Investing in energy's middlemen

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Investing in Energy's Middlemen

The upside could be high dividends and inflation protection.

They may not be household names, but midstream energy infrastructure companies generate lots of cash and typically pay large dividends.

What’s more, while these companies — engaged in the processing, storage and transportation of oil and natural gas through pipelines — are less sensitive than other energy companies to rising energy prices, they still have attributes that can provide a measure of inflation protection.

Here's a quick overview of the basics.

What is energy infrastructure?

In the U.S., energy infrastructure consists largely of 2.6 million miles of pipelines — enough to stretch to the moon and back more than five times.1 These pipelines connect upstream energy producers with downstream refineries and distributors.

Map of U.S.: 26 million miles of energy pipelines

How the middle makes money

Midstream companies make money primarily from fees for gathering oil and gas from upstream operators, and from regulated tariffs for transporting these via interstate pipelines.

Some companies also earn income from buying natural gas and natural gas liquids (NGLs) from a producer to create products such as ethane and propane.

Pipeline operators also enjoy considerable protection against inflation because their long-term transport contracts typically contain inflation escalators. Some are protected on the downside as well. If their contracts include a “take or pay” provision, they get paid even if the customer doesn’t make full use of the capacity they’ve secured.

3 types of midstream operators

Integrated oil companies. These companies are involved in every part of the oil and gas industry, from exploration and production to refining and marketing. Examples: ExxonMobil (XOM), Chevron (CVX), ConocoPhillips (COP).

Sponsored midstream companies. Publicly traded companies created by energy producers to serve their sponsor and other exploration and production companies. Example: Shell Midstream Partners LP (SHLX).

Independent midstream companies. “Pure play” pipeline companies. Examples: Kinder Morgan (KMI), Williams Companies (WMB), Magellan Midstream Partners (MMP).

One drawback for investors: tax delays

Many midstream companies are structured as master limited partnerships (MLPs). These entities are allowed to avoid income taxes if they pay out 90% of their taxable income to shareholders, also known as “unitholders.”

Unfortunately, MLPs complicate tax preparation. Instead of a 1099-DIV for use in preparing taxes, unitholders receive a Schedule K-1 form. This form requires extra time to prepare, and so unitholders don’t receive it by the January 31 deadline required for other tax documents.

You can avoid delays by buying shares in a mutual fund or ETF that invests in MLPs or by purchasing stock in a pipeline company structured as a c-corporation. A third option is to invest in an energy company that owns an MLP. For example, Phillips 66 Partners is a wholly owned subsidiary of Phillips 66.

What about risks?

Regulation

The industry is subject to regulatory risk from the Biden administration, which – at least until recent energy shortages and price inflation – appeared unfriendly to fossil fuels. State and local governments may also deny permits or cancel new pipelines.

Falling prices

While pipeline companies are not directly exposed if energy prices decline, low prices can mean less production and therefore less volume.

This presents a threat primarily for the gathering pipelines that transport raw materials to processing locations.

Transmission pipelines, which move processed materials to distribution hubs, are somewhat protected by contracts guaranteeing volume minimums.

Capital access

Because MLPs pay out most of their income to unitholders, many rely heavily on new equity and debt to fund acquisitions and expansion projects. If energy prices decline, those capital sources may dry up, potentially leading to cuts in dividend payments.

Did you know?

Investing in midstream energy infrastructure received a stamp of approval of sorts in 2020 when Warren Buffett bought the natural gas pipeline business of Dominion Energy (D) for $10 billion. This acquisition upped Berkshire Hathaway’s share of the interstate natural gas transmission market to 18%.

Ways to invest

Despite overall volatility in the energy industry, some midstream companies have outstanding dividend-paying track records. Enbridge (ENB), a leading midstream company based in Canada, has paid a dividend that has grown every year for the past 27 years. Not far behind is Texas-based Enterprise Product Partners (EPD); it has raised its dividend for 23 straight years.

Here are 10 of the largest midstream companies by revenues, according to ValueWalk, a value-oriented investment service.

Largest publicly traded midstream companies, by revenues

Energy Transfer LP (ET), Revenues $54 billion, MLP Yes, Dividend yield 6.41%

Plains GP Holdings (PAGP), Revenues $33 billion, MLP No, Dividend yield 6.49%

Enterprise Products Partners (EPD), Revenues $32 billion, MLP Yes, Dividend yield 7.09%

NGL Energy Partners (NGL), Revenues $24 billion, MLP Yes, Dividend yield 5.13%

Kinder Morgan Inc. (KMI), Revenues $13 billion, MLP No, Dividend yield 5.93%

ONEOK Inc. (OKE), Revenues $10 billion, MLP No, Dividend yield 5.93%

Targa Resources Corp. (TRGP), Revenues $8.6 billion, MLP No, Dividend yield 1.69%

Williams Companies Inc (WMB), Revenues $8.2 billion, MLP No, Dividend yield 4.87%

DCP Midstream LP (DCP, Revenues $7.6 billion, MLP Yes, Dividend yield 4.21%

EnLink Midstream LLC (ENLC), Revenues $6 billion, MLP Yes, Dividend yield 4.15%

Sources: ValueWalk, May 2, 2022 (companies selected from the Fortune 1000). Yield data updated August 31, 2022, via Morningstar.

Investors don’t have many options for buying shares in exchange-traded funds that invest in pipeline companies. But here are the “best” five, as ranked by U.S. News & World Report.

Energy infrastructure ETFs

Tortoise North American Pipeline Fund (TPYP), Net Assets $0.6 billion, Expense Ratio 0.40%, Dividend Yield 4.24%

Global X MLP & Energy Infrastructure ETF (MLPX), Net Assets $1 billion, Expense Ratio 0.45%, Dividend Yield 4.88%

Alerian Energy Infrastructure ETF (ENFR), Net Assets $0.1 billion, Expense Ratio 0.35%, Dividend Yield 6.41%

Global X MLP ETF (MLPA), Net Assets $1.3 billion, Expense Ratio 0.45%, Dividend Yield 7.05%

Alerian MLP ETF (AMLP), Net Assets $6.7 billion, Expense Ratio 0.87%, Dividend Yield 7.42%

Source: U.S. News & World Report ETF Rankings, accessed July 20, 2022. Data updated August 31, 2022, via Morningstar.

Options for mutual funds devoted to pipelines are more plentiful. Here are the top five, also ranked by U.S. News and World Report.

Energy infrastructure mutual funds

Virtus Duff & Phelps Select MLP & Energy Fund (VLPAX), Net assets $0.04 billion, Expense Ratio 1.4%, Yield 3.03

Tortoise MLP & Pipeline Fund (TORTX), Net assets $2.4 billion, Expense Ratio 1.19%, Yield 4.20

Cohen & Steers MLP & Ener Opportunity Fund (MLOAX), Net assets $0.14 billion, Expense Ratio 1.25%, Yield 2.95

Eagle MLP Strategy Fund (EGLAX), Net assets $0.09 billion, Expense Ratio 1.68%, Yield 5.07

Invesco SteelPath MLP Income Fund (MLPDX), Net assets $2.9 billion, Expense Ratio 1.39%, Yield 8.68

Source: U.S. News & World Report Funds Rankings, accessed July 20, 2022. Data updated August 31, 2022, via Morningstar.

Kiplinger

© September 2022, Future US LLC

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