As Energy Pursues Free Cash Flow, Midstream/MLPs Stand Out

09/29/20 | Stacey Morris

Summary //

  • While energy companies across the sector are pounding the table on free cash flow, midstream has a distinct advantage over its counterparts when it comes to the predictability of free cash flow and the generous income on offer.
  • In contrast with other energy sectors, midstream’s more predictable cash flows allow for a greater degree of confidence in free cash flow generation regardless of the commodity price environment.
  • Midstream’s fee-based cash flows tend to support more predictable income for investors, whereas oil and gas producers are increasingly discussing variable or special dividends.

Setting aside an oil price rally, free cash flow generation is broadly seen as the means for the energy space to reignite interest in the sector from a generalist investor base that has long been content on the sidelines. Free cash flow, often in company with capital discipline, is espoused in investor presentations across the energy landscape from Chevron (CVX) to Baker Hughes (BKR) to EOG Resources (EOG) to midstream companies like Enterprise Products Partners (EPD), Kinder Morgan (KMI), and MPLX (MPLX). As discussed a few weeks ago, midstream is well positioned to generate significant free cash flow next year with estimates for excess cash even after generous dividend payments (read more). While energy companies broadly are pounding the table on free cash flow, midstream has a distinct advantage over its counterparts when it comes to the predictability of free cash flow and the generous income on offer.

Midstream’s free cash flow advantage relative to other energy sectors.
As we often point out, midstream’s largely fee-based cash flows have allowed for more resilient earnings expectations compared to other sectors of energy. The fee-based nature of midstream and contractual protections like minimum volume commitments also enable midstream companies to provide annual financial guidance, whether it’s EBITDA, distributable cash flow, or another metric (read more). Not all midstream companies provide this type of guidance, but many do.

Other energy companies also often provide guidance – throughput for refiners, production volumes for exploration and production (E&P) companies, and indications of activity levels or revenues for oilfield services. However, in contrast to midstream, guidance may only be for the next quarter or may only relate to operations. It is difficult to project full-year, earnings-related metrics for companies more dependent on commodity prices. If provided, guidance usually relies on some assumptions. For example in its 2Q earnings presentation, E&P Pioneer Natural Resources (PXD) estimated free cash flow of $600 million for this year assuming strip pricing (futures prices) for 2H20.

Midstream’s more predictable cash flows allow for a greater degree of confidence in free cash flow generation regardless of the commodity price environment. Some companies have maintained EBITDA guidance throughout 2020, including Williams (WMB), Enbridge (ENB), and Cheniere Energy (LNG). Stable financial guidance during an extremely volatile year would be unfathomable for producers, which had to contend with both weak prices and resulting production shut-ins unforeseen at the start of this year. To be fair, many midstream companies have lowered their initial guidance from early in 2020, but the revisions have largely been modest, particularly compared to other energy sectors (read more). The stability of midstream cash flows provides greater visibility to free cash flow generation, whereas other energy sectors have the same emphasis on free cash flow, but actual dollar amounts will see greater variability to the upside or downside depending on commodity prices.

Midstream’s income stream is also differentiated.
The stability of midstream cash flows and variability for other energy sectors also has implications for the dividends companies provide investors. Midstream’s fee-based cash flows tend to support more predictable income for investors. Admittedly, there were a number of distribution/dividend cuts for 1Q20 among smaller names in the universe, but the larger names in the space held steady (read more). Overall, there is good visibility for midstream payouts. For MLPs, their pass-through structure allows for more generous distributions, and the tax-advantaged nature of distributions is also unique relative to other sectors of energy. Recall, typically 70-100% of an MLP’s distribution is tax-deferred, which means taxes are not paid on that portion until the units are sold (read more).

Due to the greater irregularity of their cash flows, oil and gas producers are increasingly discussing variable or special dividends. Special dividends would give investors direct participation in the upside in commodity prices and complement regular dividends, which tend to be low in absolute terms for E&Ps due to the greater variability in cash flows, as shown in the chart below. PXD expects to establish a variable dividend framework next year. Devon Energy (DVN), which is merging with WPX Energy (WPX), expects to deploy a fixed plus variale dividend strategy with a fixed quarterly dividend of $0.11 per share and a variable quarterly dividend of up to 50% of the remaining free cash flow. Because cash flows will fluctuate with commodity prices, variable dividends are a better fit for E&Ps. Companies can pay out more when cash flows are higher but are able to pay less when times are leaner. To that end, there is some question of whether special dividends actually enhance equity values over time, but that is a debate we will leave to others.

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Special dividends provide a flexible way for E&Ps to return cash to shareholders, but for investors, fluctuating payouts may or may not meet their needs. Investors interested in using energy to play a commodity price recovery may be pleased to have a more tangible benefit in the form of extra cash from special dividends. A retiree with fixed living costs would probably prefer the more predictable income from midstream than a windfall one quarter and a potential dry spell the next quarter or quarters.

Beyond dividends, excess cash flows could also be returned to investors through share repurchases. For its part, ConocoPhillips (COP) continues to analyze the best way to return cash to shareholders, weighing buybacks and a variable dividend. For midstream investors, it may be possible to have the best of both worlds – generous, steady income and buybacks as well. Within midstream, EPD, KMI, and Magellan Midstream Partners (MMP) have current buyback authorizations, and others have discussed the potential for repurchase programs (read more). Admittedly, buybacks may gain more traction as the macro environment stabilizes and companies increasingly generate free cash flow after dividends (read more).

So what?
A focus on free cash flow has permeated the energy space as companies try to lure generalist investors back with a renewed focus on returns and capital discipline. Free cash flow can help enhance valuations and support shareholder-friendly actions like buybacks and dividend increases, which would also support equity values. For many energy companies, the amount of free cash flow generated will depend on the commodity price environment, but midstream’s fee-based cash flows provide greater predictability for free cash flow generation while supporting generous quarterly dividends and distributions.