Investing in North American energy infrastructure: Alerian Midstream Energy Dividend ETF
While the energy sector has had a torrid time in recent years, specific parts of the industry appear good value. Companies involved in the transportation and processing of oil and natural gas currently yield over 10%.
Why invest in energy infrastructure companies?
North American energy infrastructure companies play a critical role in supporting everyday life by connecting energy supply with demand locally and overseas. These companies ensure that energy reaches end markets safely and ready for consumption. Compared to the rest of energy, investing in midstream energy infrastructure can offer unique benefits, such as generous income yields, stable cash flows and defensive qualities.
What is the current dividend yield on the Alerian Midstream Energy Dividend Index?
The current yield on the Alerian Midstream Energy Dividend Index was 10.4% as of 24 November 2020. For comparison, at the same date, the Energy Select Sector Index (IXE), which consists of the energy companies in the S&P 500, was yielding 5.8%. However, past performance is no guarantee of future income.
Recent headwinds in energy have resulted in discounted valuations and elevated yields, creating a compelling opportunity for investors looking for income and total return. Of course, with any investment your capital is at risk and past performance is no guarantee of future performance.
Investors can see the current yield on the index compared to other major indices such as the S&P 500 on Alerian’s website.
Midstream companies can deliver more predictable cash flows
Within the energy value chain, the midstream space performs the shipping and handling function, collecting fees for each barrel of oil or unit of natural gas handled. Fees are generated from transporting, processing, and storing hydrocarbons with these services performed under long-term contracts ranging from a few years to upwards of ten years. Pipelines have long been the cornerstone of this space.
The North American midstream universe includes US and Canadian corporations and master limited partnerships (MLPs), which enjoy a tax-advantaged structure in the US. These are the companies that have invested billions of dollars over the last decade to facilitate the tremendous growth in US and Canadian energy production and have supported the transformation of the US from a major energy importer to now being a significant exporter.
The fee-based nature of midstream sets it apart from other energy subsectors and has resulted in more stable cash flows independent of the commodity price environment. These stable cash flows support attractive dividend payments, with midstream offering income that supersedes other yield-oriented investments like real estate investment trusts (REITs) or utilities. In particular, MLPs do not pay taxes at the entity level, which has allowed these companies to pay out more of their cash flows as dividends.
Investing in midstream companies can offer diversification benefits
While income has historically attracted investors to midstream, the space offers other benefits from a portfolio perspective, including diversification, real asset exposure, and more defensive energy exposure. MLPs, which represent about half of the index, are not included in broad US equity indexes, providing an element of diversification. Furthermore, midstream can diversify an income or infrastructure portfolio given moderate correlations with REITs and utilities. Midstream also provides real asset exposure with contracts often including inflation protection.
Given the fee-based nature of these businesses, midstream is more defensive relative to other energy sectors and has seen a muted impact to forward earnings expectations since oil’s price decline in the wake of Covid-19. Specifically, 2020 and 2021 EBITDA estimates for midstream have been revised down by less than 10% from the end of January 2020 (pre-Covid) to 31 August. Resilient cash flows have helped midstream outperform broader energy this year and reinforced the defensive characteristics of midstream. That said, midstream has not been immune to broader energy headwinds in 2020 with a noticeable disconnect between equity performance and the stable earnings outlook for these companies. This disconnect creates an opportunity to look at quality companies offering relatively high yields that are trading at deep discounts to historical valuation multiples.
Midstream companies are also largely well positioned to generate significant free cash flow in 2021. The combination of stable cash flows and a healthy decline in growth capital spending from the elevated levels of recent years results in meaningful free cash flow, with many companies expected to have excess free cash flow even after sizable dividends. In the near term, excess cash flow will likely be used to reduce debt, but as the macro environment stabilizes, these companies are well positioned to pursue shareholder-friendly returns such as share buybacks and dividend increases.
How are midstream companies evolving to manage ESG considerations
Finally, the energy infrastructure space has been responsive to the increasing focus on environmental, social, and governance (ESG) considerations. The number of companies providing sustainability reports continues to grow, and some midstream names are directly investing in renewables. Natural gas pipeline company Williams Companies (WMB) is investing $400 million in solar installations to power its facilities and is targeting net-zero emissions by 2050. Many midstream companies are primarily focused on transporting and processing natural gas, which has been widely touted as the bridge fuel of the energy transition. Until renewable power becomes more widely available or reliable, natural gas is going to play an important role in providing affordable, cleaner power, especially relative to coal. Midstream companies will help facilitate this shift in North America and overseas through exports of liquefied natural gas.
For investors seeking income or total return, midstream remains well positioned to provide income and potential capital appreciation as significant free cash flow generation complements an ongoing energy recovery. Of course, past performance is no guarantee of future performance and your capital is at risk.
IG analyst’s view on investing in energy infrastructure
For investors seeking income, diversification, real asset exposure, or a way to play the ongoing recovery in the energy sector, the Alerian Midstream Energy Dividend UCITS ETF (MMLP) provides exposure to North American energy infrastructure. The fund currently holds 31 companies and approximately 50% of these companies are MLPs.
As of 24 November, the index yield of 10.4% was above its five-year average of 7.5%. Notably, elevated yields are coming from quality companies, with 84.5% of the index having investment-grade credit ratings as of 30 September.
Remember, past performance is no guarantee of future performance and your capital is at risk.
While the headline fund has the ticker MMLP, UK-based investors might wish to search for PMLP in the IG platform which is the GBP share class of the fund. This helps to avoid paying a foreign exchange fee when buying the shares. The annual fee for both share classes is 0.4%.
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