Midstream energy infrastructure companies have, in our view, generally emerged from the balance sheet and financing challenges that had plagued the sector since 2014. With these issues now largely in the rearview mirror, oil and gas master limited partnerships (MLPs) and other midstream firms appear poised to capitalize on the North American energy renaissance – and we believe investors who embrace opportunities in this strengthening sector could stand to benefit over the long term.

Midstream energy companies provide the critical infrastructure linking the supply of commodities, such as crude oil, natural gas and natural gas liquids (NGLs), to end users and include pipeline operators and other firms involved with processing, storage and transport of petroleum products. Midstream firms generally operate under a business model with recurring fee-based revenues that depend on volumes and throughput, which tends to limit direct exposure to commodity prices.

With attractive dividend yields, increasing free cash flow and a robust production outlook, we believe the midstream energy sector may currently be an attractive option for value-oriented investors seeking to invest in critical North American infrastructure assets with high barriers to entry and cash flows secured by long-term contracts. And, based on our view that growth for these companies will likely outstrip the pace of nominal GDP, we believe growth-oriented investors may see a compelling opportunity as well.

A supportive macro backdrop

According to International Energy Agency (IEA) data, oil demand over the past five years has grown near the fastest clip for any five-year period historically, and we expect continued robust demand growth over the secular horizon even as global economic growth sees a synchronized slowdown over the coming years. Lower oil prices have typically led to stronger oil demand historically, and we expect current valuations to support global demand. In addition, we expect natural gas to grow at an even faster pace than oil over the foreseeable horizon due to its relative environmental benefits for both home heating and power supplies, along with further modest inroads into transport. Lastly, International Maritime Organization (IMO) standards that go into effect in 2020 will likely benefit U.S. producers, due to the requirement for lower-sulfur products in marine transport.

We believe that non-OPEC producers outside the U.S. are not generating consistent output growth and that the U.S. will play a crucial role in meeting future energy needs. This is true not only for crude oil and refined products, but also natural gas, which, in our view, is serving a critical role in helping developing economies reduce carbon emissions, and natural gas liquids, which  are seemingly penetrating deeper into home heating markets and are key to meeting growing petrochemical demand. Simply put, we believe that North American energy production will be a critical input to the global growth engine, and that the midstream sector will underpin this growth.

Robust infrastructure demand

The resilience of the shale industry and declining per-barrel extraction costs have disrupted the world energy market, and according to IEA data, the U.S. overtook Russia as the largest producer of crude oil in the world in mid-2018. But while the crude markets garner the most attention, they are not the sole focus for midstream companies: A large portion of energy infrastructure capital is being deployed to capitalize on U.S. leadership in low-cost natural gas production and transport, both within the country and in global markets. According to IEA data, nearly three-quarters of global liquefied natural gas (LNG) export growth now originates from the U.S., and the abundance of low-cost natural gas has fueled a petrochemical revolution, with $180 billion of export-focused facilities coming online across the U.S. Gulf Coast by the end of the decade, according to data from the American Chemistry Council.

We expect that rising U.S. crude, natural gas and NGL production (see Figure 1), buttressed by low-cost supply and fueled by strong emerging market demand, will continue to test the existing pipeline infrastructure. This will not only improve current asset utilization, but also create a strong case for new growth projects secured by long-term contractual cash flows.

U.S. production has risen sharply, underscoring need for infrastructure investment

Although volatility related to oil prices may persist, our analysis of company reports indicates that one important outcome of the oil price plunge in 2014 was that U.S. producers significantly lowered their operating costs by improving drilling efficiencies. As a result, oil-exposed midstream companies may no longer need lofty crude price assumptions to sustain their growth. Indeed, our analysis suggests that breakeven prices for many shale plays are now as low as $40 per barrel – down 40% since 2014, when breakevens exceeded $70 per barrel.

Moving past capital market challenges

Despite tumult in the midstream sector since mid-2014 – the Alerian MLP Index has substantially underperformed the S&P 500 over the past two years – share price performance alone has belied resiliency in underlying profitability in recent years: Far from crumbling, EBITDA growth has in fact been robust during this period, illustrating the midstream sector’s potential ability to generate predictable revenue streams from long-lived assets (see Figure 2).

Midstream earnings growth has been robust

The volatility in oil prices that began in 2014 exposed what we believe to be a structural flaw in the way the MLP sector had financed itself: MLPs were continually tapping the equity markets, while at the same time distributing virtually all cash flows in an effort to make equity issuance more appealing to retail investors, who had been promised a “growing dividend,” according to data from Wells Fargo Securities through 4 December 2018. Add to this an elevated leverage ratio and complicated financing structures, and the sector faced a “buyers’ strike” when oil prices became volatile. The result was the need for highly dilutive equity capital raises to complete ongoing growth projects.

After a four-year adjustment process, we believe midstream companies have generally turned away from equity market financing and now seem to be relying on internally generated cash flows to self-fund growth projects. While this shift has been painful for shareholders, as it required either dividend cuts or moderation in dividend growth to retain cash flows, we believe it has made midstream companies stronger and lessened the need for dilutive equity issuances. Debt levels have moved down substantially, to approximately 4.0x projected for 2019, and at the same time, the average dividend coverage ratio has moved up, to about 1.3x from 1.1x in 2014 (according to Goldman Sachs data). Finally, many midstream companies have simplified their complex corporate structures and improved corporate governance by eliminating incentive distribution rights paid to the general partners, which better aligns the incentive structure for management and investors.

While the midstream energy sector’s fundamentals have greatly improved in recent years, the most notable development may be an apparent change in the management mindset: The focus, in our view, is no longer primarily on growing the yield, but rather on operational discipline, return on invested capital, total shareholder return and long-term value creation. 

All in all, after 20 years as a primarily retail-centric asset class, we believe the midstream energy story has now begun to resonate with discerning institutional investors as well.

Key takeaways: The midstream sector appears poised for a rebound

In our view, the midstream sector is at the cusp of a recovery: Funding issues now appear to be largely in the past, dividend cuts are seemingly nearing an end, balance sheet repair seems to be near completion and capital structures have been simplified. As a result, we believe these companies are now well-positioned to take advantage of future growth opportunities, with the potential to deliver attractive risk-adjusted returns to investors willing to take the long view on current market volatility.

Several key factors support our constructive view on the midstream sector, including still-high starting yields, improving company fundamentals, and attractive valuations relative to high yield and other income-oriented sectors, along with a robust oil and gas production backdrop (see Figure 3). MLPs in the Alerian MLP Index are trading at a significant discount to historical valuations, and by our estimates offer the potential for relatively strong annual returns.

Midstream fundamentals have strengthened

Some risks bear watching, however. Despite the recent improvements in the midstream sector, energy markets are cyclical and subject to unpredictable swings in both supply and demand. Geopolitical risks are also an ongoing reality, given the outsize influence of OPEC and the Middle East on the energy markets. Additionally, proposed pipeline projects require regulatory approval to proceed and have faced increasing opposition given environmental concerns. These risks may persist even as midstream fundamentals continue to strengthen.

All told, we believe midstream energy now offers one of the more attractive secular growth stories among all asset classes with support from a favorable – and much improved – entry point.

The Author

John M. Devir

Portfolio Manager and Head of Americas Credit Research

Greg E. Sharenow

Portfolio Manager, Real Assets

Mark R. Kiesel

CIO Global Credit

Related

Disclosures

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd- Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH(Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1° andar, Rio de Janeiro – RJ Brasil 22210-906.

Past performance is not a guarantee or a reliable indicator of future results.  All investments contain risk and may lose value. Investing in MLPs involves risks that differ from equities, including limited control and limited rights to vote on matters affecting the partnership. MLPs are a partnership organized in the US and are subject to certain tax risks. Conflicts of interest may arise amongst common unit holders, subordinated unit holders and the general partner or managing member. MLPs may be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer. MLP cash distributions are not guaranteed and depend on each partnership’s ability to generate adequate cash flow.  Many MLPs and other energy companies operate natural gas, natural gas liquids, crude oil, refined products, coal, or other facilities within the energy sector. As a result, they are susceptible to adverse economic, environmental, or regulatory occurrences affecting that sector. Midstream MLPs and other entities that provide crude oil, refined product and natural gas services are subject to supply and demand fluctuations in the markets they serve, which may be impacted by a wide range of factors including fluctuating commodity prices, weather, increased conservation or use of alternative fuel sources, increased governmental or environmental regulation, depletion, rising interest rates, declines in domestic or foreign production, accidents or catastrophic events, and economic conditions, among others.  Concentration of assets in one or a few sectors may entail greater risk than a fully diversified portfolio and should be considered as only part of a diversified portfolio.

PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO.