Finding Value in Energy Midstream Companies

Intro

In a previous blog (click here to read), we discussed how the “2-10-10” screen provided us a list of candidates (midstream and downstream energy companies) who have performed well so far and could continue to perform well in this volatile oil price environment. We also talked at a high level about how those companies make money and what drives their profitability. Those companies consist of the following:

O&G Screen

In this blog we’ll look in more detail at the top companies we like in the midstream space. More specifically, we’ll focus on some of the financial metrics we like to use for further consideration and talk about some of the qualitative factors that give us additional confidence in owning such companies. This blog may look a lot like the one we did previously on downstream companies as the criteria we use to identify quality companies is the same but the qualitative reasons for why we like midstream companies will differ slightly, which we will get to in the Qualitative Section below.

Financial Metrics

There are a wide variety of metrics to look at when analyzing a company so we like to pick the metrics that give us sufficient confidence the companies we invest in are financially healthy and have a track record in both prudent debt management and historically consistent profitability. After all, this current commodity price environment is extremely volatile so prudence in finances and efficiency in management are of utmost importance. Although having a high ROE answers many of these questions, we will look a little deeper into a few other metrics that provide deeper insight into how the company manages its business. More specifically, we’ll want to ensure:

  • Current assets >= 2 * Current liabilities
    • This can be found from the company’s balance sheet. Current assets are usually liquid assets that can be easily converted into cash while current liabilities are ones (ie. Debt or other payments) usually due within a year. Ensuring current assets are at least twice as great as current liabilities gives us confidence the company can easily meet its obligations should some short-term downturn occur and not risk insolvency. This gives us a buffer in stock price depreciation, as it will decrease the chances of the stock price completely bottoming out from beneath us in an unexpectedly short period of time.
  • Debt / EBITDA < 4
    • This ratio looks at total debt compared to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Generally speaking, debt should not be so great that it overwhelms the company’s earnings. What we want to see is a declining ratio over time, which tells us that the company is getting better at managing its debt and/or increasing its earnings power.
  • EBITDA / Interest Expense >> 1
    • By looking at EBITDA compared to the interest a company pays on its short-term debts, we can get a feel for how much of its earnings are used just to pay it’s interest liabilities. A ratio close to 1 should send up some red flags so we want a ratio much greater than 1.
  • Consistent history of dividend payments and sufficient growth
    • A dividend is what gets paid back to shareholders after operating expenses, taxes, interests on debt, etc. are paid. We like to see a consistent and increasing dividend payment to shareholders over a long time period as this gives the investor insight into how well management is managing company finances while being able to generate some return to the investor with a consistent, increasing dividend payment.
  • Return on Invested Capital (ROIC)
    • Probably one of the most important measurements of management effectiveness and ability to be profitable. It is calculated as: (Net Income – Dividends) / Invested Capital. As a rule of thumb, the greater the ROIC, the more attractive the investment as this is an indication of how well management can earn returns on capital deployed. We aim for ROIC’s of greater than 15% or at least greater than the company’s weighted average cost of capital, but sometimes that is difficult to get in some industries. If that is the case, then we will look for those with the greatest ROIC compared to their peers.
  • Comparison of Free Cash Flow to competitors
    • Free cash flow is a key metric in measuring any company’s ability to generate sustainable profits. It is the amount of cash earned after taking into account what the company needs not only to maintain operations, but also to expand its business. The higher cash flow per share, the better. (NOTE: Because these companies are Master Limited Partnerships and the nature of the business – high amount of capex spent on expanding infrastructure, this metric, while still relevant, should not be a silver bullet in investing decisions as these companies’ cash flow will likely be impacted by large capex spend. We invest in MLP’s, typically not for appreciation in stock price but for the growing and consistent distribution to unit holders.)
  • Higher profit margins compared to competitors
    • This one is self-explanatory. We want companies who have refined their operations and can generate higher income while maintaining a low operating cost compared to their peers.

The table below summarizes the past 10 years’ results of each of our six primary midstream candidates: Magellan Midstream Partners (MMP), Genesis Energy (GEL), EQT Midstream partners (EQM), Holly Energy Partners (HEP), Enterprise Products Partners (EPD) and Buckeye Partners (BPL).

Midstream Compare 1

Midstream Compare 2

Given the tables above, we can see how each of these companies compare with each other based on the metrics outlined above and who, in our opinion, tops (or done exceedingly well) each category under the “Stand Outs” column.

First, we’d like to highlight note on our methodology for selecting top companies in each category. Generally speaking we are looking for two things:

  1. Consistency in above average (or better-than-peers) performance AND
  2. Improvement from historical performance in most recent years (particularly since oil & gas prices have been beaten up pretty badly in 2014 through now).

As a result, the three companies that stand out in our analysis are: EQM, HEP and MMP. All three are financially healthy and conservative with highly effective management. Below we will get into a few more details on primary areas of operation and qualitative factors on why we like them.

Qualitative Factors

What are some of the factors driving the attractiveness of these companies? If we go back to our recent blog describing how midstream companies, work, we’ll recall that they make their money primarily on fee-based contracts for volumes transported or stored which means their revenue stream is highly dependent on consistent and increasing volumes from producers. Wait a moment though, aren’t U.S. producers struggling to keep up volumes with low oil and gas prices? True, but not true for all producers. We must be highly selective in whom we pick to make sure these companies are not exposed to producers or regions that face excessively high development costs. Having said this, let’s take a brief look at where MMP, EQM and HEP primarily operate, potential volume loss (supply or demand) risks and what they may have going in their favor.

Magellan Midstream Partners (MMP)

  • MMP is a major provider of storage (inland and marine) and transportation services for refined products (primarily gasoline and diesel), crude oil, condensate and ammonia. This is key as gasoline and diesel are still very much in-demand transport fuels. It’s unlikely we’ll see a massive shift over to Tesla vehicles in the short-term.
  • Their pipeline network stretches over 9,700 miles with access to approximately 50% of the nation’s refining capacity. This provides MMP ample access to a diverse and wide array of supply options. Majority of their assets are anchored by long-term, fee-based commitments and in some cases, take-or-pay
  • About 85% of their revenue comes from low-risk activities such as transportation tariffs (58%), leased storage (15%) and other fees (12%) while 15% of their revenue is directly subject to commodity price swings.
  • Capital expenditures on expansion infrastructure are expected to exceed USD 500 MM over the next two years on much-needed infrastructure, including incremental refined product export capacity to capture higher margins in overseas markets.
  • Targeting 10% distribution growth for FY 2016, having already successfully distributed over 56 quarters since its IPO.
  • Below is a snapshot of MMP’s asset footprint

MP Footprint

Primary MMP near-term risks:

  • Low crude oil price may impede continued production of crude oil, therefore limiting supply of crude as a feedstock.
  • Economic headwinds (both local and international) may slow down demand for transport fuels
  • Tightening fuel efficiency standards mandated by the government may slow fuel demand growth

 

EQT Midstream Partners (EQM)

  • Growth-oriented Limited Partnership formed by EQT Corp. (an E&P company specializing in Utica and Marcellus shale) to own, operate, acquire and develop midstream natural gas and natural gas liquids solutions in the Appalachian Basin (incl. Utica and Marcellus). Majority of its services are based on long-term contracts, firm reservation or usage fees. The revenue structure of EQM is setup so that it is much less susceptible to fluctuations in commodity prices, assuming production in the region is economically viable.
  • This region, for those who are not familiar, is the fastest growing gas play in the country and in an area where there was very little infrastructure to begin with and adjacent to the country’s largest demand center, the U.S. East Coast. As a result, demand for infrastructure is tremendous.
  • EQM is strategically located in the core of the Marcellus and Utica, meaning its assets stretch over the most productive parts of the play and subsequently can access many of the interstate pipelines (5 to be exact) in the region delivery supply to major demand regions while having connectivity to 4 LDCs and 14 storage fields.
  • EQT, its primary General Partner, is a major producer in the region, and accounts for over 70% of EQM’s revenue. While being dependent on one producer is risky, it is worth noting that EQT has established a strategic position in the Marcellus and Utica plays and has very attractive economics with gas as low as $2.00/MMBtu. EQT was able to grow sales volumes by 27% in 2015, a notable feat given the challenging gas price environment.
  • Looking forward, EQM has plans to organically expand its footprint with an additional 1.5 Bcf/d of planned transmission capacity while enhancing pipeline connectivity in the region.
  • As far as distributions go, EQM is planning for 20% distribution growth through the end of 2017, also a notable feat while others are growing distributions at only at high single-digits.
  • Below is a snapshot of EQM’s asset footprint:

 

EQM Footprint

Primary EQM near-term risks:

  • Low natural gas prices may slow development of natural gas production
  • Increased scrutiny (and potential increased regulation) into hydraulic fracturing in PA and WV may slow gas production

 

Holly Energy Partners (HEP)

  • HEP’s business is the operation of petroleum product and crude pipelines, storage tanks, distribution terminals and loading rack facilities in the mid-west to western U.S., primarily West Texas, Utah, New Mexico, Nevada, Oklahoma, Wyoming, Kansas, Idaho and Washington. Their assets support the refining and marketing operations of Holly Frontier Corp (HFC) in the Mid-Continent, Southwest and Rocky Mountain regions of the U.S.
  • Revenues are made, similar to MMP and EQT, by charging tariffs for transporting petroleum products and crude oil through pipelines or by charging fees for terminalling and storing refined products and other hydrocarbons.
  • HEP owns approximately 3,400 miles of crude oil and petroleum product pipelines with 14 million barrels of crude oil storage. That’s in addition to 9 terminals and 7 loading rack facilities in 10 western and mid-continent states.
  • Similar to Valero in the pervious blog, HEP has access to five complex refineries with a total capacity of 443 Kbbls/d with an average Nelson complexity of 12.2 and access to discounted WTI crude oil (Canadian supply, Bakken, Niobrara and Permian).
  • HEP has realized double digit growth in revenue, EBITDA and discounted cash flow of 16% to 17% over 10 years since inception.
  • HEP has a healthy portfolio of $400 to $450 MM growth projects that are expected to increase EBITDA by 42% compared to 2014 with just over two-thirds of capex dedicated to expansion projects.
  • Below is a snapshot of HEP’s asset footprint

HEP Footprint

Primary HEP near-term risks:

  • Low crude oil price may impede continued production of crude oil, therefore limiting supply of crude as a feedstock.
  • Economic headwinds (both local and international) may slow down demand for transport fuels
  • Tightening fuel efficiency standards mandated by the government may slow fuel demand growth

 

Bottom Line

All three companies mentioned above (MMP, EQM and HEP), in our opinion, are solid, well-run companies with strategic assets with potential to continue to perform over the longer-term as their exposure to swings in crude oil and natural gas prices is limited. MMP and HEP are both somewhat similar in terms of business models and focus on petroleum products with the former having more marketing focus on the eastern U.S. and the latter with a heavy focus on western and mid-western U.S. Our favorites though, are MMP and EQM. We like MMP for it’s larger pipeline distribution network (which also accesses a wide variety of crude oil supply) and ability to export refined products overseas, providing it additional sales optionality. EQM, from out point of view, represents a strong play on gas production growth from the Utica and Marcellus with the latter being one of the lowest cost, if not lowest, pure natural gas play in the country.

Summary

To summarize, we’ve identified three strong performers in the midstream space, two of them focused on crude and crude products with one focused on natural gas. While all three represent solid investments in our opinion, our personal favorite amongst the three is EQM. We like it longer-term not as a growth stock, but as a consistent and safe income distributer as we believe natural gas is and will remain a much-needed commodity in the U.S. given its reputation as a clean fuel and EQM’s access to the fastest growing and largest gas play in the U.S., the Marcellus. This blog wraps up our series on midstream and downstream companies. Going forward we will cover a variety of topics and markets that look interesting and try to help you find value in various sectors. Until then, stay tuned. Stay curious. Happy investing.

 

Disclosure: We do not own any of the shares mentioned above nor do we have any intention to purchase any of the shares mentioned above in the next 72 hours.

Disclaimer: The opinions expressed in this article are those of our own and are expressly meant to give the investor our own insight into companies we believe will provide long-term value to investors. 

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