As the market continues to progress, with the S&P500 Although the energy sector regularly hits new all-time highs, there is at least one sub-sector of the market that is significantly undervalued relative to the historical value of its shares. This is the midstream energy sector.
Better yet, the midstream industry as a whole is in much better shape today than it was a decade ago, when the stocks within it were trading at much higher valuations. Let’s take a look at the sector’s dynamics and some stocks in the sector that look poised to outperform over the coming years.
The midstream sector of the energy industry
Although midstream companies are best known for their pipeline active, they perform various tasks in the energy complex. This ranges from the collection of crude and natural gas at the wellhead to the separation of hydrocarbons (such as processing and fractionation) to the supply and disposal of water (hydraulic fracturing requires a lot of water). It also manages storage, long-distance transportation, marketing, compression and other services.
Midstream companies tend to favor fee-based contracts, in which they accept no raw materials and assume no spread risk. And when new projects are built, they often come with buy-or-pay provisions, whereby the company gets paid whether or not its services are used, or minimum volume commitments (MVCs), in whereby the intermediary company receives compensation payments if a customer fails to do so. use its full volume capacity.
Some contracts still include price elements that allow midstream companies to also participate in rising commodity prices, generally on the side of natural gas and natural gas liquids (NGLs). For example, with a percentage of revenue contract, a midstream company will sell residual gases and/or NGLs into the market on behalf of a producer and retain a percentage of the sale. Another type of contract is conservation agreements, where natural gas processors retain the retired NGLs but must replace them with an equivalent amount of gas on a BTU basis. This exposes a company to price variations between NGLs and natural gas.
The trend in recent years, however, has been toward fee-based contracts, which provide high visibility for these companies. And while there is volume risk, it is generally somewhat mitigated by take-or-pay and MVC arrangements. Having assets tied to stronger demand centers or basins also helps reduce risk, as utility demand for electricity tends to remain strong while basins with better economics tend to be more resilient during periods of lower prices.
Meanwhile, with energy demand coming from data centers and the rise of artificial intelligence (AI), companies involved in natural gas transportation appear well-positioned to benefit from the current AI wave. Goldman Sachs recently predicted that data center electricity demand would increase 160% by 2030, resulting in 3.3 billion cubic feet per day of new natural gas demand.
Utilities will need to invest in new generation capacity and new pipelines will be needed to support this growth. Midstream companies with well-established systems around areas with cheap natural gas reserves, such as the Permian and Appalachians, will be best positioned to take advantage.
Historically low valuations in the sector
Between 2011 and 2016, midstream companies traded at an average of enterprise value (EV)-to the EBITDA (earnings before interest, taxes, depreciation and amortization) multiple of more than 13.5 times. This is one of the most commonly used metrics to value these companies because it takes into account their net debt and depreciation expenses associated with pipeline construction. Today, multiples across the industry are much lower.
The irony is that companies in the sector are in much better shape today than they were then. Leverage (debt divided by EBITDA) is down significantly within the sector, while distribution coverage ratios are increasing and midstream companies generally generate strong free cash flow.
It is also worth noting that energy producing (E&P) customers of midstream companies tend to be in better financial health, which helps reduce customer risk, and that the industry has focused on liquidity available rather than searching for volumes.
Midstream stocks expected to outperform
Historically low valuations, combined with improved financial health and strong growth resulting from increased demand for natural gas from AI, allow the sector to potentially return to the valuation levels these stocks experienced at their peak.
Among the main actions that should benefit are Energy transfer (NYSE:ET), Enterprise Product Partners (NYSE:EPD)And Morgan Kinder (NYSE:KMI)all of which have large integrated systems and a strong presence in the Permian. Williams Enterprises (NYSE:WMB) is another strong option given its extensive network of natural gas pipelines that connect the Appalachian region to power demand centers in the Southeast. However, its shares trade at a premium compared to its peers.
Of the stocks highlighted above, Energy Transfer stands out for its low valuation and growth prospects and is my favorite stock in the space. It and Enterprise also have the most attractive yields in the group, at 8.1% and 7.2%, respectively.
A more discreet name that could benefit from this is Antero Midstream (NYSE: AM)which noted the data center power consumption demanded by the Marcellus shale region and its main customer, Antero Resources (NYSE: AR), I saw. Antero Midstream is a well-managed natural gas gathering operation serving Antero. It benefits from rebate reductions (it previously gave Antero Resources a price discount when natural gas prices were low) and appears poised to begin increasing its distribution in the future.
Energy Transfer, Enterprise, Kinder Morgan and Antero Midstream all trade at forward EV/EBITDA multiples below 10, while Williams trades below 11.5.
Given the opportunities ahead of them and where they trade today relative to historical valuations, these undervalued stocks could be among the best performing value stocks over the next few years.
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Geoffrey Seiler holds positions in the energy transfer and enterprise products industries. The Motley Fool holds positions and recommends Goldman Sachs Group and Kinder Morgan. The Motley Fool recommends Enterprise Products Partners. The Mad Motley has a disclosure policy.
Prediction: These Stocks Could Be Top Performers Through 2030 was originally published by The Motley Fool
