates on bank CDs and bond yields tend to follow, which makes them more appealing to yield-focused investors. Since those options are lower risk, pipeline stock dividend yields need to rise to compensate for their higher risk, which can weigh on pipeline company stock prices.

Pipelines laid out for construction at sunset.

Image source: Getty Images.

Tailwinds driving the pipeline industry

Despite rising opposition to pipelines, North America needs more of them to efficiently transport the continent's rising oil and gas production. U.S. oil production alone is on track to grow 46% from 2019 through 2025. Therefore, pipeline companies will need to build more infrastructure. According to an estimate by the INGAA Foundation, the U.S. and Canada need to invest $44 billion per year -- nearly $800 billion overall -- through 2035 on new midstream infrastructure. More than half of that amount will be on new natural gas-related infrastructure, including gathering and transmission pipelines. This forecast suggests that pipeline companies should have no shortage of opportunities to expand their footprints in the coming years.

Pipeline companies in North America are not only benefiting from supply growth, but also from rising demand in the U.S. and abroad. The chemicals industry, for example, is investing more than $200 billion through 2025 into building new petrochemical facilities along the U.S. Gulf Coast to consume natural gas and NGLs produced in the country. Meanwhile, U.S. energy export volumes are rising sharply, with oil shipments expected to rise from 2 million BPD in 2018 to more than 8 million BPD by 2025. This rapid rise in demand from both the petrochemical industry as well as for exports will drive the need for new pipelines to supply these facilities, especially along the U.S. Gulf Coast.

Opportunities in the pipeline industry

One of the biggest expansion opportunities for pipeline companies is in the fast-growing Permian Basin in western Texas and southeast New Mexico. Oil output in that region is expected to double from 2019 to 2025, going from around 4 million BPD up to 8 million BPD. Because of that, pipeline companies need to continue building infrastructure. Oil pipeline MLP Plains All American (NASDAQ:PAA) is one of several that are taking advantage of this opportunity. The company has leveraged its leading oil gathering footprint to spearhead the development of new transmission pipelines. In 2019, Plains All American had three long-haul Permian pipelines under construction and will likely be an essential partner in developing future oil infrastructure in the region. 

Associated gas and NGL output from the Permian is on track to roughly double from 2018's level by 2025. This rapidly rising output will drive the need for not only new gathering pipeline systems but also additional transmission pipelines. Natural gas infrastructure giant Kinder Morgan (NYSE:KMI), for example, had two major long-haul Permian transmission pipelines under construction and the third one in development in 2019. Given the projections that the region will need one new major transmission pipeline per year to meet the demand, companies like Kinder Morgan should have no shortage of opportunities.

The Marcellus and Utica shale regions in the Northeast are also major opportunities for pipeline companies. Gas output from those two regions is on track to increase 67% by 2030, or by about 17 billion cubic feet per day (Bcf/d). For perspective, that's almost double the growth of the Permian Basin, which is on pace to add nine Bcf/d to its gas output by 2030. The rapidly rising output from this region will drive the need for additional pipelines to bring gas to market centers along the east and Gulf Coast.

In addition to those supply-driven opportunities, the industry needs more pipelines and related infrastructure to support North America's export growth. Many pipeline companies are expanding their pipeline systems to support export-related projects like LNG terminals and export docks. In addition to that, some are also investing directly in building export assets. Kinder Morgan, for example, finished an LNG export terminal in Georgia in 2019 and had another one along the Gulf Coast in development. 

Risks facing pipeline companies

Government regulation is a major risk facing pipeline companies. FERC, as previously mentioned, sets rates for some pipelines. Therefore, it can reduce them if it deems them to be too high. It can also change its policies governing what pipeline companies can charge as part of their rates. For example, in March of 2018, FERC changed a long-standing policy that allowed MLPs to collect an income tax allowance as part of their cost-of-service rates. That reduced the cash flows these entities collected on their pipelines, which caused several to convert to a corporation.

Government agencies like FERC are also responsible for approving projects. If an agency deems a project unnecessary, it can lead to its cancellation. In the meantime, local and state governments can deny permits for pipelines that FERC has approved. For example, Williams Companies (NYSE:WMB) received FERC approval to build the Constitution pipeline. It would transport natural gas from the Marcellus and Utica shale regions to high demand centers in New England. However, environmental groups in New York oppose Williams' pipeline, which led the state's Department of Environmental Conservation to deny its water quality certification. These delays added to the pipeline's cost, which had risen from $683 million when Williams proposed it in 2013 to an estimate of $875 million in 2019.

Another major risk investors need to watch with pipeline companies is poor financial management. In the years before oil prices crashed in 2014, pipeline companies tended to distribute all their cash to investors to support their high-yielding dividends. They then had to rely on the debt and equity capital markets to raise the funds they needed to finance expansion projects and acquisitions. However, when oil prices plunged, the energy capital markets tightened up, which made it challenging for pipeline companies to raise outside financing. That forced many to cut investor payouts so that they could use that cash to pay down debt and fund expansions. Most pipeline companies have become much more fiscally conservative in the years following the oil market downturn. However, investors need to watch out for those with weaker financial metrics since they could struggle if oil prices slump again.

How to find the best pipeline stocks

Pipeline companies typically get paid fees as oil and gas flow through their systems, which enables them to generate lots of cash that they can distribute to investors. Thus, many pipeline companies pay high-yielding dividends. That makes them excellent options for retirees as well as other income-seeking investors.

However, not all pipeline stocks are great investments. Some have weaker financial profiles because they borrowed heavily to fund expansion projects at the same time  that they tried to maintain their high-yield dividends. That caused them to underperform when headwinds like oil price volatility or risks such as FERC policy changes unexpectedly cut into their cash flows.

Given the industry's risks and headwinds, investors should seek out pipeline companies that have strong financial profiles such as low leverage and high distribution coverage ratios. In addition, they should look for companies that mainly operate stable transmission pipelines as well as in high growth areas like the Permian Basin or Marcellus shale. These factors should reduce the risk that something will derail a pipeline company's ability to continue expanding its operations, cash flow, and shareholder distributions.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.