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Midstream energy: A profitable bridge to a renewable future?

This midstream energy ETF provides exposure to companies instrumental in the energy transition while also offering an outsized income yield.
The post Midstream energy: A profitable bridge to a renewable future? first appeared on ETF Strategy.

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Midstream energy companies probably aren’t front of mind when considering lower-carbon investment opportunities.

Stacey Morris, Head of Research, Alerian

In fact, almost the contrary. As society has become more aware of the impact of climate change, investors have progressively reduced allocations to the traditional energy sector, of which midstream companies are a part.

This trend has been facilitated by a growing number of responsible investment products, including ETFs, that explicitly and routinely exclude, or at the very least under weight, companies linked to fossil fuel industries.

Yet, according to Stacey Morris, Head of Research at midstream indexing specialist Alerian, many of the firms operating in this space actually specialize in lighter hydrocarbons, such as natural gas, that will play an important role as lower-carbon bridging fuels en route to a renewable future.

Morris, who recently shared her views on the midstream energy sector in a webcast hosted by ETF Strategy in partnership with white-label ETF platform HANetf (see ‘Midstream Energy: An Investment Grade Investment Opportunity‘), notes that the transition to renewable energy is likely to take much longer than most would expect. While electrification and decarbonization are key themes in developed economies, approximately three billion people are still dependant on solid fuels for cooking. Sweden, which is a country at the forefront of the energy transition, is targeting carbon neutrality in 2045 – that’s 25 years from now.

Meanwhile, the United Nations has set a medium-term goal of reducing greenhouse gas emissions by 45% over the next decade.

This combination of long-term ambition for carbon neutrality and shorter-term reduction goals points to the utility of relatively cleaner bridging fuels in achieving progress on the path to meeting ultimate end goals. Ardent climate change purists will argue for the immediate surrender of all carbon fuels, but others, perhaps more pragmatic, contend that a gradual transition that incorporates the use of bridge fuels is more feasible.

FEATURED PRODUCT

Alerian Midstream Energy Dividend UCITS ETF

– Tracks the Alerian Midstream Energy Dividend
Index
, providing exposure to North American
MLPs and C-corps belonging to the GICS Oil &
Gas Storage and Transportation industry.

– 60% exposure to lower carbon bridging fuels
such as Natural Gas.

– 11.6% dividend yield with 83% of constituents
rated investment grade

– Available on London Stock Exchange in USD
(MMLP LN) and GBP (PMLP LN) and on Xetra
(JMLP GY) and Borsa Italiana (MMLP IM) in
euros.

– Expense ratio of 0.40%.

For those investors who consider themselves to be sympathetic to this latter view, Morris believes the Alerian Midstream Energy Dividend Index offers a compelling tool for exposure to companies that are poised to benefit during a bridging period while also providing a very attractive income proposition to boot.

This index is the underlying reference for the Alerian Midstream Energy Dividend UCITS ETF, which was launched in July in partnership with HANetf. The fund is available on London Stock Exchange in US dollars (MMLP LN) and pound sterling (PMLP LN), and on Xetra (JMLP GY) and Borsa Italiana (MMLP IM) in euros. It comes with an expense ratio of 0.40%.

The ETF provides exposure to North American midstream energy infrastructure companies – companies that own and operate pipelines, storage facilities, refineries, and import/export terminals that facilitate the transportation or processing, for fees, of natural gas, natural gas liquids, and crude oil to customers in domestic and international markets.

This segment is typically more resilient than upstream producers due to steady cash flows based on long-term contracts that are often linked to inflation. The fee-based nature of midstream operators, as well as the regular presence of minimum volume commitments, makes their cash flows less sensitive to commodity prices than other parts of the energy value chain, providing useful defensive characteristics.

These companies are typically organized as Canadian corporations (C-corps) or as Master Limited Partnerships (MLPs) – a corporate structure that enjoys a tax-advantage in the US that enables cash flows to be passed on to investors as attractive dividend distributions.

The index includes US and Canadian companies, both MLPs and C-corps, which belong to the Oil & Gas Storage and Transportation industry group, a subset of the Energy sector, as defined by the Global Industry Classification Standard (GICS). Constituents are weighted by aggregate annualized dividends in a bid to boost income potential, while any individual security is capped at 10% to ensure diversification.

Importantly, about 60% of the index by weight is allocated to companies that are primarily focused on transporting and processing natural gas. Natural gas is widely considered to be the key bridging fuel (assuming, of course, one acknowledges such an approach to carbon reduction) for the energy transition, with studies indicating that natural gas produces roughly half the carbon emissions of coal and 30% less than oil when burned.

US natural gas production has accelerated over the past ten years, expanding by roughly 5% per annum with the US currently on track to become the biggest exporter of liquefied natural gas by 2025. Midstream companies, through extensive capital expenditure over the past decade, have established core infrastructure for moving liquefied natural gas to the coast and thereby play a vital role in facilitating the world’s access to this cleaner bridging fuel.

Beyond this, some of the index’s largest constituents – Enbridge (10.4%), TC Energy (8.4%), and Williams (7.4%), for example – are directly investing in renewables, with Williams targeting net zero emissions by 2050, further showcasing how even traditional energy companies are aligning with a low-carbon future.

This is something that is not always recognized in ESG approaches, meaning that investors who adhere to blanket exclusionary approaches could be throwing the baby, i.e. an attractive portfolio proposition, out with the bathwater when the bathwater isn’t all ‘bad’. As more investors do this, those investors who accept a role for bridge fuels could potentially earn an outsized yield premium.

Unparalleled income opportunity

The midstream segment was dealt a significant blow by this year’s Covid-19 disruption – the Alerian Midstream Energy Dividend Index plummeted 60% between 21 February and its bottom on 18 March. While the index has recovered somewhat since then, it is still down 39% year-to-date (data as of the market’s close on 18 September).

According to Morris, however, the sell-off has been overdone and represents a unique moment for investors. Falling valuations have pushed the segment’s yield to near all-time highs, presenting a significant opportunity for income-seeking investors in the record low-interest-rate environment. The yield on the index is currently at 11.6%, notably above its five-year average of 7.4% and head and shoulders ahead of other income-producing asset classes such as REITs (3.5%), utilities (3.5%), and bonds (1.2%).

Despite the index’s unusually high yield, fears of a value trap would appear to be overdone when one considers that investment-grade-rated credits make up some 83% of the total weighting.

Alongside this, Morris points out that MLPs are typically omitted from mainstream indices, such as the S&P 500, while their historically low correlation to other income-yielding securities makes them attractive portfolio diversifiers.

For pragmatic investors who recognize the need to balance real-world income demands and portfolio diversification requirements with a reasonably grounded climate conscience, then the midstream energy space should not be rejected out of hand. Indeed, it seems wholly deserving of much closer inspection.

The post Midstream energy: A profitable bridge to a renewable future? first appeared on ETF Strategy.

Author: James Lord, CFA

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