The Benefits of Midstream Companies in an Inflationary Environment

For investors looking to position their portfolio to counter rising inflation, midstream energy companies may offer a number of key advantages.  

June 2021
  • Ben Cook
    Ben Cook, CFA
    Portfolio Manager
  • Toby Loftin
    Toby Loftin
    Portfolio Manager

Key Takeaways

»    We believe Midstream energy companies should continue to outperform as the re- opening/cyclical trade unfolds.
»    Midstream companies may offer several key advantages in an inflationary environment.
»    It may be an opportune time to consider investing in midstream energy companies.

Concern About Rising Inflation 

Rising inflation has been an increasing concern in recent months with the passage of enormous economic stimulus, higher than expected commodity price increases, and the rise in interest rates. While absolute rates are still very low, the increase in the 10-year Treasury yield has caused market jitters and corresponded with trading pressure on higher valuation multiple, longer-duration cash flow stocks, such as those in the Technology sector. 

To illustrate the diverging performance trend, in the chart below, we compare the Midstream Energy group (represented by the AMUS: Alerian US Midstream Energy Index) to the Technology sector (represented by the XLK ETF, which tracks an index of S&P 500 Technology stocks).

We believe Midstream energy companies should continue to outperform as the re-opening/cyclical trade unfolds. While there are no performance guarantees with an interest rate shock, the Midstream group offers important advantages in an inflationary environment:

1. Current Income with Growth: The average yield for the Midstream group remains high, at approximately 7%, with projected dividend growth of approximately 2% over the next several years.1 Additionally, as Free Cash Flow after dividends is positive and expected to increase, several management teams have stated they can supplement modest dividend growth with potential share buybacks.

2. Yield Spread: With valuation multiples for Midstream stocks still below pre-Covid levels and a yield spread of a historically high ~600 basis points, we believe there is plenty of “buffer” for the group to absorb an increase in the 10-year Treasury yield.

3. Contract Protection: Many Midstream companies’ contracts include inflation escalators. For example, FERC-regulated interstate liquids pipelines can increase tariffs by a percentage equal to the change in the producer price index for finished goods (PPI-FG) plus 0.78%. The below table shows what has generally been a positive revenue driver well in excess of inflation.

4. U.S. Dollar: A weakening dollar may be supportive for crude prices (denominated in U.S. dollars), all else equal, and this can promote drilling activity and higher throughput for midstream systems. At the very least, higher commodity prices can fuel positive investor sentiment for the broader Energy group, which has been the case in recent months. It is noteworthy that less than a year ago WTI crude hit a historic bottom (-$37.63 on 4/20/20), and has traded in the $60-65 range in the past few months. Further, propane prices could spike this coming winter given low domestic inventories and strong international demand.

5. Energy Demand: Not all increases in interest rates are bad.  When driven by economic growth, which typically corresponds to better energy demand, rising rates are generally seen as a positive. As an example, gasoline demand is back to pre-COVID levels as the economy continues to re-open, helped by increasing COVID immunity. 

6. Cyclical Trade and Momentum: The shift to cyclical stocks appears to be in full effect. Further, with outperformance for the Energy group over the past several months, “momentum” trading baskets are now net-long Energy, which is a supportive trading dynamic.

An Opportunity to Benefit

With multiple advantages in an inflationary environment, it may be an opportune time to consider investing in midstream energy companies. Actively managed, the Hennessy BP Midstream Fund offers a concentrated portfolio of midstream companies we believe have stronger balance sheets and lower leverage, advantaged geographic/asset footprint, cash flows supported by a more diversified customer base, and meaningful long-term volume contracts that can protect revenue streams.

 

1. Wells Fargo Securities LLC Equity Research, “Comparative Valuation Tables,” 5/24/2021.