With oil and gas midstream project spending set to begin declining in 2020, the sector's companies need to carefully prioritize how they use their excess cash when it comes to lowering debt, stabilizing investor payouts and conducting share buybacks, energy industry analysts at Bernstein said.
With oil and gas transportation bottlenecks out of high-production areas such as the Permian Basin unclogging by a slew of pipelines and export facilities, midstream management teams are under pressure from investors and analysts to show that the companies can be good stewards of their projects' returns. That involves pivoting toward free cash flow — interpreted broadly as cash flow from operations minus capital expenditures — and de-emphasizing distributable cash flow as the primary way to illuminate how much money it has available.
How to use that cash, however, "is a fraught question" because shareholder preferences are split among a few different priorities, according to Bernstein's Jan. 10 note to clients. Investors in favor of loan repayment are likely against stock repurchases, Bernstein wrote. Meanwhile, there is "little evidence" that raising dividends and distributions is the solution to persistently sluggish equity values across the midstream sector, the note said.
"It seems that the [Kinder Morgan Inc.] route has been the relative winner over the past two years. Get debt just to a safe level, usually 4-4.3x depending on assets," the analysts wrote. "Then, pay a dividend in the 5-6.5% range — in line with quality peers. ... Then whatever free cash flow is left should be used for buybacks."
Higher yields have become anathema to midstream investors in the past few years as institutional unit holders expect companies to ditch the master limited partnership model to look and act more like traditional corporations. Further debt reduction, though, does not necessarily translate into higher stock prices, so buybacks are emerging as a fix to ebbing fund flows because "the companies need to be their own marginal buyer," the Bernstein note said.
Oil and gas drillers have not seen any sectorwide direct correlation between repurchases and equity values, but Bernstein expressed optimism that midstream firms could materially benefit from that strategy.
"The high (but we think safe) dividends for large-cap midstream coming from lower ongoing cash spend than [exploration and production companies, or] E&Ps are the main driver, suggesting that over time the dividend will set the value of the assets rather than the whims of capital markets," the analysts said.
Despite spending on big-ticket items, such as the $5 billion acquisition of SemGroup Corp., Energy Transfer LP CFO Tom Long said in November 2019 that issuing unit buybacks is a priority for the pipeline heavyweight.
"We hear you loud and clear. ... We get it also, and I think we are taking all the steps necessary to position ourselves financially to be able to do that," he said.
Enterprise Products Partners LP is already conducting opportunistic buybacks as it sees fit, but President and CFO Randall Fowler said in October 2019 that the company would "rather allocate our capital to good growth projects as opposed to coming in and doing programmatic buybacks."