Midstream/MLP: leveled up with leverage down

Summary

  • With free cash flow generation becoming more significant since 2020, many companies have used excess cash flow to reduce debt, while EBITDA growth has also helped lower debt ratios.
  • With improved balance sheets, midstream companies were able to proceed with dividend increases and buyouts, as strong free cash flow generation provided increased financial flexibility.
  • Lower leverage speaks to the improving overall financial health of the space and builds confidence that companies will be able to continue to maintain and grow their dividends.

Debt reduction and balance sheet improvement have been key themes in energy infrastructure for years. For many names, deleveraging was a prerequisite before deploying excess cash flow to boost dividends and buyouts. Others are still working to reduce their leverage before pursuing these shareholder-friendly initiatives. Today’s note examines leverage improvements from 2016 to 2022 for MLPs and the broader midstream sector using the Alerian MLP Infrastructure Index (AMZI) and the Alerian Midstream Energy Index, respectively ( NAMA), and explains why these improvements are important.

Average leverage at the index level reflects broad improvements for intermediaries/MLPs.

With free cash flow generation becoming more significant since 2020, several companies have used excess cash flow to reduce debt, while EBITDA growth has also contributed to lower leverage ratios. The chart below shows the average leverage of the current AMZI and NAMA components for 2016, 2019 and 2Q22. The average leverage of AMZI and AMNA constituents has fallen from over 4.2x in 2016 to less than 3.9x today. Leverage was calculated using the companies’ long-term debt and reported Adjusted EBITDA. Note that leverage calculations may vary. Net debt is often used and banks/creditors can make other adjustments.

Average leverage tends to fall for current NAMA and AMZI components

The charts show notable improvement over time, with 2016 and 2019 providing useful benchmarks. Recall that WTI oil prices fell to a multi-year low of $26 a barrel in February 2016, and this was also before the major adoption of equity self-financing, which began to gain traction in late 2017. 2019 data provides a pre-pandemic measure and coincides with a period when capital spending in space was still high. Finally, 2Q22 and trailing 12-month EBITDA data reflect improvements from the shift to strong free cash flow generation as expenses moderated, supporting debt reduction. With improved balance sheets, midstream companies were able to proceed with dividend increases and buyouts, as strong free cash flow generation provided increased financial flexibility.

Enterprise-level data gives more color to improvements.

Examining debt ratios at the constituent level provides useful context regarding company-specific improvements and the various factors that may affect debt trends over time. The chart below shows the leverage ratios, sector classifications and weightings for the top ten NAMA constituents (please see the appendix to refer to the same chart for AMZI). All ten names are less leveraged today than in 2016. Seven of the ten have less than 4.0x leverage today, while only Pembina Pipeline (PPL CN) had less than 4.0x leverage. 4.0x in 2016.

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Digging into the constituent data provides several observations. Some companies had leverage ratios of 4.0x or less in each period, including Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP) and MPLX (MPLX). These names have been able to maintain or grow their distros in harsh macro environments. Cheniere (LNG) and Cheniere Energy Partners (CQP) have seen notable improvements in their leverage since 2016 with the commissioning of capital-intensive LNG projects. Since announcing its long-term capital allocation plan in September 2021, Cheniere (LNG) has repaid $3.1 billion in debt through 2Q22. For major Canadian companies Enbridge (ENB CN) and TC Energy (TRP CN), leverage has declined from 2016 levels but remains high compared to other names as both companies work on a large backlog project orders unlike many peers.

Why is lower leverage important?

Massive construction of energy infrastructure in the 2010s and financing difficulties in 2014-2016, when oil prices were falling, left an imprint on the balance sheets of many midstream companies. Several names took steps to improve their balance sheets and were better positioned financially when the pandemic rocked energy markets. For some companies that were financially strained, dividend cuts were essential to shore up the balance sheet during these tough times, and those cuts have been painful for investors. The macroeconomic volatility of recent years adds important context to why companies have prioritized debt reduction and why companies that were perhaps comfortable with 4.5 to 5x leverage in the past have adopted more cautious goals today. Lower leverage speaks to the improving overall financial health of the space and builds confidence that companies will be able to continue to maintain and grow their dividends.

Conclusion :

With stronger balance sheets and increased financial flexibility supported by strong free cash flow generation, midstream companies execute shareholder-friendly returns in the form of dividends and buybacks and are better equipped to weather potential periods of market volatility. .

Annex:

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AMZI is the underlying index of the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB). AMNA is the underlying index of the ETRACS Alerian Midstream Energy Index ETN (AMNA).

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.