This section is designed for people that are brand new to energy infrastructure or those that simply want a refresher. Energy infrastructure, or midstream, companies are engaged in the transportation, storage, and processing of natural resources. These fee-based business models benefit from the abundance of natural resources in the US and generate consistent cash flows. An investment in energy infrastructure is an investment in North America’s continued production and consumption of transportable energy over the next several decades.
The Very Basics
Energy infrastructure (EI) companies are involved in the transportation, processing, and storage of oil, natural gas, and natural gas liquids (NGLs). To a lesser extent, energy infrastructure companies may also transport or handle renewable natural gas, renewable fuels, feedstocks for producing renewable fuels, and carbon dioxide.
Historically, a majority of the midstream space was structured as master limited partnerships, or MLPs (we won’t cover MLPs extensively in Energy Infrastructure 101, but those looking for more information can find it in our MLP Primer). However, C-Corporations have become more prominent in midstream in recent years.
The Basic EI Business Models
- Transportation Energy commodities such as oil and natural gas are moved from one place to another through a pipeline, or via truck, railcar, or ship. It’s important to note that pipelines are the cornerstone of the energy infrastructure space, and most energy is transported through pipelines.
- Processing Put simply, processing is transforming a raw commodity into a usable form. This includes removing impurities such as water and dirt from wellhead natural gas and separating the natural gas stream into pipeline-quality natural gas and NGLs, which are used as heating fuels and petrochemical feedstocks.
- Storage Storage includes tanks, wells, and other facilities both above and below ground. These assets provide flexibility to the energy economy, so there is propane available for winter heating, gasoline for summer driving, and jet fuel for travel.
How Energy Infrastructure Companies Make Money
Energy infrastructure companies typically operate fee-based business models. EI companies earn a set fee for each barrel of oil or million British Thermal Unit (MMBtu) of natural gas transported, stored, or processed (in the case of natural gas) regardless of the price of the hydrocarbon. This is because these companies typically do not own the oil or gas. EI companies generally sign long-term contracts (5 to 20 years in length) with their customers, which makes for stable cash flows. Accordingly, the revenue equation for most business activities is fairly simple: fee multiplied by volume. As such, more volumes mean more cash flows. Fees may be negotiated based on market rates or based on the cost of operating the pipeline. Depending on the pipeline, a federal or state agency will have oversight of the fees charged to ensure rates are reasonable.
How Investors Make Money with Energy Infrastructure
If you own a stock, there are two ways to make money. The price of the stock increases and you can sell it for more than you bought it (price appreciation), and the stock pays a dividend (income). The dividend amount relative to the share price is known as yield.
The historical average yield of energy infrastructure over the past five years has been approximately 6.5%. In other words, if you invested $100, on average, you would be paid $6.50 each year.
The chart below shows yields for energy infrastructure, represented by the Alerian Midstream Energy Index (AMNA), compared to other asset classes. Energy infrastructure boasts a higher yield than utilities and real estate investment trusts (REITs), which are asset classes known for their income potential.
The Pipeline Business, Explained
The modern pipeline network in the United States has its roots in the outbreak of World War II. Before the war, the East Coast was the largest consumer of energy in the country. Refined products (such as gasoline, diesel, and jet fuel) were delivered from Gulf Coast refineries via tankers. Tankers also carried raw crude oil from the Middle East. However, once the U.S. became involved in the war, German submarines began sinking these tankers. Together, the U.S. government and the petroleum industry built pipelines that could cover long distances and transport large amounts of petroleum. This network subsequently fueled the economic boom that followed
the war, and many of those original pipelines are still in service today.
Pipelines can be quite large or relatively small. Large diameter trunk lines are often three-and-a-half feet in diameter. Think of them as interstate highways that can handle a lot of traffic. Smaller delivery lines connect the large pipelines to each town.
Product traveling through trunklines is fungible—that is, the customer will receive the product on the other end that is the same quality as that which was sent, but they won’t be the exact same molecules. It is as if someone sent $100 to a college student through a bank. That student will not get the exact same $100 bill as his or her benefactor sent, but the student doesn’t care because $100 is $100.
However, smaller delivery lines operate on a batch system, where the exact same molecules are delivered as were shipped. In this case, a loved one sends our lucky college student a couple dozen cookies, and the ones delivered are the exact same cookies that were sent.
The term “energy renaissance” refers to the transformative growth in U.S. energy production that has occurred over the last several years, culminating in the U.S. becoming a net energy exporter in 2019.
Prior to the 2000s, much of the energy industry was focused on peak oil and the ways companies and our society would have to shift in response. While producers knew that oil reserves existed, accessing the oil in a cost-effective way was difficult. Experts forecasted that expensive and complex recovery methods would be needed to continue to produce even a modest number of barrels.
In the early 2000s, the natural gas industry in the U.S. began widespread application of horizontal drilling and hydraulic fracturing. The technologies were not new, but the combination of the technologies made it possible to profitably produce the large reserves of crude oil, natural gas, and NGLs trapped between layers of North American shale rock. Horizontal drilling was developed in the first half of the 20th century, and the first commercial applications of hydraulic fracturing took place in 1949. After seeing the success of natural gas companies in applying these technologies, oil producers began implementing the same drilling technology, seeing strong production growth from oil wells.
In 2009, the US became the world’s largest producer of natural gas. By 2012, the US had an abundance of natural gas, leading to lower prices, but gas production continued to grow. In 2014, rapid growth in US oil production had led to a global crude oversupply and weakness in oil prices. A multi-decade ban on US crude exports was lifted by Congress in December 2015. In 2018, the US became the world’s largest oil producer. For the first time since the early 1950s, the U.S. in 2019 was a net energy exporter and remained so in 2020.
The U.S. exports liquefied natural gas (LNG) and millions of barrels per day of crude and refined products like gasoline and diesel. As shown in the chart below, U.S. energy production is expected to rebound and remain fairly steady over the long-term, with natural gas production expected to grow noticeably.
The outlook for production growth contributes to expectations that the U.S. will remain a net energy exporter in the coming decades.
What the North American Energy Landscape Means for Energy Infrastructure
The tremendous growth in U.S. oil and natural gas production necessitated a significant investment in the buildout of new energy infrastructure. While not as dramatic, energy production from Canada has also increased, necessitating new infrastructure. The production growth seen over the last decade or so in the U.S. and Canada would not have been possible without these infrastructure assets.
Clearly, this massive infrastructure buildout had a hefty price tag, with midstream companies spending significant capital for years. However, annual capital investment peaked in 2018 or 2019 as production growth rates were expected to moderate. The weakness in oil prices in 2020 led to a decline in U.S. energy production, and companies recalibrated spending plans in response, with some planned projects tabled. While U.S. energy production is expected to recover into 2022, midstream capital spending plans are generally more modest than in the past. As such, midstream is expected to enjoy the fee-based cash flows of previously completed projects, while reduced growth spending should allow for significant free cash flow generation.
If you have listened to a company’s earnings call, viewed an investor presentation, or perused a company’s annual report, you will have noticed disclaimers and/or a discussion of risk factors. While some of these risks may be unlikely to occur, they could impact your expected total return. While several key risks are discussed below, this list is not intended to be exhaustive.
Commodity Price Sensitivity – Since energy infrastructure companies do not typically own the oil and gas they transport, their business performance is less directly connected with the price of oil or gas. However, commodity prices can have implications as there are indirect connections between energy prices and the performance of midstream companies. If commodity prices are very low, upstream companies will drill less, and demand will fall for gathering pipelines and other infrastructure. Additionally, in an environment with falling commodity prices, investor psychology may connect energy infrastructure with the broader energy sector and commodity prices beyond what the underlying business models would otherwise indicate. In other words, commodity prices can impact sentiment for energy infrastructure companies.
Environmental Risk – Some pipelines in major transportation corridors were constructed in the 1950s and 1960s. An aging pipeline system, as well as high-profile oil spills and gas leaks, have increased investor concerns regarding transportation safety and environmental risks. Pipelines are by far the safest form of transportation for oil and natural gas. Increased maintenance and new technologies enabling more frequent and accurate monitoring of pipelines has helped improve pipeline safety.
Alternative Energy and Demand Destruction – The potential for alternative energy (solar, wind, hydro, electric vehicles, etc.) to replace hydrocarbon-based energy is a long-term risk for energy infrastructure companies as demand for the products handled by midstream companies could change. Energy transitions tend to take many years, but energy infrastructure companies are actively evaluating opportunities in alternative energy today. Perhaps, pipelines could be repurposed in the future to transport captured carbon dioxide or hydrogen. Existing infrastructure assets should be largely compatible with drop-in fuels like renewable natural gas or renewable diesel that have a similar chemical makeup as their hydrocarbon-based counterparts. The adoption of alternative energy sources represents a risk for energy infrastructure but may also provide opportunities.
Recontracting Risk – Recontracting refers to midstream companies having to renew or establish new contracts with customers when existing long-term agreements expire. Market dynamics may have changed since previous agreements were put into place, potentially making it difficult to sign contracts with a similar fee structure. Companies often stagger their agreements across their asset base and even for a single pipeline to help mitigate recontracting risk.
Regulatory Risk – Government policies impacting the production of oil and natural gas or the regulation of pipelines could have implications for energy infrastructure companies.
Permitting Risk – The permitting process for a new pipeline involves federal and state government approvals and permits, as well as environmental impact studies and potentially eminent domain complications. Each state has its own regulations, and pipelines often pass through many states. Should an approval not be granted (or conditionally granted), a pipeline may need to be rerouted, which is an expensive and time-consuming necessity. Any delays or cost overruns in the permitting process may make the project less profitable, as well as potentially prevent the pipeline from being built, resulting in lost sunk costs for the company. With fewer major new-build pipelines under construction, permitting risk has become less relevant for many midstream companies.