Oil prices continue to defy logic. Having dipped below $60 per barrel in the final week of 2014, a lot of investors have lost their shirts.
At the same time, it is becoming increasingly clear that investors think the market may have hit a bottom. Despite the fact that oil prices fell 22 percent in the month of December, investors poured over $3.3 billion into exchange-traded funds that focus on energy companies, a record amount and more than four times the average for 2014.
That’s because bargain hunters are beginning to pounce, expecting energy prices to rebound. Goldman Sachs thinks it’s time to get back in on energy. In a note to investors, the investment bank recommended 27 energy stocks that offer huge growth opportunities. Market pessimism has these companies trading below their forward-looking valuations, offering an excellent entry point.
But given how volatile oil prices have been – there has been a litany of trading days where oil prices look set to rebound, only to resume their downfall – it is far from clear how upstream companies will perform in the coming months. However, there is one energy subsector that has strong growth prospects even in a period of oil price swings.
In last week’s Executive Report, we discussed how the downstream sector can perform well during an oil and price downturn. We also touched briefly on the midstream sector, which can also provide resilient investment opportunities in the current…
Oil prices continue to defy logic. Having dipped below $60 per barrel in the final week of 2014, a lot of investors have lost their shirts.
At the same time, it is becoming increasingly clear that investors think the market may have hit a bottom. Despite the fact that oil prices fell 22 percent in the month of December, investors poured over $3.3 billion into exchange-traded funds that focus on energy companies, a record amount and more than four times the average for 2014.
That’s because bargain hunters are beginning to pounce, expecting energy prices to rebound. Goldman Sachs thinks it’s time to get back in on energy. In a note to investors, the investment bank recommended 27 energy stocks that offer huge growth opportunities. Market pessimism has these companies trading below their forward-looking valuations, offering an excellent entry point.
But given how volatile oil prices have been – there has been a litany of trading days where oil prices look set to rebound, only to resume their downfall – it is far from clear how upstream companies will perform in the coming months. However, there is one energy subsector that has strong growth prospects even in a period of oil price swings.
In last week’s Executive Report, we discussed how the downstream sector can perform well during an oil and price downturn. We also touched briefly on the midstream sector, which can also provide resilient investment opportunities in the current market situation. Let’s dive a little deeper into the midstream sector now.
Midstream Energy – Steady Profits
Midstream companies offer investors a safe haven from commodity price swings. Here’s why. Companies that own pipelines and storage tanks earn fees from the functions these assets perform – moving and storing oil and gas. Those fees are often fixed and not influenced by the ups and downs of the oil markets. They are also usually agreed to under long-term contracts, offering certainty to owners of pipelines and storage facilities.
Moreover, even during periods of low demand, pipeline owners have signed customers up to long-term contracts for a given amount of capacity, meaning they get paid whether or not the pipelines operate at full capacity. Upstream or downstream companies essentially lease pipeline space, and must pay regularly even if oil and gas flows slow down.
This insulates pipeline owners from market crashes, and ensures much steadier profits relative to their upstream and downstream peers.
Midstream Set to Grow
Not only are profits insulated from commodity price swings, but demand is still growing for more pipeline and storage capacity.
Coal and nuclear power plants are shutting down as cheap natural gas – and in the case of coal, stiffer environmental regulation – force these plants out of the market. Just this week Vermont’s sole nuclear power plant shut down after 42 years of operations.
Renewable energy is making strides, but natural gas is forming the backbone of new electricity capacity. That means more natural gas needs to get from the shale patch to the power plant, hence the demand for pipelines.
Another big source growth for the midstream energy sector is the construction of export terminals on the Gulf Coast to send liquefied natural gas (LNG) abroad. Cheniere Energy’s (NYSE: LNG) Sabine Pass facility is under construction, and needs a steady supply of natural gas to feed its shipments once it comes online. That means as long as LNG export terminals such as Sabine Pass and others along the Gulf Coast remain in operation, there will be strong demand for pipeline capacity.
One pitfall for midstream companies is the potential for drillers to go out of business because of low oil or natural gas prices, killing off new demand for pipeline capacity. But just as growth on the supply side could damage midstream companies, demand from end users is picking up. In other words, downstream demand for more pipeline capacity is picking up where upstream drillers are leaving off.
While not all of the proposed projects will be constructed, an estimated $116 billion worth of petrochemical investments were slated to be completed over the next several years along the coast in Texas and Louisiana. According to the Federal Reserve Bank of Dallas, petrochemical manufacturing and refining is expected to grow by 33 percent by 2017.
Who Are the Players?
Kinder Morgan (NYSE: KMI), the largest pipeline owner in North America, is the obvious choice for investors looking at this sector. It is big, diversified, and this year it consolidated several companies into one behemoth that has its sights set on further growth.
Kinder Morgan operates over 80,000 miles of oil and gas pipelines across the U.S. and Canada. Approximately 54% of its business comes from leasing capacity to move natural gas through its pipelines. The company also stores refined petroleum products – gasoline, jet fuel, etc. – and other commodities such as ethanol, steel, coal, pet coke, and more. It has pipelines connected to every major natural gas resource play. It also operates over 180 shipping terminals capable of handling both liquids and dry bulk products.
As mentioned above, Kinder Morgan earns most of its revenues from fixed contracts that are not impacted by oil prices. In fact, an estimated 82% of the company’s cash flows for 2014 were fee-based, with another 12% hedged. This means its exposure to price swings for oil and gas is limited.
Kinder Morgan has increased its dividend each of the last four years and expects to issue a 2015 dividend of $2.00 per share, which is a 16% increase over 2014.
Kinder Morgan is in a strong position. It moved 33 billion cubic feet per day (bcf/d) of natural gas across the U.S. in early 2014, compared to a total market of 100 (bcf/d). As that market grows, so will Kinder Morgan.
One of Kinder Morgan’s competitors is Spectra Energy (NYSE: SE). The Texas Eastern pipeline, a major natural gas pipeline that runs from the Gulf Coast to the northeast (and was touched on previously in this column) is the linchpin of Spectra Energy’s portfolio. But it is also building out more capacity to integrate gas markets in the northeast.
Spectra is building a greenfield pipeline that will connect natural gas from the Marcellus and Utica shales to customers in the Midwest. This will allow industrial users, power plants, and distribution companies in Ohio, Michigan, Chicago, and Ontario to connect to the vast shale fields in Ohio and Pennsylvania.
While Kinder Morgan and Spectra Energy are on the larger end, a smaller play for investors that would offer more risk (and more upside) could be Rice Midstream Partners (NYSE: RMP). The midstream company is a spinoff of Rice Energy (NYSE: RICE), an independent oil and gas exploration company. Rice Midstream just launched its IPO in late December 2014 with a target of $604 million.
The upstart pipeline company will initially have assets moving natural gas from Rice Energy’s shale resources in Ohio and Pennsylvania, including pipelines, storage facilities, and compressor stations. It will have fee-based revenues focused on capitalizing on the ongoing growth in the Marcellus shale. The region is still underserved by pipelines, particularly connecting to the northeast. This should result in robust demand for pipeline capacity for quite some time.
Conclusion
The commodity boom over the last decade offered a nearly unbeatable opportunity for investors in the upstream sector. After cratering, the sector is looking increasingly appealing for investors to get back in after bottoming out. But who knows? The markets could remain depressed for quite some time.
Midstream assets could offer the safety and stability that investors crave, while still offering a bet on America’s energy future.
