With low levels of economic depreciation (i.e. low required maintenance), we believe that the midstream sector of the energy industry – pipelines, storage assets, processing facilities, to name several types of midstream assets – can offer a differentiated source of income for investors. Midstream investments have historically exhibited lower correlation to broad interest rates than other traditional sources of income, such as bonds and utility stocks.
With historically low correlations to the broader market and generally high levels of free cash flow compared to other energy sectors, midstream has plenty of compelling features for potential investors.
That said, within midstream, we count no fewer than 10 business models, including transport, storage, processing, and others, each with its own return characteristics, earnings volatility, and commodity exposures.
Importantly, midstream assets might have useful lives ranging from less than 10 years to over 50. This means that midstream businesses generating the same economic returns might trade at significantly different EV/EBITDA multiples. Therefore, EV/EBITDA and yield analysis alone is insufficient for successful MLP investing.
With such a wide range of businesses and cash flow exposures, there are few “universal truths”, and each business requires detailed bottom-up analysis.
Recurrent’s intense focus on returns on invested capital (ROIC) extends into our analysis of the MLP and infrastructure sector. Long-term returns reflect a company’s ability to drive value throughout the commodity cycle.
We use detailed financial models of the midstream MLPs and energy infrastructure companies to evaluate a midstream company’s historical return profile (measured by ROIC) and prospective returns based on public information regarding capital expenditure and financing plans.
With a view of a company’s past and expected returns, we form a view of a “justified” valuation multiple using EV/IC. Generally, a company’s return profile should be reflected in its valuation. Companies with excess returns should trade at higher EV/IC multiples while companies with lower returns should trade at lower multiples.
In addition to our core EV/IC methodology, we use our financial analysis tools to consider other company valuation metrics, such as EV/EBITDA, cash flow yields, as well as financial attributes like balance sheet strength, business mix, and commodity price exposure.
For years, the midstream and MLP sector has been marketed to investors under slogans that are, at best, partially true:
“a bond substitute” – source of income with no dividend cut risk
“all take-or-pay contracts” – income backed by unassailable contracts
“no commodity risk” – little to no sensitivity to commodity prices or volumes
We want our investors to be comfortable investing in midstream. Some potential compelling features:
income with historically lower interest rate correlation vs. other income investments
exposure to North American oil and gas production volumes
some revenue streams with explicit and some with implicit inflation protections
potential for income growth over time
Contrary to the narrative that MLPs have moved from “commodity-insensitive” to “commodity-sensitive” investments, the reality is that MLPs are broadly in two categories: producer-facing and consumer-facing. Consumer-facing MLPs typically exhibit roughly 30-50% lower beta to oil price vs. producer-facing MLPs, yet consumer-facing MLPs represent a minority of passive index portfolios.
We do not use commodity views to drive investment decision-making and believe that commodity-driven “bets” generally lead to inferior long-term performance. We use valuation to solve for implied commodity prices, and invest where we see misaligned expectations and mispriced risks.
We believe that companies with commodity exposure will often generate lower full-cycle returns on capital which will, in turn, be reflected in market valuations. We believe stable and less stable companies alike can present attractive opportunities for investment, as long as valuations appropriately discount a company’s long-term return profile.
In a cyclical industry, sell-side reports and investor sentiments follow the commodity price, so a well-honed counter-cyclical methodology is key.