Energy-related equity prices are plunging on declining energy prices amid fears of an oncoming recession. While we understand the reasoning, we believe Mr. Market is irrationally selling off these midstream equities for the following reasons:
- Energy prices currently remain elevated relative to recent history and the threat of escalating geopolitical tensions with Russia, Iran, and/or China provides a very plausible catalyst to send energy prices soaring even higher. In fact, some experts think that geopolitical tensions with Russia could send oil prices over $200 a barrel if the G7 decides to try to cap Russian prices.
- Midstream (AMLP) valuations are extremely cheap relative to their own history despite industry and business fundamentals being more favorable than they have arguably ever been. For example, Energy Transfer’s (NYSE:ET) forward EV/EBITDA is considerably lower today than it was 1 year ago despite the distribution yield being far higher, the leverage ratio being far lower, and the price of oil being far higher today.
- Midstream businesses are much more commodity price and even demand resistant than energy production and exploration companies are. As a result, even if we go into a recession and the price of oil falls by another third like some analysts project, the cash flows for most midstream businesses are unlikely to be significantly impacted unless these conditions persist for several years.
As a result, we believe that this is an exceptional opportunity to buy midstream businesses. In this article we will compare two of the cheapest high yielding midstream opportunities available today: ET and NuStar Energy (NYSE:NS).
NuStar Energy Vs. Energy Transfer: Business Model
NS operates three main businesses: renewable fuels, refined products, and crude supply/export. Its renewable fuels business has an established West Coast network and services ethanol and biodiesel blending and is developing an ammonia system. In fact, its ammonia pipeline is the only ammonia pipeline in the country, spanning over 2,000 miles and reaching seven states from Louisiana to Nebraska and Indiana. This gives it a competitive advantage as the lowest-cost transportation option for imported and domestically produced ammonia for producing crop fertilizers in the U.S.’s breadbasket, making it a highly valuable asset.
Its refined products business is concentrated in Colorado, New Mexico, Texas, and Northern Mexico. Its crude supply and export segment consists of three main businesses: its Permian crude system, its Corpus Christi crude system, and its St. James Terminal. T
Its business that services the Permian basin is particularly high quality and – assuming that the long-term prospects there are strong – should boom in the years to come.
Furthermore, 72% of their pipeline revenues are either take-or-pay (32%) or structurally exclusive (40%), and 62% of their storage revenues are take-or-pay, making their cash flows pretty stable.
Additionally, 63% of their pipeline and storage revenues come from investment grade customers, with another 12% coming from large private or international companies that also have considerable financial resources with which to honor contract commitments during market downturns. As a result, NS’s business model is pretty resistant to short-to-medium length downturns.
ET’s business model is far larger and better diversified than NS’ is. As Moody’s said, ET’s owns an
“extremely large and diversified midstream asset base, generating largely fee-based cash flows.”
This results in it benefitting from a geographically and economically diverse asset portfolio with a fully-integrated platform spanning the entire midstream value chain. In fact, ET is one of just three midstream businesses that services all 15 major U.S. oil & gas producing regions.
ET’s best asset is arguably its Texas intrastate pipeline system, which is the largest intrastate pipeline network in the U.S. with the capacity to service Texas’ entire gas demand year-round.
On top of that, ~90% of its expected 2022 adjusted EBITDA is sourced from fee-based contracts and its Q1 adjusted EBITDA was spread fairly evenly across 5 different business segments.
While NS has some high-quality niche assets, ET’s sheer scale, great exposure to fee-based contracts, and its substantial exposure to natural gas and NGLs puts it in a league above NS when it comes to midstream capabilities.
NuStar Energy Vs. Energy Transfer: Balance Sheet
NS has dramatically curtailed its capital spending and is instead intently focused on maximizing free cash flow in order to deleverage its balance sheet by paying down debt and redeeming its preferred equity as quickly as possible.
In Q1, NS closed on the divestiture of its Point Tupper terminal facility for $60 million in proceeds that it will be using to further strengthen the balance sheet by reducing debt. Management reduced interest expense by $5 million on a quarterly basis year-over-year due to a reduced debt burden and reduced the debt to EBITDA ratio from 4.39x to 3.92x year-over-year and by 0.07x sequentially.
As a result of its aggressive work to deleverage the balance sheet, NS has no debt due prior to 2025, giving it plenty of time to redeem most if not all of its $621 million in Series D preferred units at their earliest possible date (July 2023) using free cash flow. Management stated on the earnings call that they expect to be able to fully redeem these preferred units by 2025 or 2026 at the very latest. By that point, it should be in a financial position which should enable it to quite easily refinance its substantial debt maturities in 2025-2026.
Overall, while still sporting a junk credit rating (BB- (Stable) from S&P), NS is in pretty sound financial position and – if it is successful in paying down its Series D preferred units aggressively while continuing to incrementally grow EBITDA – it could very likely earn some credit upgrades ahead of its debt refinancings in 2025 and beyond.
ET, meanwhile, sports a BBB- (Stable) credit rating from S&P and could very possibly experience an upgrade in the near future given its impressive progress towards deleveraging its balance sheet, reducing debt by ~$6.6 billion over the past five quarters. Management has doubled down on this initiative in recent earnings calls, saying that it plans to pay down its upcoming maturities with retained cash flow instead of refinancing them.
It also took an additional significant step in that direction by announcing the sale of its interest in Energy Transfer Canada recently. This is expected to reduce approximately $450 million in net consolidated debt. While neither business is in danger of financial distress here, ET gets the edge.
NS Vs. ET: Growth Outlook
Despite its focus on deleveraging, NS is still expecting to spend up to $145 million in strategic capital spending this year as it continues to build out its renewable fuels business and pursue opportunities to capitalize on its existing strengths in the Permian basin. That said, growth here should be fairly minimal in the coming years as the vast majority of NS’ cash flows are being allocated towards deleveraging and distributions, leaving little for investing in meaningful growth.
Analysts expect EBITDA to grow at a 3.1% CAGR through 2026, while distribution growth is expected to limp along at 1.1% per year, with none expected to come prior to 2025 once management has successfully redeemed its series D preferreds and refinanced its major debt maturities. Meanwhile distributable cash flow per unit is expected to compound at a much brisker 6.7% pace due to a combination of expected EBITDA growth and reduced interest and preferred distribution expense as management aggressively redeems its series D preferred units.
The good news here is that the common distribution looks quite safe as there are no debt maturities until 2025 and distributable cash flow is expected to cover the distribution by over 2x this year, with that coverage ratio improving each year moving forward.
ET meanwhile continues to spend fairly aggressively on CapEx, though it has curtailed this some in order to focus on paying down debt. As a result, EBITDA is only expected to grow at a 1% CAGR through 2026 and distributable cash flow per unit is expected to only grow at a 1.8% pace over that same time span. However, distribution growth is expected to be much stronger with a CAGR of 8.4% expected (with much of that frontloaded) as ET currently has an enormous 3x coverage ratio of its distribution
NS Vs. ET: Stock Valuation
When it comes to valuation, ET appears to be the clear winner, trading at a meaningfully cheaper EV/EBITDA and P/DCF valuation despite having a stronger credit rating and a larger and better diversified portfolio of assets and businesses:
|Metric||EV/EBITDA||EV/EBITDA 5-Yr Avg||P/DCF||Distribution Yield|
That said, NS does have a 300-basis point higher distribution yield (though ET will likely be closing the gap in that category soon) and also has a significantly higher expected distributable cash flow per unit growth rate through 2026 as per our previous comments in the Growth section of this article. Ultimately, it comes down to what you are looking for, but given ET’s lower risk profile, we believe ET is a better overall buy right now.
Both NS and ET offer investors compelling value right now. NS offers a sky-high yet sustainable 11.4% distribution yield, but carries with it higher risk and little to no distribution growth potential for the foreseeable future as management focuses on deleveraging the balance sheet.
Meanwhile, ET offers investors a less compelling, but still very high yield that is not only very safe, but should grow meaningfully over the next two to three years as management has nearly achieved its deleveraging goals and will then be able to pivot towards returning more capital to unitholders. We rate both of these opportunities a Strong Buy here, but favor ET as offering a more attractive risk-reward.