Part 1: An Introduction to Midstream Energy Infrastructure
Part 2: Understanding the Pipeline Business
Part 3: Midstream Energy: An Investment Case
Introduction
An investment in energy infrastructure is an investment in North
America’s continued production and consumption of transportable energy over the
next several decades. Energy infrastructure companies own the pipelines,
storage tanks, and processing facilities that bring energy from the wellhead to
America’s doorstep and increasingly to the coast to be exported internationally.
In the energy industry, these activities are typically described as “midstream”. This is the bridge between production
(upstream) and consumption (downstream). While still related to the energy
industry, most energy infrastructure business lines do not have direct exposure
to commodity price fluctuations. Their businesses take place on a set fee per
volume or fee for service basis. In short, the business model is driven by
volumes.
The prices (or tariffs) that energy infrastructure companies can charge
are determined either by negotiated contracts or are federally regulated.
Typically, tariffs increase each year by a measure linked to inflation. In
terms of volumes, the significant growth in North American oil and gas
production has increased the need for energy infrastructure assets. While
energy demand in North America has remained fairly steady in recent years,
long-term global demand growth is expected to continue, particularly for
emerging markets, creating opportunities for energy infrastructure companies.
Increasingly, these companies are processing, transporting, and storing
hydrocarbons that will ultimately be sent to locations worldwide.
Energy
Infrastructure Overview
Energy infrastructure companies are involved in the transportation,
processing, and storage of oil, natural gas, and natural gas liquids (NGLs).
Historically, much of the midstream space has been structured as master limited
partnerships, or MLPs. C-Corporations have also become more prominent in
midstream in recent years.
Midstream Energy Infrastructure Business
Models
Midstream MLPs and c-corps are involved in the
transportation, processing, and storage of oil, natural gas, and natural gas
liquids (NGLs).
1. Transportation: Transportation MLPs and
c-corps move energy commodities like oil and natural gas from one place to
another. In North America, most energy travels through a pipeline, but it can
also move via truck, train, or ship. Pipelines are the cornerstone of energy
infrastructure companies.
2. Processing: Processing encompasses any business that transforms a raw
commodity into a usable form. It involves removing impurities like water and
dirt from natural gas and separating the natural gas stream into
pipeline-quality natural gas and natural gas liquids (NGLs), which are used as
heating fuels and petrochemical feedstocks.
3. Storage: Storage includes tanks, wells, and other facilities both
above and below ground. These assets provide flexibility to the energy economy,
so there is propane available for winter heating, gasoline for summer driving,
and jet fuel for the holidays.
What
are MLPs?
MLP
stands for Master Limited Partnership. You can think of MLPs as US energy
pipeline companies with an advantageous tax structure. MLPs pay no income tax
at the partnership (or company) level. Unlike most partnerships, MLPs are
public companies, trading on U.S. stock exchanges and filing reports with the
Securities and Exchange Commission (SEC).
What are C corporations?
A C corporation, under US federal income tax
law is a corporation that is taxed separately from its owners. Many companies
are treated as C corporations for US
federal income tax purposes and are subject to corporate income tax.
How
is an MLP Different Than a Traditional Corporation?
From a
business perspective, MLPs limit themselves to handling natural resources and
minerals, MLPs do not pay federal income tax at the entity level, meaning that
they can pay out more of their cash flow to investors as dividends.
Corporations, on the other hand, do pay federal income tax.
MLPs
are also governed differently from regular corporations. Companies such as
Exxon, Apple, and Ford are primarily owned by shareholders. Decisions are made
by management teams as well as by shareholders at an annual meeting where major
issues are decided by voting. A shareholder has one vote per share owned, and
either a majority or a plurality of votes may be required for particular
decisions.
Most
MLPs, on the other hand, are governed by their general partner. MLPs generally
have two classes of owners, the general partner (GP) and the limited partner
(LP). The general partner interest of an MLP is typically owned by a major
energy company, an investment fund, or the direct management of the MLP. The GP
controls the operations and management of the MLP and typically owns some
portion of the LP. Limited partners (aka people who own units) own the
remainder of the partnership but have a limited role in its operations and
management.
How
do Midstream Companies Make Money?
MLPs and
energy infrastructure companies largely operate fee-based business models. They
earn a set fee for each barrel of oil or unit of natural gas transported,
stored, or processed. This is because these companies largely do not own the
oil or gas. They generally sign long-term contracts (5 to 20 years in length)
with their customers, which makes for stable cash flows.
Accordingly,
the revenue equation for most business activities is fairly simple: fee
multiplied by volume. As such, more volumes mean more cash flows. On the fee side,
a federal agency sets the fee charged by interstate liquids pipelines, and the
fee increases with inflation. Pipeline fees can also be negotiated with a
customer based on the cost of operating the pipeline and market rates for
liquids or natural gas pipelines.
On the
volume side, growing production of US oil and natural gas over the last decade has
necessitated more energy infrastructure such as pipelines, storage tanks, and
processing plants.
How Investors May Make Money With Midstream
Companies?
If you
own a stock, there are two potential ways to make money.
1) The price of the stock increases and you can
sell it for more than you bought it.
2) The stock can also pay you dividends.
MLP dividends are called distributions because of the partnership structure. The amount of distributions relative to the unit (or share) price is known as yield.
MLP distributions are not guaranteed and vary depending on the MLP. The partnership agreements of individual MLPs determine the level of distributions.
The historical average yield of energy infrastructure companies over the past 5 years has been around 7.6%, which means that if you invested $100, on average, you would be paid $7.60 each year. The chart below shows yields for energy infrastructure companies, represented by the Alerian Midstream Energy Dividend Index -AEDW ), compared to other asset classes. Midstream companies yield 7.6% and boast a higher yield than Utilities and Real Estate Investment Trusts (REITs), which are asset classes known for their income potential.
YIELD %
Past performance is no guarantee of future returns. Source: Alerian, Bloomberg. Data as of 30/06/21. US Bonds = US Bloomberg Barclays Aggregate Bond Index.
REITS = FTSE NAREIT Real Estate 50 Index. Utilities = S&P 500 Utilities Index. Please note that all performance figures are showing net data.
MLP Distributions
and Midstream Dividends
Stable distributions were historically a hallmark of the
MLP and energy infrastructure space, though the energy downturn that began in
the second half of 2014 blemished that track record and additional distribution
cuts have been announced in the wake of oil’s price collapse in 2020. When an
MLP is going through financial difficulties, it can free up cash by reducing or,
in rare cases, eliminating its distribution. While some MLPs continued to grow and
maintain their distributions through the downturn, other MLPs cut their
distributions. The same can be said of midstream corporations, with some
growing their dividends and others cutting.
MLP distributions are not guaranteed and depend on each
partnership’s ability to generate adequate cash flow. Unlike Real Estate
Investment Trusts (REITs) that must distribute a certain percentage of their cash
flow each quarter in order to retain their tax-advantaged designations, MLPs
have no such requirements. Like REITs, MLPs pay no taxes at the entity level,
so they can distribute much more of their cash flow to investors. Typically,
the partnership agreements of individual MLPs determine how cash distributions
will be made to GPs and LPs.
Classification
of Energy Infrastructure Companies and MLPs
Under
the Energy Midstream Classification Standard (EMCS), midstream companies are
classified according to their primary business activity:
-
Pipeline
Transportation: Transportation by large diameter pipeline of
crude oil, refined petroleum products, natural gas and natural gas liquids.
-
Storage:
Storage of crude oil refined petroleum, natural gas and natural gas liquids in
above ground tanks, depleted gas reservoirs, aquifers and salt caverns
-
Gathering
and Processing: Transportation of petroleum or natural gas
from the wellhead to processing plants
-
Liquefaction:
Supercooling natural gas and transforming it from a gaseous state into a
liquid, which can be shipped overseas
-
Marketing:
Retail
distribution of heating fuels and wholesale distribution of motor fuels
-
Services:
Provision
of field services to the midstream and upstream sectors, including offshore
drilling, compression and saltwater disposal
-
Mineral
Interest: Ownership of mineral interests leased to third parties that
develop, mine and sell reserves
-
Regasification:
Conversion of natural gas from a liquid to a gas
The Alerian
Midstream Energy Dividend UCITS ETF Dist
In July 2020, HANetf and Alerian launched the Alerian
Midstream Energy Dividend UCITS ETF Dist (MMLP)which seeks to track the price
and yield performance , before fees and expenses, of the Alerian Midstream Energy Dividend IndexTM
(Total Return).
The fund offers diversified exposure
to energy companies involved in the processing, transportation and storage of
oil, natural gas and natural gas liquids in the US and Canadian market and
includes MLPs and C-corps.
It is the first
UCITS ETF to provide exposure to the energy infrastructure sector via an
Alerian index. By employing a synthetic strategy, MMLP enables efficient
replication of the index.
The index is fundamentally-weighted by dividends in a
transparent, straightforward process. Each company’s total distribution is
calculated as shares outstanding multiplied by its annualized dividend based on
the most recent dividend.
Each constituent’s weight is then calculated by taking its
total distribution and dividing by the sum of all in index constituent
distributions. Finally, a 10% cap is applied to constituent weights.
Simply put, companies that pay out more cash flow per share
are weighted higher relative to peers that distribute less. MMLP is rebalanced
quarterly and reconstituted annually. Quarterly re-balances occur in January,
April, July, and October, with only the weightings of constituents adjusted.
Excluding spin-offs,
companies can only be added to Alerian Midstream Energy Dividend UCITS ETF during
the annual reconstitution in October. However, constituents can be removed from
the index between reconstitutions due to special situations such as mergers,
acquisitions, or bankruptcies.