"When you're looking at small-caps that have basin-specific exposure or are very upstream-oriented, talking about investing in green hydrogen … is not a viable path forward," Tudor Pickering Holt & Co. analyst Colton Bean said.
Source: Robert Korner/Getty Images News via Getty Images
Battered by collapsing oil prices and a global pandemic, North American pipelines companies have moderately recovered from their 2020 stock price and balance sheet lows. There could be even more upside in 2021, according to some industry experts, but only for the biggest and best-performing firms.
"I think we're cautiously optimistic," Mizuho USA Securities Managing Director Gabriel Moreen said in an interview. "It's an intriguing setup for midstream where for the first time you potentially have stabilized and realistic earnings expectations into a backdrop where the energy tape can look better, and you also have low-capex, so the setup is for incremental free cash flow and that's something you haven't seen in midstream in quite some time."
The haves and the have-nots
Spiraling crude prices in March forced midstream management teams to slash investor payouts and cut spending just as the sector was winding down a years-long mega-pipeline infrastructure buildout. Shareholders welcomed the pullback and pushed for even more limited capital growth budgets given production declines predicted for 2021. While oil prices have inched higher, pipeline firms still plan to stick to what Regulatory Research Associates analyst Brian Collins called "budget austerity measures."
But while a gas pipeline heavyweight such as Kinder Morgan Inc. can aim to invest just $800 million in expansion projects and contributions to joint ventures in 2021 and expect its equity value to climb higher, CBRE Clarion Securities portfolio manager Hinds Howard said smaller midstream companies should not expect to be similarly rewarded.
Instead of investing in a broader range of pipeline firms by buying into midstream-specific closed-end funds, he explained, more retail and institutional investors are avoiding those struggling vehicles and sticking to individual stocks. That trend limits any upside to a select group.
"The number of tickers has gone down, and that means there's less of a need for these fund vehicles, so I think you'll see more divergence in quality names ... that's going to lead to some skew in performance," Howard said in an interview.
That divergence is already pronounced heading into the new calendar year. As of the Dec. 22 market close, the 10 largest pipeline companies have seen their stock prices decline nearly 28% during 2020, while 10 of the smallest companies' shares are down 43%.
Energy transition hang-ups
Smaller midstream firms also face a disadvantage when it comes to attracting environmental, social and governance-oriented investors, according to Tudor Pickering Holt & Co. analyst Colton Bean.
Companies such as Enbridge Inc. and Williams Cos. Inc., which are aiming for net-zero Scope 1 and Scope 2 carbon emissions by 2050, can afford incremental projects that decarbonize existing operations and add renewable energy to their portfolios. That is not the case for companies with significantly less market capitalization.
"When you're looking at small-caps that have basin-specific exposure or are very upstream-oriented, talking about investing in green hydrogen … is not a viable path forward, and so I do think the focus is going to be pay off as much debt as you can, buy back as many shares as you can," Bean said in an interview. "For the large-caps … they do have more flexibility. I think you're going to see more of them investing outside of the traditional footprint."
Still, larger oil-focused pipeline firms such as Plains All American Pipeline LP and Magellan Midstream Partners LP could struggle to pivot toward decarbonization.
"I think it's hard. You can't change the business that you're in," CBRE's Howard said. "I think they probably just start at a disadvantage, but I think they can … still improve disclosures and talk about how much better it is to have pipeline transportation than rail transportation or truck transportation."
A midstream oil and gas group and an allied trade association recently released an ESG reporting template that could help, but the Energy Infrastructure Council did not indicate a deadline for reporting 2018 and 2019 metrics that will be compared to 2020 data once it becomes available.
Hesitating on M&A
The widening split between small and large pipeline firms will not necessarily stimulate industry consolidation, either. Enterprise Products Partners LP, Energy Transfer LP and Kinder Morgan, for example, have indicated they are reluctant to snap up smaller companies as long as investors prefer that management teams return capital to unit holders instead of buying and adding infrastructure.
"This will not be a single-year process for most of these companies. It's going to take a couple of years to really get back to healthy balance sheets," Tudor Pickering Holt's Bean said.
The only transaction on the horizon so far for 2021 is CenterPoint Energy Inc. potential divestment from Enable Midstream Partners. President and CEO David Lesar said Dec. 7 that CenterPoint has retained a financial adviser to support its evaluation of the pipeline partnership and will provide an update in the next 60 days.
CenterPoint — which holds 53.7% of common units representing limited partner interests in Enable Midstream and 50% of the management interests in its general partner — formed a committee in May to reassess its stake in Enable Midstream. OGE Energy Corp. — which holds 25.49% of the partnership's common units and the other 50% of the general partner — is reportedly also considering unloading its stake.
"I think next year sets up to be a year where … we will see fewer tickers," CBRE's Howard said.