It is no secret that hydrocarbon energy companies are generous with their dividends. And the dividend safety is quite high, with the energy companies within the S&P 500 sporting modest payout ratios (the percentage of a company’s earnings paid out in dividends) at 37%. However, their distributions primarily depend on produced volume, the prices they can charge, and their access to capital to support growth projects.
The supply and demand for energy can vary, and we have seen a few major swings in recent years. We saw the shale boom lead to plummeting prices and oversupply of oil in the 2010s. We saw the global pandemic bring down prices, but the insatiable demand associated with the economic recovery resulted in soaring prices. The distributions from this sector must be monitored on a company-by-company basis. Some companies can sail through or even thrive during a recession, while others can run into turbulence even during bullish times. The cycle for energy doesn't always correlate with the overall economic cycle.
Midstream refers to a segment of energy companies that own and operate pipelines, storage, transportation, and processing assets that help move hydrocarbons from their extraction points to their consumption, processing, or export locations. It is well-known that crude oil and natural gas prices are volatile, but several midstream operators don't care, thanks to their fee-based contracts with take-or-pay arrangements with credit-worthy Exploration & Production firms. The fee-based arrangement makes their business more correlated with demand for commodities and relatively immune to commodity price volatility. For example, despite the oil shock in early 2020 due to the global pandemic, the U.S. Energy Information Administration estimates that global demand for oil fell just 8.5%.
Let us now look at two midstream operators that are asset-rich and maintain high cash flows and liquidity to self-fund their operations, all while paying generous distributions.
Pick 1: EPD – Yield 7.1%
Formed in 1968, Enterprise Products Partners (EPD) is one of the largest midstream companies in North America, operating over 50,000 miles of pipeline, over 400 MMBls of liquid storage, 20 deep water docks, 42 natural gas processing trains, and 26 fractionators. EPD is more focused on NGLs and petrochemical products, making its commodity base an essential feedstock for global manufacturing as 96% of manufactured goods are based on products derived from petroleum.
EPD maintains an investment-grade balance sheet with an A3 credit rating, the best in the midstream business. At the end of Q2, EPD reported a 3x leverage ratio and a 4.7% weighted average cost of debt. The company maintains $3.4 billion in liquidity, positioning it well to tackle its well-staggered maturities and to expand its asset base organically and through accretive M&A activity.
EPD has delivered growing dividends to shareholders for 26 years. The partnership’s current payment represents a 7.1% annualized yield and enjoys a 1.7x TTM distribution coverage. Moreover, EPD has utilized 50% of its 2019 unit buyback plan with $40 million worth of unit repurchases during Q2. The company has $1 billion available to continue unit repurchases.
With high insider ownership (32%), adequately covered distributions, significant unit repurchases, investment-grade balance sheet and strong liquidity position, EPD checks all the boxes for a solid long term investment.
Pick 2: WES – Yield 8.8%
Western Midstream Partners LP (WES) owns and operates 21 gathering systems, 69 processing and treating facilities, seven natural gas pipelines, 12 crude oil/NGL pipelines, and over 14,000 miles of pipeline infrastructure across key basins in Texas, New Mexico, Colorado, Utah, and Wyoming.
During 1H 2024, 95% of the wellhead natural gas volume and 100% of the crude oil and produced water throughput were serviced under fee-based contracts, resulting in 88% of the midstream company’s revenues being derived from fee-based services.
WES maintains an investment-grade BBB- balance sheet with a leverage ratio of 3x at the end of Q2. The midstream MLP has over $2.3 billion in liquidity, including its $344 million cash on hand and $2 billion credit facility. The company projects FCF to be between $1.05 - $1.25 billion and $2.3 billion in adj. EBITDA for FY 2024, marking a 19% and 11% YoY increase, respectively. In the past twelve months, WES has repurchased $128 million of its common units.
Altogether, WES is delivering the trifecta for shareholders: unit repurchases, debt reduction, and distribution raises. This rare investment-grade MLP has ~ a 9% yield, indicating solid prospects for improved valuations and strong total returns for shareholders.
Conclusion
Thanks to their long-term fee-based contracts with E&P firms, midstream companies are able to maintain consistent cash flows that are disconnected from underlying commodity prices. These companies maintain an asset base that is so widespread and extensive that there is a significant cost barrier for new players. Moreover, strict regulations make it very difficult for new projects to receive approvals, making the existing network tremendously valuable.
As we approach a weakening economy with volatile energy prices due to uncertainties over demand, having exposure to midstream is essential for income safety. With generous distributions from these companies, the next time you fill up at the gas station, turn up the heat this winter or buy something made of plastic, remember that a small percentage of your expense goes straight into your pocket. This is income investing at its finest—earning from everything around us. That’s the value proposition of our Income Method.
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