Mar 265 min read

Midstream MLPs: Stocks in Goldilocks Stage of Upcycle

New York, NY, Ed Ryan, InfraCap COO - In our view, the midstream energy sector is in the Goldilocks stage of what could be a long and extended upcycle. This stage is characterized by stable and growing cash profits, balance sheet strength and shareholder-friendly actions. Domestic oil and gas production is at record levels and still rising. Export markets are a growth driver.

The Goldilocks stage has the potential to be very rewarding for shareholders. I want to address some questions being asked by investors.

Did my clients miss the sector move?

Midstream stocks are in a commodity sector where volatility returns without warning. We think the sector is best for long-term investors, not traders. We encourage the following approach:

Dollar-cost average to build a position. The stocks are at new highs but the pattern since the market lows is for the stocks to back off after hitting new highs. Higher lows are then followed by higher highs. This pattern could persist and give investors a chance to benefit from the volatility.
Buy the stocks for the rising cash distributions and leave them to your estate. We expect steady growth in cash distributions. Tax deferral benefits are maximized by transferring your holdings to your heirs. Talk to your tax advisor and trust attorney for more information.
Manage the position size to minimize client anxiety. Midstream businesses are largely stable and slow-growing, but the stocks can be as volatile as oil prices. Some income-focused clients might prefer a half-sized position in their portfolios.

What happened to the forecasts of peak oil and gas demand?

Doomsayers forecasting shrinking demand for oil and gas were wrong. The energy transition to renewable resources is not happening.

Global demand for energy is growing at a pace that cannot be satisfied by the buildout of wind and solar projects. Renewable resources are simply being layered on top of traditional supplies. Energy from all sources is needed to meet growing demand.

In recent years, advocacy for the green dream clouded public perceptions. Forecasts made by the International Energy Agency (IEA) tell the story. Most people mistakenly think of it is an independent observer of the global energy industry.

In 2021, the IEA issued a report1 making the case that global oil demand had peaked in 2019 at 100 million barrels per day and would shrink to 72 million barrels per day (mb/d) by 2030. Many believed it and avoided traditional energy stocks.

How’s this for a transition? The end-of-decade projection for global demand was raised sharply higher just two years after it was made. In 2023, the IEA forecast global demand2 of 105.7 mb/d in 2028, a level 46% higher than the 72 mb/d estimate it highlighted in 2021. Demand in 2023 reached a new high of 101.7 mb/d.

The IEA is not unbiased. In 2015, it recast its mission to formally adopt advocacy for an energy transition away from hydrocarbons alongside its advocacy of energy security3. In doing so, it swayed public opinion toward an impractical outcome. Confidence in the outlook for traditional energy companies was shaken.

Demand for oil and gas may eventually peak in the world’s largest developed economies, a group that includes the USA, Western Europe, Canada, Japan and Australia. Interest in controlling carbon emissions is strongest there. The population totals about one billion people.

But in the Rest of World (ROW), including India, Asia, Africa and Latin America, the unmet demand for energy is enormous. The population totals about seven billion. Per capita consumption of hydrocarbons is a small fraction of per capita consumption in the most developed economies. An estimated 3 billion people have no electricity. One billion burn wood and cow dung to cook.

To take people out of poverty, the ROW needs reliable, low-cost energy resources. Hydrocarbons, including coal, are the resources that can fill a large part of that need.

The US is the largest producer of hydrocarbons in the world, and there is likely to be strong demand for its exports. Midstream infrastructure companies will be critical to the improved economic well-being of the developing world. We think U.S. oil and gas production is likely to exceed market expectations in coming years.

What’s the outlook for cash distributions?

When we wrote about the sector in October 2022, we said accelerating distribution growth is the coming story. We are in that period now.

The key to this story is steady growth in operating cash flow in combination with reduced capital spending on growth projects. Capex fell more than 50% in 2021 from its peak in 2019 but rebounded modestly off its low4.

We expect spending to be constrained in the coming years, influenced by political and regulatory factors. For most companies, capex will be funded internally.

This leaves more cash available for shareholder-friendly actions. Debt repayment has already strengthened balance sheets and lowered leverage ratios. Other priorities for cash allocation are taking the lead.

Shareholder cash returns are the focus. Capital allocations to dividends and share buybacks will grow by about 32% by 20284. Companies will be evaluating which of those two alternatives is the best way to boost shareholder value.

In the last cycle, companies chose to distribute as much cash as possible and valuations rose in response. Coverage ratios got very low and capex was funded with debt. Those trends might re-emerge late in this cycle, but in the medium-term, we expect coverage ratios to stay high and debt issuance to be minimal.

InfraCap MLP ETF

Our actively-managed energy infrastructure ETF (AMZA) may meet the needs of your income-focused clients:

AMZA maintains its focus on Master Limited Partnerships (MLPs) in order to maximize the amount of cash available for distribution to investors.
Tax deferral benefits are passed through the fund’s C-Corp legal structure to shareholders. Tax reports are issued on Form 1099, like other corporate entities.
AMZA owns a highly concentrated portfolio of some of the leading midstream MLPs and C-Corps. The top five positions accounted for 62% of the fund’s total assets on Mar 20, 2024.
It uses modest leverage (20-30% of NAV) and writes covered calls.
The fund’s NAV is over $380 million, as of Feb 29, 2024.