Ditch The Drill, Buy The Pipe: Why 5%-Yielding ONEOK Is A Smart Energy Play (NYSE:OKE)

Introduction

The other day, I was looking into ICE Midland WTI futures as part of my research into Intercontinental Exchange (ICE), the owner of these futures and one of my favorite financial dividend growth stocks – that is not yet a part of my portfolio.

So, I thought, why not start this article with a micro lecture on this futures contract?

I believe that most will be familiar with the NYMEX WTI future, which is owned by the CME Group (CME). Next to ICE Brent, it’s the biggest oil future in the world.

As we can see below, ICE Midland WTI and NYMEX WTI have a perfect correlation. The correlation is so high that it’s hard to see the blue line behind the black line.

However, a quick look at the x-axis shows that there’s one difference: pricing.

Usually, ICE Midland is roughly $1.50 per barrel more expensive than NYMEX WTI.

What makes ICE Midland so special is its focus on America’s highest-quality oil from the Midland Basin (a part of the mighty Permian Basin). The oil is deliverable into the Brent complex and can be used in American, European, and Asian refineries.

As the U.S. has become an energy powerhouse, exporting more than 4.5 million barrels of oil per day, new methods to buy oil and hedge risks are needed.

The reason I’m bringing this up is because ICE Midland oil isn’t delivered via Cushing, Oklahoma, like NYMEX WTI.

ICE Midland WTI is deliverable to both the Enterprise Crude Houston and ONEOK Magellan East Houston (“MEH”) terminals.

This brings me to ONEOK Inc. (NYSE:OKE), which owns the MEH terminal after merging with Magellan, making it an even more important player in the U.S./global energy industry.

When it comes to long-term investments, I want to own the best companies that are so important that, without them, we would run into trouble.

While an efficient energy infrastructure may feel like something we take for granted in the West, recent developments show that energy infrastructure is vital to our everyday lives.

It also explains why, in a war, energy infrastructure is a core target.

With that said, my most recent article on ONEOK was written on December 29, titled “5.4% Yield And Up to 10% Annual Return Potential – Buying Top-Tier Income With ONEOK.”

Since then, OKE shares have returned 16%, beating the S&P 500 by roughly 6 points!

In this article, I’ll revisit the stock to explain why it’s such a powerful midstream company and what to make of the risk/reward after such an impressive rally.

On a side note, OKE is a C-Corp. It is not taxed as a Limited Partnership like many of its midstream peers.

So, let’s get to it!

Buying Diversified Energy Infrastructure

Initially, OKE was a natural gas and natural gas liquids (“NGL”) player. However, after a number of major deals, including the merger with Magellan, it is now a highly diversified midstream company.

• As we can see below, close to 70% of its earnings come from NGL and refined/crude oil operations.
• 22% of its earnings come from gathering and processing operations, which are primarily fee-based operations. In the Williston Basin, the company is a leading natural gas processor.
• 10% of its earnings come from natural gas pipelines that directly connect supply to end-use markets.

The company has roughly 50 thousand miles of pipelines and access to half of the refining capacity in the U.S.

Even better, the company also benefits from increasingly favorable contracts. As we can see below, this year, more than 90% of its NGL earnings are expected to be fee-based. That would be up from 80% in 2019.

In fact, over the past decade, the company has transformed from an ultra-high volatile midstream company to a reliable giant with a consistently rising dividend, subdued capital requirements, and an increasingly healthy balance sheet.

Over the past decade, the company has maintained an impressive streak of adjusted EBITDA growth, which proves its resilience through many commodity cycles, including the 2014/2015 oil price crash and the pandemic.

As we can see below, the company hasn’t seen a decline in adjusted EBITDA since at least 2013, growing its adjusted EBITDA by 12% per year during the 2013-2022 period.

That’s the power of midstream companies. They benefit from throughput volumes. They are somewhat immune against low commodity prices unless prices are so low that producers reduce output.

However, please be aware that investors wanting to bet on higher commodity prices may be better off buying oil and gas producers.

Personally, I’m doing both. I’m buying upstream for special dividends and potentially outsized gains if oil continues to rally and midstream for consistent income growth and safety.

Going back to OKE’s track record, dividends paid to shareholders have also increased significantly. In 2000, the company paid $0.31 per share. After hiking its dividend by 3.7% on January 17, it has an annualized 2024 dividend of $3.96. This translates to a yield of 4.9%.

The best news for the dividend is that OKE is increasingly flushed with cash.

See, one of the biggest problems midstream companies faced in the past ten years (and before that) is elevated capital expenditures (“CapEx”). After all, building a massive pipeline network is very expensive!

Now, these companies are seeing lower expenses as projects have been finished and are now bringing in cash.

For example, in 2019, OKE spent $3.8 billion on CapEx. This year, that number is expected to be $1.8 billion, potentially followed by a decline to $1.5 billion in 2026.

Meanwhile, free cash flow is expected to rise from -$1.9 billion in 2019 to $2.9 billion in 2024 and $4.0 billion in 2026.

As OKE has a $46.8 billion market cap, it implies a 2024E free cash flow yield of 6.2%.

In other words, the company has enough free cash flow to cover its dividend 1.3x! In 2026, that number could rise to 8.5% (1.7x its current dividend).

Even better, the company has an investment-grade credit rating of BBB and a long-term net leverage target of 3.5x EBITDA. This year, net leverage is expected to be 3.5x.

As a result, the company remains committed to consistent dividend growth and buybacks.

• It targets annual dividend growth between 3-4%.
• It announced a $2 billion buyback program.
• Over the next four years, the company aims to distribute up to 85% of post-CapEx operating cash flow.

In January, we increased our quarterly dividend 3.7% to $0.99 per share, or $3.96 per share on an annualized basis. Going forward, ONEOK expects to target an annual dividend growth rate ranging between 3% to 4%.

We also announced a $2 billion share repurchase authorization, which we target to largely use over the next 4 years. This program is complementary to the dividend growth rate when thinking about shareholder return in the future.

Over the next 4 years, ONEOK’s combination of dividends and share repurchases is expected to trend towards a target of approximately 75% to 85% of forecasted cash flow from operations after identified capital expenditures. – OKE 4Q23 Earnings Call

I believe these numbers make OKE – and many of its peers – fantastic long-term investments, as we are dealing with a company capable of consistent earnings growth used to reward shareholders in ways that were unimaginable a few years ago.

Consistent Growth & A Good Valuation

In addition to having an increasingly favorable free cash flow profile, there’s plenty of growth left.

For example, the Rocky Mountain region has seen significant growth.

NGL volumes from the region have surged at an annual rate of more than 20% over the past five years, while natural gas processing volumes have grown at a steady 10% annual rate during the same period.

In 4Q23, the company reported 14% higher natural gas processing volumes. NGL volumes rose by 10%.

Moreover, OKE is officially moving forward with expanding the Elk Creek pipeline to 435,000 barrels per day, increasing total NGL capacity out of the Rocky Mountain region to 575,000 barrels per day.

Even better, expectations for volume growth in the Rocky Mountain and Mid-Continent regions remain strong, driven by higher-than-expected well connections in 2023 and consistent producer activity levels expected in 2024.

Moving over to its valuation, despite returning 16% since December 29, the stock still offers potential for new investors and investors looking to add to their positions.

Currently, OKE trades at a blended P/OCF (operating cash flow) ratio of 8.9x.

Historically, the company has traded at an 8.9x multiple. However, because the company has become more mature, I expect that a 10x multiple is very appropriate. I would not even rule out an 11x multiple in the years ahead if the market shifts from growth to value stocks.

Moreover, the company is expected to grow its OCF by 7% in 2025 after a potential 8% decline in 2024. 2026 is expected to see 1% growth.

My personal opinion is that all of these growth rates will likely end up being higher than expected, as I’m very bullish on NGL production and because I see higher associated gas production – especially if crude oil production in key basins continues to increase.

Combining a 10x OCF multiple with expected EPS growth and its 4.9% yield, we get a potential annual return of 9.5-10.0%.

I believe the company will likely exceed that number on a prolonged basis.

As a result, I remain bullish and believe that OKE remains a fantastic investment for everyone looking for high-quality income – especially in an environment where we could see a rotation from growth to value, as I discussed in this article (among many others).

Takeaway

Investing in energy infrastructure giants like ONEOK offers not just consistent income growth but also the potential for substantial long-term returns.

With its diversified operations, resilient earnings, and commitment to shareholder rewards through dividends and buybacks, ONEOK stands out as a promising player in its sector.

Its increasingly favorable free cash flow profile, combined with expansion projects and strong volume growth expectations, make it an attractive stock for both income-focused investors and those seeking capital appreciation.

Pros & Cons

Pros:

• Consistent Income Growth: OKE has a diversified portfolio and a track record of steadily increasing dividends, making it a reliable income generator.
• Resilient Earnings: Despite market fluctuations, OKE has shown resilience with its consistently growing adjusted EBITDA over the past decade.
• Favorable Free Cash Flow Profile: The company’s improving free cash flow position, coupled with reduced capital expenditures, bodes well for sustained dividend growth.
• Growth Opportunities: The Rocky Mountains and other regions provide consistent growth opportunities.
• Reasonable Valuation: Despite recent gains, OKE’s valuation remains reasonable.

Cons:

• Demand Dependency: Although OKE’s dependence on commodity prices is limited, commodity demand risks could rise in a recession.
• Potential Regulatory Risks: Changes in regulations or environmental policies could affect the company’s operations and profitability.
• Competitive Landscape: OKE operates in a competitive industry, facing competition from other midstream companies. However, in general, the major midstream companies tend to come with wide moats.
• Market Volatility: Like any stock, OKE is subject to market volatility, which could lead to short-term fluctuations in its share price.