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.