The Best Risk-Reward Plays In Oil

Market Trading EssentialsJuly 28, 2021

5 minutes read

Oil prices have been ticking upwards after OPEC+ reached an agreement on Sunday that will see the group start adding 400,000 bpd production each month from August. Goldman Sachs says the agreement is modestly bullish and has forecast that Brent will hit $80 per barrel this summer.

Piper Sandler says that whereas the backdrop of tighter monetary policy, the trajectory of the economic recovery, and the sustainability of inflation are likely to create some volatility curveballs, they will not be enough to derail the secular bull market.

Meanwhile, the fossil fuel sector is enjoying a rare blowout season: Over the past few earnings seasons, the majority of companies in the energy sector have comfortably beat Wall Street’s expectations

With impressive bottom-line growth, many top energy names are returning more capital to shareholders in the form of dividends and share buybacks. Companies usually repurchase shares when they believe they are undervalued, a big endorsement for oil and gas bulls.

The biggest gainers in the current environment are integrated oil companies such as ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX), which own assets that run the whole gamut of the oil business, including drilling (upstream) and processing (downstream).

However, the latest oil price downturn has reminded us that these companies also tend to be highly volatile because their business model is heavily reliant on commodity prices.

To build a well-balanced and diversified portfolio, you need to invest in the midstream sector that carries less commodity price risk.

Midstream oil companies provide the pipelines, processing, storage, and transportation, and processing assets that help move oil and gas commodities from the point of production to their eventual consumption points. Many midstream companies are fee-based, meaning their businesses depend more on commodity demand and are less affected by commodity price swings because demand tends to be more stable while prices tend to be more volatile.

Another big draw: Midstream energy companies are some of the highest dividend payers, with many sporting yields above 6%.

That said, midstream energy companies are not without risk.

Just like the rest of the oil and gas sector, the U.S. midstream oil and gas segment was disrupted by the plunge in global energy demand spawned by the coronavirus pandemic. Many saw their market values cut in half, with huge pullbacks in production as well as a ramping down of capacity by refineries, liquefaction facilities, and exporters, as well as rampant project cancellations all taking a heavy toll.

Nevertheless, last year was an outlier, and we are not likely to see anything that dramatic in the near future. Here are our top picks in the midstream oil sector.

Enbridge Inc.

Market Cap: $78.7B

Dividend Yield: 7.11%

If you prefer an energy stock that offers a rare combination of high yield and growth, then look no further than Enbridge Inc. (NYSE:ENB), a Canadian energy transportation company based in Alberta. Enbridge owns a network of transportation and storage assets that connect some of North America’s richest oil and gas fields. As low-cost shale drilling continues to grow the continent’s energy production volumes, Enbridge should be able to see healthy demand for its pipeline and transportation facilities.

This midstream energy company sports a healthy dividend yield with a target to grow the dividend at 10% per annum while at the same time maintaining an impressive distributable cash flow ratio of 1.4x forward dividend.

Enterprise Products Partners L.P.

Market Cap: $51.4B

Dividend Yield (Fwd): 7.65%

Enterprise Products Partners L.P. (NYSE:EP) is the top transporter of natural gas liquids (NGLs) and also owns the most NGL fractionation capacity in the United States, as well as dock space for exports. Enterprise Products is the largest midstream MLP in the country.

Enterprise has clearly read the signs of the times and has begun to work with partners to scale back its project backlog. In the past, EP was able to weather the normal industry headwinds thanks to robust cash coverage and manageable leverage. Unfortunately, Covid-19 has been anything but your average downturn, and EP has been forced to seriously cut back on Capex.

After spending $17 billion in capital projects in 2015-19, including new oil pipelines, NGL and LPG pipeline-and-export facilities, and NGL fractionation plants, the giant MLP now plans to spend a combined $4 billion in 2021-22.

These dramatic cuts are expected to pay off big time in higher earnings and distributions.

Phillips 66 Partners

Market Cap: $8.4B

Dividend Yield (Fwd): 9.56%

Phillips 66 Partners (NYSE:PSX) is a midstream company founded in 2013 as a subsidiary of Phillips 66 (NYSE:PSX).

Phillips Partners owns 75% of its MLP’s limited shares, providing crucial

support for revenues and financing. Indeed, PSXP has one of the strongest balance sheets of the refining-sponsored MLPs, with a huge dividend that appears well covered.

The main risk when investing in PSXP hinges on whether the Dakota Access Pipeline (DAPL) will eventually be shut following a permitting dispute. But with states and municipalities starving for tax revenues and jobs amid Covid-19, this does not look like something that’s likely to happen any time soon. In July 2020, a District Court judge issued a ruling for the pipeline to be shut down and emptied of oil pending a new environmental review. The temporary shutdown order was overturned by a U.S. appeals court on August 5, though the environmental review is expected to continue.

Back in May, Reuters reported that the U.S. Army Corps of Engineers said it does not believe a judge should order the Dakota Access oil pipeline shut while environmental review continues.

Master Limited Partnerships

For decades, master limited partnerships, or MLPs, have been a source of reliable, high-yield income for energy investors. An MLP is required by law to derive at least 90% of its cash flow from commodities, natural resources, or real estate. They, in turn, distribute cash to shareholders instead of paying dividends like a standard company would. MLPs combine the liquidity of publicly traded companies and the tax benefits of private partnerships because profits are taxed only when investors receive distributions.

The biggest draw of MLPs is that they are considered pass-through entities under the U.S. federal tax code. Whereas most corporate earnings are taxed twice (first through earnings and again through dividends), pass-through status of MLPs allows them to avoid this double taxation because earnings are not taxed at the corporate level. Another key benefit: Midstream MLPs act as toll collectors for the energy companies that use their pipelines. As such, their cash flows are protected by long-term, take-or-pay agreements, meaning they are less susceptible to commodity price fluctuations.

It’s, therefore, hardly surprising that MLPs typically pay the highest distributions in the energy sector. Here are some top payers.

MPLX LP

Market Cap:$28.8B

Dividend Yield (Fwd): 9.85%

MPLX LP (NYSE:MPLX) is an Ohio-based crude oil and natural gas transportation and processing company.

MPLX has been making good progress reducing operating and capital expenses as well as securing and developing joint venture growth projects. In addition, parent company Marathon Petroleum Corp. (NYSE:MPC) recently completed the sale of its Speedway assets for $21 billion, with the proceeds to be used to pay down debt and shore up the company’s balance sheet.

Rattler Midstream LP

Market Cap: $1.5B

Dividend Yield: 8.57%

Rattler Midstream LP (NASDAQ:RTLR) provides water-related services to oil and gas shale producer Diamondback Energy (NASDAQ:FANG) in the Permian Basin in West Texas.

Rattler’s management has been aggressively cutting back on capital expenditure which has helped support sustained free cash flow generation. Further, Rattler Midstream is not present on all the company acreage of Diamondback Energy which allows it to grow revenue at a time when Diamondback Energy has forecast a period of no growth.

Other top-paying MLPs are: