The Opportunity in Midstream Energy Companies

Portfolio Managers Toby Loftin and Ben Cook discuss the business operations and primary growth drivers of midstream energy companies, and the Fund’s investment and distribution strategies.

 

October 2018

  • Toby Loftin
    Toby Loftin
    Portfolio Manager
  • Ben Cook
    Ben Cook, CFA
    Portfolio Manager

Can you describe the business operations of U.S. midstream energy companies?

Midstream energy companies provide a link between the producers of crude oil, natural gas, and natural gas liquids (NGLs) and their customers in the U.S. and in international markets. Midstream companies typically own and operate pipelines, storage facilities, processing plants, and export/import terminals that facilitate the transportation of crude oil, natural gas, and NGLs. These companies can be structured as master limited partnerships (MLPs) or C corporations, both of which can provide attractive distributions or dividends to income-oriented investors.

The business models of midstream energy companies typically focus on achieving steady growth while minimizing risk. Across an energy cycle, these companies often exhibit more predictable, less volatile earnings, and therefore potentially less volatile equity prices, than companies in other segments of the energy value chain, particularly commodity-sensitive upstream companies.

What are the primary growth drivers for midstream energy companies?

Midstream companies benefit primarily from growth in the production of crude oil, natural gas, and NGLs, as well as from higher demand for energy and energy-intensive products.

  1. Production Growth. As production grows, more pipelines and storage capacity are needed to transport oil, natural gas and NGLs from centers of production to refiners, export markets, and other customers.
  2. Exportation. Exports from the U.S. of crude oil, natural gas, and NGLs have been growing rapidly, increasing demand for new pipelines, LNG terminals, and other midstream infrastructure assets. Crude oil exports have seen particularly fast growth, rising from 50,000 barrels per day in 2013 to 2.5 million barrels per day in October 2018. Exports of natural gas, via pipelines to Mexico and liquefied natural gas (LNG) to world markets, have also been growing rapidly.
  3. Power Generation. Power plants increasingly use cleaner-burning, competitively priced natural gas in place of coal, which has increased their demand for natural gas by over 60% in the past decade, driving demand for midstream transportation services.
  4. Commodity Prices. Midstream companies can also benefit from higher energy commodity prices.

Can you please explain the Fund’s investment strategy and what sets it apart from its competitors?

When selecting portfolio holdings, we favor companies with the following characteristics:

» Less Commodity Exposure. Cash flows that are linked more closely to less volatile, non-price factors, such as “miles traveled” or “volumes consumed”, rather than companies whose contracts are predominantly commodity price-based

» “Demand Pull” Bias. Companies that are closer to the end consumer, such as utilities, power consumers, or refineries that provide steady demand that is generally less sensitive to commodity prices

» Long-term Agreements. Long-term agreements with customers based on capacity reservation

» Strong Balance Sheets. Strong balance sheet metrics and sufficient cash flows to support an attractive yield and distribution or dividend growth

Our intensive, fundamental, “boots-on-the-ground” research process, coupled with proprietary financial modeling, differentiates us from our competitors and allows us to uncover potential equity mispricings that can meaningfully drive performance. Working alongside legendary energy investor and BP Capital founder, T. Boone Pickens, has helped our portfolio managers to develop a broad network of relationships throughout the energy industry and has facilitated access to management teams and other information sources.

Can you please describe the Fund’s distribution strategy?

A primary goal of the Hennessy BP Midstream Fund is to deliver a significant and predictable income stream. As such, the Fund strives to maintain a conservative distribution coverage ratio at the portfolio level as a “margin of safety” that provides the underpinnings for a stable and consistent distribution to shareholders at the Fund level. The Fund has paid a distribution each quarter since inception, and it has never reduced the dollar amount of its distribution.

The Fund’s historical distributions have largely been characterized as a “return of capital,” which can offer important tax advantages for shareholders. Importantly, the Fund offers daily liquidity and issues a 1099 to shareholders (no K-1s are issued).

A significant portion of the Fund's distributions to shareholders will be characterized as a "return of capital" because of its MLP investments.