When it comes to energy stocks, there is one sector that offers a real source of value for long-term investors — midstream players.
After having been beaten down substantially during the fall in energy prices, I expect it to be the first sector to begin the energy stocks’ renaissance.
And the one midstream player worth your attention right now is Kinder Morgan (KMI). It’s the granddaddy of the sector — the largest energy infrastructure firm in North America. And its executive chairman, as well as its president and CEO, both only make $1 a year and do not receive bonuses or stock options.
That no-nonsense approach is what built KMI and keeps it on top of its competitors.
Where KMI Fits Among Energy Companies
First, a brief explanation of what the midstream energy sector represents. Basically, energy companies are broken into three sectors – upstream, midstream and downstream.
Upstream companies are basically anything to do with getting the energy out of the ground. They’re also called exploration and production (E&P) companies.
Midstream companies do the processing, storing, transporting and marketing of the product. Generally speaking, these are the pipeline companies, of which KMI is a major player.
Downstream is where they refine the products and then distribute at the retail level.
Some companies, like Exxon Mobil (XOM), are vertically integrated across all the sectors. But in each sector, there are major independent players, and during market cycles, each sector benefits from different dynamics.
Of course, all of them react very well to strong demand. But at this point, strong demand is not in great supply around the world, and this has hurt all the sectors.
The young U.S. energy sector has been especially hurt, because low prices and low demand mean E&P firms shutter operations to stay alive long-term. That means less flowing through the midstream players and less for the downstream firms to do.
However, there are opportunities here. Just this week, another major midstream firm, Energy Transfer Equity (ETE) announced it was going to buy smaller Williams Companies (WMB) for $37 billion.
This ETE deal is very similar to the consolidation purchase KMI made last year with Kinder Morgan Energy Partners, Kinder Morgan Management and El Paso Pipeline Partners.
Both firms operated a number of individual master limited partnerships. These are pass-through companies, where the MLPs pass on profits to shareholders (unitholders) directly as part of their corporate mandate.
Similar to real estate investment trusts, MLPs generally have very attractive yields. But in challenging times like these for energy companies, sometimes those yields can become unsustainable.
By bringing all the companies under one roof, it lowers the risk of bleeding the MLPs dry in tough market conditions while still preserving the MLP structure.
When KMI consolidated last year, many thought the firm was crazy. Now it looks like a very smart move, way ahead of the curve.
The new ETE will be the fifth-largest energy infrastructure company in the world, and No. 3 in the U.S.
And KMI remains the top dog in the U.S. It has $60 billion market cap, almost three times larger than ETE’s. That gives you some idea of what a powerhouse KMI is in the midstream sector in North America.
What’s more, although it consolidated, it still offers a massive 7%-plus dividend yield. And unless energy prices head down another 50% from here — which I seriously doubt — this is a safe yield. The stock has been hammered in the past nine months, as you can expect, but it’s likely oversold at this point, and at least its downside risk is far more limited.
Bottom Line
While three years ago was a great time to be a small upstream or midstream MLP in North America, now it’s a major liability. Major Canadian midstream player TransCanada (TRP), of Keystone XL fame, just cut 20% of its senior management because Canada, as a commodity-based economy, is now in recession.
These types of market dynamics mean the big companies are looking for bargains — and even if they don’t buy struggling competitors, there’s less competition in the market as the weak fall by the wayside.
That means better pricing power for the survivors.
Remember, midstream companies are agnostic to the price of the product that flows through their pipes. They’re like a toll booth. They make money off of traffic, not whether someone is driving a Ferrari or a Kia.
As we enter the cooler months, and as the economy picks up, energy consumption will grow and the midstream players will be the first sector in the energy patch to benefit.
And in the meantime, you can pull down a more than 7% dividend to wait it out.
Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won seven Best Financial Advisory awards from the Newsletter and Electronic Publishers Foundation.
