Buy The Dip: 2 energy stocks become irresistible

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Co-produced by Austin Rogers for High Yield Investor

The United States is the largest producer of oil and natural gas in the world. Add Canada, and we find that North America is the world’s largest supplier of fossil fuels.

Now, that fact may not seem like such a great strength at a time when record-breaking heat waves and deleterious weather anomalies have driven governments and private actors to invest more and more in green energy solutions. Indeed, renewables are expected to account for around 95% of new global electricity generation capacity over the next five years.

However, what has been proven recently by Europe’s desperate search for an adequate supply of winter fuel and California’s need to restrict electricity consumption is that fossil fuels will be needed to supplement renewable energies for a long time to come. Renewables are simply not ready to fully replace existing infrastructure yet.

This is especially true for natural gas, which plays a major role in powering the utility and industrial sectors of the economy. And the United States has vast proven reserves of natural gas. In fact, over the past 20 years, US natural gas reserves have roughly tripled.

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US Proven Natural Gas Reserves Data by YCharts

Currently, terminal facilities are being built to export gas from North America as well as import it to markets around the world such as Europe, China, India and Africa. These facilities virtually guarantee that global demand for North American natural gas will remain strong for many years, if not decades, to come.

We at High Yield Investor are very bullish on US natural gas, and our favorite way to express that bullishness is through midstream gas infrastructure owners (ENFR, AMLP, MLPX, MLPA).

Below we explain our thesis.

Natural Gas: Essential to Prosperity

Everything in our modern world runs on energy. This statement is so obvious that it is trivial, but it deserves reflection.

Although most people would probably agree at this point that the goal of reducing carbon emissions is good and worth pursuing vigorously, few people think it should be pursued so aggressively that it would reduce forces our access to energy. Few people, for example, believe that power outages are an acceptable sacrifice to reduce carbon emissions. Likewise, few people like the idea of ​​knowing when they can or cannot charge their electric vehicle.

It is important to recognize that humanity’s progress, prosperity and productivity depends on a sufficiently abundant supply of energy and electricity to meet our needs and desires.

So even as renewables are deployed in developed countries around the world, the reliability and dispatchability of natural gas will continue to be in high demand as an essential supplement.

Note, for example, that while the Energy Information Administration predicts that renewables will increase generating capacity faster than any other source of electricity over the next several decades, it still considers natural gas to hold firm as a share. of the total mix.

energy forecast

Energy Information Administration

Over the past 15 years, the share of coal in electricity generation has fallen from around 50% to 20%, while the share of natural gas has increased from 15% to over 40%.

And while the increasing deployment of twin battery storage facilities as well as new solar power generation assets are expected to decrease the demand for natural gas peaking facilities to some extent, the EIA clearly does not anticipate that this will have a significant impact on the global share of natty gas in electricity production in the next three decades.

The situation is almost identical in Europe. As Russia’s gas supplies have dwindled this year, it has become abundantly clear that renewables are far from ready to fill the void and won’t be for a long time.

That’s why the Europeans turned to their friends in North America for help. This should continue to support U.S. natural gas production growth to new highs, as forecast by the Energy Information Administration.

natural gas production

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This is a logical move for Europe and other developed countries looking to reduce their overall carbon emissions, as natural gas is a cleaner fuel than coal or oil. This is what makes it the perfect “bridging fuel” to use as the world gradually moves towards net zero carbon emissions.

Although many coal-fired power plants are permanently closed, some are being converted to burn gas instead. This, along with the continued use of the extensive existing gas-fired electric infrastructure in the United States and elsewhere, is what gives the EIA confidence that gas production will continue to increase in the decades to come.

production and consumption of oil and gas

Energy Information Administration

You may notice a discrepancy between the EIA’s projections of future gas production and consumption. This is because the EIA only measures gas consumption in the United States. But the United States will continue to produce more gas than we consume, because the difference will be exported to other countries.

In fact, the surge in US gas exports has already begun. Around 2016, gas exports began to soar, fueled mainly by increased exports of liquefied natural gas (“LNG”).

Chart
US Natural Gas Export Data by YCharts

The drop you see this year is mainly caused by the fire at the Freeport LNG terminal, owned mainly by ConocoPhillips (COP). Once this facility is back up and running at full capacity later this year, U.S. gas export growth is expected to continue on its previous upward trajectory.

Our favorite way to take advantage of this growth in North American natural gas production and export is through the midstream. This is the “middle” part of the energy industry in which fossil fuels are transported, stored, processed and shipped overseas via terminals.

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Long-term take-or-pay contracts dominate corporate revenues in this sector, making cash flows more stable than those in the upstream or downstream energy segment. While midstream companies lose some of the upside when commodity prices are high, they are also protected from most of the downside when commodity prices and throughput volumes are low.

Moreover, since the oil and gas glut of the mid-2010s, these companies have on the whole become very disciplined and conservative allocators of capital. Balance sheets improved dramatically and growth became largely self-funded by operating cash flow. This makes interim dividends safer than they have ever been.

Two best choices

At High Yield Investor, we hold several mid-tier stocks with significant exposure to natural gas. Although we will reserve a discussion of our specific holdings in the members area, we will highlight two examples of attractively priced gas-focused midstream stocks at this time.

1. Enterprise Product Partners (EPDs)

EPD’s portfolio of pipelines, storage, processing facilities and liquids terminals is one of the largest in North America, focused primarily on the Gulf Coast, but with significant inter- states reaching all over the country.

EPD Wallet

Presentation of the EPD in August

EPD has several major advantages.

  • First, it is heavily insider-owned, with management and the founding Duncan family owning about a third of the company. This basically aligns interests between management and shareholders.
  • Second, perhaps as a result of the first point, management has an excellent track record of capital allocation with average returns of 12% on invested capital over the past decade.
  • Third, the dividend yield of around 7.4% EPD is well protected with a TTM FCF payout ratio of 72%, not to mention the company’s consecutive 24-year dividend growth.
  • Fourth, EPD boasts unparalleled balance sheet strength with a BBB+ credit rating and a leverage ratio of 3.1x EBITDA TTM.
  • Fifth, EPD has a very strong position in natural gas liquids (different from LNG) and petrochemicals, which are widely used for plastics production and domestic heating and cooking in developing countries.

Although EPD does not do as much directly in LNG, it does own many pipelines and processing facilities that are indirectly involved in the process of increasing LNG exports.

2. Kinder Morgan (KMI)

Like EPD, KMI has an extensive portfolio of pipelines, storage facilities and processing plants primarily focused on natural gas.

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Presentation of KMI in August

Compared to just over 50,000 miles of EPD’s pipelines, KMI’s pipeline network reaches approximately 71,000 miles and transports approximately 40% of the gas produced in the United States. This focus on natural gas virtually guarantees that KMI’s pipelines carry gas that will eventually become exported LNG, even though KMI does not directly engage in LNG exports.

Although KMI’s balance sheet is of slightly lower quality than that of EPD, it still benefits from a BBB credit rating and net debt to 2022 EBITDA of 4.3x. The company has self-funded its dividends and capital expenditures for the past six years while increasing its dividend and occasionally engaging in stock buybacks.

KMI’s 6.2% dividend yield is also well protected with a low payout ratio of 48% based on distributable cash flow. This leaves plenty of room for the dividend to continue to rise for many years to come.

Conclusion

Our confidence in the long-term prospects for U.S. natural gas production translates into similar confidence in gas-focused midstream stocks like EPD and KMI. They may not enjoy as many advantages as companies directly involved in exporting LNG, such as Cheniere Energy (LNG) and Tellurian (TELL), but they promise greater stability and higher dividend yields. students.

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