A lesser-known subsector of energy, midstream offers compelling investment opportunities.
Investors may be less familiar with midstream as it serves an intermediary role in the energy value chain. However, this is a unique segment that provides stable cash flows, nice dividends, and can be really interesting for investors, Stacey Morris, head of energy research at VettaFi, said on May 15 during UBS Trending hosted by Anthony Pastore.
“Midstream companies are performing the shipping and handling function of the energy value chain,” Morris said. “Midstream is unique because these companies are earning fees for providing services. Often that looks like pipeline transportation of oil or natural gas, but it can also be processing natural gas and natural gas liquids into usable form.”
Natural gas liquids include propane and butane, for example. “[Midstream] is a space that helps enable our everyday lives whether you’re filling up your tank with gasoline or turning on your grill for a cookout,” Morris added.
Many midstream companies are structured as MLPs, a tax-advantageous structure in the U.S. MLPs are pass-through entities, meaning they do not pay taxes at the entity or company level. Morris said the MLP structure provides benefits to investors, primarily the potential for tax-deferred income.
“In short, what that means is you get a dividend, but you can delay paying taxes on it until you sell out of your position,” Morris said. "MLPs have historically been interesting to investors because they paid out attractive dividends. MLPs today are yielding north of 8%, which is much more than you’ll find from your typical dividend income investments; things like REITs or utilities that investors may be more familiar with.
How Midstream Is Position in the Current Environment
Midstream differs from other energy subsectors as midstream companies provide services for a fee, lending to very stable cash flows relative to a typical energy company, Morris said. The segment’s defensiveness is a favorable quality as concerns of a looming recession are top of mind.
“[Earlier this month] is a perfect example of this. We saw WTI oil prices fall 7% for the week, and midstream and MLPs were down about 2% to 3%, whereas broader energy was down 5% or 6%,” Morris said. “This is a space that can hold up well and has done better than broader energy in past recessions.”
In addition to being defensive, the generous dividends offered by midstream companies can help boost a portfolio’s overall performance during volatility in equity markets. Midstream is also better positioned to hold up during periods of high inflation.
“These companies are providing services under long term contracts, and those contracts have annual inflation adjustments built into them typically,” Morris said. “So that can be a tailwind for this space, whereas inflation may be a headache for other spaces.”
Dividend Trends and Company Fundamentals
Morris said there have been solid trends for midstream dividends over the last two years or so, highlighting that it has been seven quarters since there has been a dividend cut across the Alerian Midstream Energy Index suite.
Midstream companies are spending much less money than they used to, instead using that extra cash to grow their dividends and buy back their equity.
Midstream companies recently reported first quarter earnings. Reports were largely very strong, with a couple of names raising guidance for 2023.
“The outlook for these individual companies remains very constructive,” Morris said. “They’re executing on dividend growth and buybacks, and the free cash flow story that we’ve talked about in the space for some time is very much intact.”
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