A 7.4%-Yielding Midstream Portfolio From The Permian To The Marcellus For Passive Income

Thesis

Midstream companies typically offer a compelling and stable dividend growth engine. These stocks are some of the most popular on Seeking Alpha as they are excellent choices for income seeking investors.

In this article, I want to take a higher level and systematic approach to the midstream sector. As I was reviewing the midstream portion of my portfolio, I realized that I didn’t really have the exposure to all of the plentiful resources that America has to offer. As an investment thesis I want to build a midstream position that is connected to all of the major basins across all of the energy products. I broke this thesis down into three categories, Where, What, and How.

The ‘Where’ covers what basins I wanted to have access too.

The ‘What’ covers the most prominent energy products I want to transport.

The ‘How’ is the hard part. It is reasonable to conclude that one company alone cannot reasonably achieve all of these goals. The ‘How’ will cover what companies I am targeting to invest in to achieve these goals.

Finally, we come to the most important part. The ‘Why’. The purpose of this thesis is to create a stable and diverse high yield energy portfolio that can grow its distributions over the long run.

Anyone who is looking to build an income stream for either now or in the future should be ready to dive into this one!

Where

Having access to large and growing basins is required to meet our goal of stable, yet reliable income. The Permian Basin and the Appalachia Basin (Marcellus/Utica) are the most prolific basin in the United States today. Both are key to highly utilized midstream infrastructure.

The image below details the total output from various regions. The Permian and Appalachia basins are obvious selections to deploy capital, dwarfing the combined output of all other basins.

What

The same pipelines that are used for crude transportation are not built to the same specifications as those containing natural gas. All of these are built to different sizes and pressures. One company can’t possibly have the best pipelines in the best markets for all of these products.

Many articles written on this platform fall under the format of Company A vs Company B. These articles are extremely useful in analyzing the difference in free cash flow generation, debt structures, and potential returns. The area that is generally lacking is the operational significance and value each company brings to the energy market.

For example, the Appalachia basin requires mainly natural gas pipelines and processing facilities. Conversely, the Permian requires infrastructure to handle natural gas, NGLs, and crude oil. To add to the complexity, large amounts of crude oil is refined into consumable products such as gasoline, diesel, and jet fuel, requiring yet more infrastructure to separately transport these products.

By selecting companies that support this diverse product set, I will be able to achieve my stability and diversity goals. How I achieve this coincident with high yield and growth is what makes this thesis unique.

How

I intend to achieve both high yield and growth using three companies; Enterprise Products (EPD), MPLX LP (MPLX), and Equitrans Midstream Corp. (ETRN). Each of these companies has individual strengths, that as a whole, build a strong midstream portfolio.

Enterprise Products

EPD hardly needs any introduction as it is often viewed as one of the top names in the industry. The company touts a 25 year history of raising its distribution while also being the only midstream company to have an A- credit rating as a result of its low debt to EBITDA ratio of less than 3x.

Operationally, EPD has the Permian covered across the three main basic products. However, the Appalachia basins are only exposed to NGL transportation.

From the company’s system (shown below) we can see that the bulk of its pipeline network supports NGL transportation and fractionation.

NGLs accounted for approximately 51.6% of gross operating margin in Q3 and over the first nine months of 2023. The remainder of its earnings are split rather evenly between the crude, petrochemical, and natural gas segments.

Enterprise currently yields 7.5% and as mentioned earlier, has raised the distribution every year for 25 years. Additionally, the company continues to invest in growth projects to continue to grow its free cash flow. These projects are all self-funded to prevent having to access the debt markets to fund growth. The distribution coverage has varied between 1.6x and 1.9x over the course of 2023, giving it a solid degree of margin to cover the current payout.

As a result of these strengths, I will target EPD to consist of 50% of my midstream portfolio.

MPLX LP

MPLX is another high yielding large cap midstream company that has a well managed debt profile. The company has a yield of 9% that has been growing its distribution since 2013 while supporting a debt to EBITDA ratio of approximately 3.4x. The distribution also has a comfortable amount of safety with a coverage ratio of 1.6.

MPLX shares hardly any similarities with EPD from an operational perspective. Around 68% of its operating margin comes from the transportation of crude and refined products. This is a direct result of being a daughter company of Marathon Petroleum Company (MPC) which owns approximately 65% of MPLX. This ownership stake is worth approximately $25 billion.

The crude and refined products pipeline system operated by MPLX are tailor made to support MPC’s refineries. MPC is the largest refiner in the US at a capacity of over 3 million barrels a day and accounts for roughly 50% of MPLX’s revenues. MPC has a vested interest in MPLX’s success as it receives approximately $2.2 billion annually in distributions from MPLX in cold hard cash. The crude and refined products segment generates 68% of MPLX’s EBITDA.

The remaining 32% of the MPLX’s EBITDA is derived from its natural gas segment. These assets operate out of the Utica and Marcellus shale regions of Appalachia while also having exposure to the Delaware basin in the Permian.

MPLX has been able to maintain a higher yield compared to EPD as a result of a lower reinvestment rate. MPLX has spent $516 million through the first three quarters of 2023 on CAPEX spending. This pales in comparison to the nearly $3 billion that EPD spent during 2023. So, while the starting yield is higher for MPLX, over the long term the growth rate of the dividend will most likely drop off as the distribution coverage will be slower to expand as a result of lower reinvestment rates.

Despite the lower growth aspects, MPLX is a meaningful contributor to our portfolio. A 9% yield with a moderate coverage ratio of 1.6 meets my goals for high yield with exposure to both crude and natural gas from the Appalachia basins. I target MPLX to eventually hold 25% of my midstream position.

Equitrans Midstream Corp.

Equitrans is the odd ball of my core three. The company has the lowest yield (5.66%), highest debt/EBITDA ratio (6x) and is a fraction of the size of EPD and MLPX. ETRN was chosen for two reasons, growth and access to the rapidly expanding southeast region of the US. ETRN is a 48% owner in the Mountain Valley Pipeline (MVP) that is scheduled to commence operations in Q1 of 2024. MVP is a 2 bcf/d, 42-inch, 300-mile pipeline that connects the Marcellus basin in West Virginia to southern Virginia where it terminates into the Transco pipeline. Additional compression projects can take future capacity up to 2.5 bcf/d.

The Transco pipeline deploys 10,000 miles of pipe that stretches from New York, down through the sunbelt and into Texas. This pipeline network accounts for 15% of the entire country’s natural gas transportation and is owned by Williams Companies (WMB).

This short connection provides an important connection for the Western portion of the Appalachia basins. Connection with the Transco pipeline provides a direct travel path to the growing southeast that is seeing both a population growth and an increase in natural gas power plants for electricity generation. By connecting the ETRN system to a major national artery, the company stands to benefit from increased revenues from the MVP pipeline as well as increased utilization through its entire system.

As the company’s finances stand today, the construction of MVP is consuming a very large percentage of its FCF. Through the first three quarters of 2023, ETRN has spent $280 million on the MVP joint venture while also spending an additional $279 million on other growth projects, including the Hammerhead pipeline. Hammerhead is a 1.6 BCF/d feeder pipeline that connects the company’s Southwest Pennsylvania infrastructure to the MVP pipeline and is expected to enter service coincident with MVP.

This level of capital spend, combined with the current dividend consume all of the cash generated by the company and has driven up the company’s debt. The company plans to use the money saved from reduced capital spending and increased profits from these projects to reduce its total debt significantly over the next two years. Equitrans’ CFO Kirk Oliver laid out the current capital allocation plan in Q3’s conference call.

I would say, two years after MVP in service will be crossing that 4 times threshold and 4 times remains kind of the target for us and as we approach and we can see that glide path, we will be evaluating what the different allocation of capital opportunities are at — to us at the time and we will be considering what we might do.

These projects are estimated to add $315 million in additional EBITDA on an annual basis, or a 30% increase for ETRN. To get to <4.0x leverage, the company will have to pay off roughly $1.6 billion in debt. Assuming a 6% average cost of debt. The company stands to save $96 million in annual interest costs when the new debt levels are achieved. The accounts for approximately 10% of ETRN’s current EBITDA. Once the debt objectives are met, I project that by mid-2026, ETRN will have substantial distributable FCF that can be used for both dividend and organic growth opportunities.

Equitrans is both a growth and an improvement story. The company certainly has some work to do to get its debt down toward reasonable levels. That said, given the appropriate time, ETRN has the ability to drive meaningful dividend growth while also providing a concentrated asset in the Marcellus to service the majority of the east coast and gulf regions through MVP and the connection with the Transco system.

I target ETRN to eventually hold 25% of my midstream position.

Note: Equitrans has begun working with an adviser to consider options for a potential sale. If a sale materializes out of this process significant near-term gains could be realized.

Summary – The ‘WHY’

The purpose of this thesis is to create a stable and diverse high yield energy portfolio that can grow its distributions over the long run. I chose three companies that filled specific purposes while also contributing to a high yield and growth portfolio.

1. Enterprise Products – EPD has a high level of exposure to NGLs. The company has grown the distribution for 25 years, while also having extremely low levels of debt and the highest credit rating in the industry. EPD yields 7.5% and continues to invest in organic growth projects to grow FCF.

2. MPLX is closely tied to the largest refiner in the United States, Marathon Petroleum. As a result, MPLX has high exposure to crude and refined products while producing a 9% yield. The company also has a moderate amount of business associated with natural gas produced out of Appalachia.

3. Equitrans – ETRN is my highest growth asset as it is close to completing its Hammerhead and Mountain Valley Pipeline projects. These projects stand to increase earnings by approximately 30% while connecting its Marcellus assets to the Transco pipeline network that stretches from New York, through the Sun Belt, and into Texas. As debt levels improve, free cash flow growth can be allocated to dividend growth, which could be substantial.

The average yield of my target portfolio is 7.4% and covers four different energy products out of the two largest basins in the United States. The exact weighting of each equity can be altered to meet individual investors’ financial goals. My personal selections support an emphasis on long term distribution growth.