With the passage of massive economic stimulus, higher-than-expected commodity price increases, and interest rate hikes, rising inflation has become a growing concern in recent months. While absolute rates remain low, the rise in the 10-year Treasury yield has prompted market worries, resulting in trading pressure on higher valuation multiple, longer-duration cash flow equities, such as those in the Technology sector. Midstream energy businesses may offer many benefits to investors wanting to position their portfolios to combat increasing inflation.
Midstream companies manage the pipelines and collection or transmission systems that transfer gas from the well (upstream) to our homes and businesses (downstream). In addition to treating the product, midstream operations also remove any water or waste, compress it, and prepare it for downstream markets.
As the re-opening/cyclical trade unfolds, we expect midstream energy companies will continue to outperform. While there are no guarantees in the event of an interest rate shock, the Midstream group provides significant benefits in an inflationary environment:
- Growth in Current Income
The Midstream group’s average yield remains strong, at almost 7%, with forecast dividend growth of around 2% over the next few years. Furthermore, while Free Cash Flow after Dividends is positive and expected to expand, numerous management teams have said that they can complement modest dividend growth with share buybacks.
- Spread of Yield
David Goodnight, Austin believes there is enough “buffer” for the group to withstand an increase in the 10-year Treasury yield, with valuation multiples for Midstream stocks still below pre-Covid levels and a yield spread of a historically high 600 basis points.
- Protection under Contract
Inflation escalators get built into several Midstream contracts, according to David Goodnight, Austin. Interstate liquids pipelines governed by FERC, for example, can raise tariffs by the percentage change in the producer price index for finished products (PPI-FG) + 0.78 percent.
- Dollar (USD)
All other things being equal, a declining dollar may benefit crude prices (priced in US dollars), encourage drilling, and increase throughput for midstream networks. Higher commodity prices, at the very least, can help to promote favorable investor sentiment in the Energy sector, as has been the case in recent months. WTI crude has traded in the $60-65 range in recent months, having hit a historic low a year ago (-$37.63 on 4/20/20). Additionally, limited domestic stockpiles and overseas demand may cause propane prices to rise this winter.
- Demand for Energy
Interest rate hikes aren’t always poor, according to David Goodnight, Austin. Rising rates are often desirable when driven by economic expansion to higher energy demand. As the economy reopens, fuel demand has returned to pre-COVID levels, aided by increased COVID immunity.
- Momentum and Cyclical Trade
The transition to cyclical stocks appears to be complete. Furthermore, as of Energy’s recent outperformance, “momentum” trading baskets are now net-long Energy, a positive trading dynamic.
With various benefits in an inflationary environment, now may be a good moment to consider midstream energy businesses as an investment.