Inflation Worries? Not for Midstream/MLPs

02/15/22 | Stacey Morris, CFA

Summary

  • Midstream/MLPs are well-positioned for the current inflationary environment thanks to real asset and energy exposure.
  • Additionally, midstream boasts contracts that are often indexed to inflation, and companies have historically been able to pass higher costs onto customers.
  • For investors, dividend growth may help offset the negative impact of inflation.

With last week’s Consumer Price Index data stoking continued inflation concerns, it is timely to revisit the advantages of midstream/MLP investing in inflationary periods. Energy infrastructure has typically outperformed in periods of elevated inflation, benefitting from its inherent real asset exposure and contract provisions that allow for annual inflation adjustments. For investors, dividend growth from the space can help offset the negative impact of inflation. While today’s note focuses on inflation, the related topic of midstream performance in periods of rising interest rates was covered in another recent Alerian note.

Midstream/MLPs have typically outperformed in inflationary periods.

Energy infrastructure is well-positioned for the current inflationary environment thanks to its real asset and energy exposure. Unlike stocks or bonds that derive value from a contractual right, real assets, such as precious metals, commodities, real estate, and infrastructure, derive their worth from the intrinsic value of a physical asset and can serve as an inflation hedge. For midstream, these physical assets include pipelines, processing facilities, storage tanks, and export terminals. In addition to midstream’s real asset exposure, the space can also benefit from improving energy sentiment broadly as oil prices move higher in inflationary periods. As shown in the table below, there have been six years since 2000 when inflation averaged above 3%, including 2021. The Alerian MLP Infrastructure Index (AMZI) outperformed the broader market in all of those years, except 2008, while the Alerian Midstream Energy Select Index (AMEI) outperformed in all three years where index history is available, including 2008.

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Midstream largely generates inflation-protected revenues.

In addition to benefitting from real asset and energy exposure, midstream boasts contracts that are often indexed to inflation, and companies have historically been able to pass higher costs onto customers. MPLX (MPLX) noted on their recent earnings call that most revenue streams have an inflation escalator, with storage one exception. However, storage contracts for the industry are typically shorter in nature (~3 years) relative to pipeline contracts (~10 years). Over 90% of revenues for Enterprise Products Partners (EPD) have an escalation mechanism based on comments from the company’s November earnings call. Similarly, Enbridge (ENB) noted last week that 80% of its EBITDA has built-in inflation protection.

Many interstate liquids pipelines (those carrying oil, natural gas liquids, and refined products like gasoline) use indexing to adjust their rates each July 1 based on Federal Energy Regulatory Commission’s (FERC) Oil Pipeline Index, which sets a maximum for annual rate increases. Specifically, the FERC uses the Producer Price Index for Finished Goods (PPI-FG) with an adjustment to reflect industry cost changes. The index is typically updated every five years and was set at PPI-FG +0.78 in December 2020 for July 2021 to June 2026. In late January, FERC announced that it was changing the index to PPI-FG -0.21%, making the calculation consistent with what was done in 2015 and 2020. With estimated PPI-FG at 8.96% in 2021, the implied ceiling for rate adjustments would be 8.75%. While the change in the adjustment factor is directionally negative, the impact for the space should be relatively muted. On their early February earnings call, the management of Magellan Midstream Partners (MMP) quantified the negative impact from the index adjustment change at just $3 million annually. For context, 30% of MMP’s refined product shipments follow the FERC index.

Dividend growth can help offset some of the impact of inflation for investors.

As noted in past research, the outlook for midstream/MLP dividends is more constructive this year as companies have made progress with reducing leverage and continue to generate significant free cash flow. In most cases, these fundamental improvements are paving the way for dividend or distribution increases, but management teams may also be considering the impact of inflation. Notably, Energy Transfer (ET) announced a 15% distribution increase in late January, and Plains All American (PAA) mentioned in their earnings release last week that management would recommend a ~20% distribution increase to the board for their May payout. When asked about inflation and the distribution on their 3Q21 earnings call in November, management from EPD indicated that they take purchase power parity into consideration. They discussed increasing the distribution growth rate relative to the last few years in response to increased inflation, and in January 2022, EPD announced a 3.3% distribution increase. This compares with a 1.1% increase in 2021 and a 1.4% increase in 2020.

Bottom Line

The combination of midstream’s real asset exposure and inflation-protected revenues has typically supported equity performance in periods of elevated inflation. Dividend growth can be particularly beneficial for investors in today’s inflationary environment.

AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB). AMEI is the underlying index for the Alerian Energy Infrastructure ETF (ENFR).


Related Research:

Midstream/MLPs Resilient in Periods of Rising Rates

Midstream/MLPs: Well-Positioned for Inflation

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