With West Texas Intermediate (WTI) oil prices nosediving 16.3% in May and the Energy Select Sector Index (IXE) barely clinging to positive year-to-date gains, it may come as a surprise that an energy sector has outperformed the broader market so far this year.
In case that weren’t enough to pique interest, this same energy sector is paying attractive yields above 6%.
For a defensive energy sector with healthy income, look no further than midstream, which refers to companies that operate pipelines, storage terminals, and processing facilities, typically charging a fee per unit of energy transported, stored, or processed.
Most investors associate midstream with energy infrastructure and pipeline companies, whether structured as master limited partnerships (MLPs) or corporations. MLPs have historically paid an attractive yield, because they do not pay taxes at the entity level, and a significant portion of MLP distributions are typically tax-deferred.
Several factors have contributed to midstream’s resilience this year despite oil volatility. Due to the fee-based nature of their businesses, midstream companies have less direct exposure to oil prices and generate more stable cash flows compared to the rest of energy.
Additionally, an announcement in May that midstream MLP Buckeye Partners (BPL) would be bought out by an Australian asset manager at a 27.5% premium highlighted the value proposition of the midstream business model and served as a catalyst for the space. Further, midstream companies have made progress to improve their positioning by reducing their leverage ratios, shifting toward self-funding equity growth capital, and in some cases, announcing buyback programs.
More broadly, the fundamental thesis for midstream is supported by the growth in U.S. oil and natural gas production, which allows for high utilization of existing infrastructure assets and creates growth opportunities. The United States became the world’s largest oil producer last year and is expected to account for 70% of the increase in global oil production capacity over the next five years, according to the International Energy Agency.
The United States has been the world’s largest producer of natural gas since 2009, and production continues to climb. With the Energy Information Administration forecasting that the United States will become a net energy exporter in 2020, midstream growth opportunities will be increasingly oriented toward facilitating exports.
Beyond a supportive fundamental backdrop, midstream provides attractive income. The Alerian MLP Infrastructure Index (AMZI), which consists of energy infrastructure MLPs, was yielding 8.1% at the end of May. The Alerian Midstream Energy Select Index, which consists of 25% midstream MLPs and 75% midstream corporations, was yielding 6.5%.
For investors looking to diversify their income portfolios, both indexes have a slightly negative three-year correlation with bonds and a correlation of less than 0.2 with utilities.
Tapping Into Energy Infrastructure
Investors wanting to add midstream exposure to their portfolios can directly invest in corporations or MLPs, though a direct MLP investment will result in a Schedule K-1 at tax time. For those not wanting to receive a K-1, there are a number of products, such as ETFs or mutual funds, that issue Form 1099s.
Due to tax rules, funds will typically either own predominately MLPs (up to 100%) or own less than 25% MLPs with the balance allocated to corporations. Funds that own more than 25% MLPs are taxed as corporations. Funds that own less than 25% MLPs are referred to as RIC-compliant funds and are not taxed at the fund level.
So, how do investors choose? If an investor is primarily interested in maximizing after-tax yield, he or she will likely prefer a fund that is predominately MLPs. If an investor prefers greater diversification and is more total-return oriented, he or she will likely prefer a RIC-compliant fund. As a word of caution, investors should make sure that what is included in the other 75% is providing the desired exposure.
For investors wanting more defensive energy exposure or simply looking for income, midstream may represent an attractive option. The fee-based nature of the midstream business model supports attractive yields, which are complemented by the benefits of growing U.S. energy production and company-level improvements.
Stacey Morris is Director of Research for Alerian.