Energy ‘Middlemen’ are ideal for those who love income.
Energy 'Middlemen' are ideal for those who love income.
Midstream Companies: The Resilient and Rewarding Investment Option
Investing in the energy sector has been quite a roller coaster ride in recent years. The energy industry experienced a series of ups and downs, with the energy sector being the worst performer in the S&P 500 in 2018, 2019, and 2020. However, things took a turn in 2021 and 2022 when the energy sector emerged as the top performer. Unfortunately, in 2023, the sector is projected to go back to its previous struggles, competing for last place with utilities. The problem with energy returns lies in their constant connection to volatile oil and natural gas prices. So, what can investors do to invest in the energy industry while seeking steady and reliable income?
The Pitfalls of Upstream and Downstream Investments
When it comes to investing in energy, it is crucial not to focus on the upstream and downstream segments of the industry, as both can be highly volatile and unpredictable.
Upstream companies, known as energy exploration and production (E&P) companies, engage in identifying energy deposits, drilling wells, and recovering raw materials from the ground. As the most directly tied segment to oil and gas prices, their stocks typically experience the biggest swings. Therefore, focusing on E&P companies is not recommended for investors seeking stability.
On the other hand, downstream investments involve crude oil and natural gas refineries that transform raw products into gasoline, heating oil, and other refined products. These businesses face a different source of volatility, as the price difference between raw energy (their input) and refined products (their output) can be wild and unpredictable. Thus, downstream investments also lack the stability investors might be looking for.
The Middle Ground: Midstream Companies
Instead of focusing on upstream or downstream investments, it is wise to shift attention to midstream companies within the energy sector. These companies play a crucial role in transportation and connectivity within the industry, making them less tied to commodity prices and offering more stability for investors.
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Midstream companies act as the “middlemen” of the energy business, connecting producers and end users. They are responsible for transporting crude oil, natural gas, and refined products through a network of pipelines, rails, barges, and tankers. Their revenue comes from the fees charged for the use of the infrastructure they’ve built. Once the infrastructure is in place, the heavy lifting is done, and investors can sit back and collect the steady income generated.
Overcoming Past Challenges
Despite the potential advantages of midstream companies, some investors have been hesitant to invest due to past industry challenges. During the U.S. shale boom of the last decade, midstream companies prioritized growth over profitability, taking on projects with poor return prospects. This approach led to difficulties in 2015 and a subsequent period of unpopularity among investors.
However, it is important to note that today’s midstream companies are in much better shape. They have been steadily paying down the debt accrued during the shale boom and are now focusing on profitability and shareholder returns. Leading midstream companies such as Enterprise Products (EPD), Kinder Morgan (KMI), and ONEOK (OKE) are paying dividends north of 6%, which is significantly higher than the S&P 500’s average yield.
The Appeal of Midstream Companies
Midstream companies offer more than just attractive dividends. They are well-insulated from competition, as acquiring government approval for new pipelines is no longer a straightforward process. Although this may limit growth, it also prevents excessive capital spending and the entry of potential competitors, ensuring the stability of existing midstream investments.
Concerns have been raised about the future relevance of midstream infrastructure as the world transitions to cleaner energy sources. However, even the most optimistic forecasts about the clean energy transition still predict a rise in the demand for fossil fuels in the coming years. In particular, oil and natural gas are projected to remain critical components of the global energy mix for decades to come. Therefore, midstream companies remain well-positioned to serve this ongoing demand.
Addressing Investor Concerns
While midstream companies offer attractive investment opportunities, there are some considerations to keep in mind. Many midstream companies are structured as master limited partnerships (MLPs), which means they issue K-1 forms for tax purposes. Dealing with K-1s can be a major headache during tax preparation.
Fortunately, there are alternative options available for those interested in midstream companies but prefer to avoid the complications of K-1s. Some midstream companies are structured as C-corps, which are easier to manage from a tax perspective. Additionally, closed-end funds specializing in energy MLPs can provide an avenue for investing in midstream companies without the hassle of dealing with individual MLP stocks and their associated K-1s. These closed-end funds issue 1099 forms for tax reporting, simplifying the investment process.
Rewarding Opportunities at a Discount
Investing in midstream companies through closed-end funds has its own unique advantage – the opportunity to buy assets at a discount. Unlike mutual funds, closed-end funds do not continuously issue and redeem shares. Instead, they are traded among investors. As a result, closed-end funds often trade at a premium or discount to their underlying asset value.
Currently, all but one of the listed closed-end funds specializing in midstream investments are trading at a discount. This is typically the case when a fund focuses on a market segment that has fallen out of favor with investors. Buying a fund at a 15% discount, for example, allows investors to acquire $1 worth of assets for only 85 cents, further increasing the potential returns.
A Dream for Income Seekers
In summary, midstream companies present a resilient and rewarding option for investors seeking stable income within the energy sector. These companies are not tied to volatile commodity prices, prioritize profitability, and offer attractive dividends. By investing in midstream companies through closed-end funds, investors can also avoid the complexities of K-1s, while benefiting from potential discounts on assets. It’s a dream come true for income-driven investors, an opportunity worth seriously considering.
