The midstream energy sector is a decent place to ride out market volatility, typically. But this is no typical oil slump.
Crude benchmarks have been cut nearly in half in six months, over which time Canadian energy stocks as a sector have gone from first to worst on the Toronto Stock Exchange. The energy crash has been all-consuming, engulfing any Canadian stock at all exposed to the oil patch.
Even those parts of the market with some built-in insulation from commodity fluctuations, such as the midstream oil and gas sector, which includes pipelines, have been traded down with varying degrees of alarm.
As with all things energy these days, caution is not a bad option with respect to oil and gas infrastructure stocks.
"These guys typically look through the short-term commodity prices," said Jeff Young, chief investment officer at NexGen Financial. "But with something so violent as we've seen here, people start to question the foundation of everything."
Midstream companies are those involved in the transportation and storage of oil and gas products, operating between producers and refiners. It's been a good five years or so for the group, as horizontal drilling and hydraulic fracturing have made vast new reserves of oil and gas accessible.
"There has been a replumbing of the energy infrastructure of North America, based on new producing regions not being where the existing pipeline was," Mr. Young said.
That era of expansion has been reflected in valuations. Prior to the correction, a group of half-a-dozen Canadian midstream stocks reached an average enterprise value in excess of 17 times trailing earnings before interest, taxes, depreciation and amortization, Mr. Young said. That compares to a 10-year average of 13.5.
"High valuations and uncertainty don't go well together," he said.
Less severe uncertainty, however, is usually met with some resilience among the midstream names. While exploration and production (E&P) companies are closely tied to commodity markets, midstream companies have a higher proportion of their business secured by contracts.
"Wherever crude is trading at today doesn't have a lot of impact on the cash flow streams of those businesses," said Gajan Kulasingam, a portfolio manager at Sentry Investments.
Almost all of the Canadian midstream stocks have good cash flow visibility over the next two to three years, RBC Dominion Securities analyst Robert Kwan said in a recent note.
Those stocks do become vulnerable, however, when investors begin to question growth assumptions beyond that time frame.
Rising energy production in North America, combined with OPEC's recent refusal to cut its output has led to a global oversupply. Markets have clearly become concerned for a prolonged, structural energy downturn.
"It is logical to believe that producers will be less willing to sign agreements with midstream companies that let them build new capital projects and create long-term growth," FirstEnergy analyst Steven Paget said in a note.
Supporting the valuations on many midstream stocks was the expectation for at least 10-per-cent cash flow growth, Mr. Kwan said. Investors assumed production growth in the oil sands and the Montney shale formation would require that much new infrastructure.
With those assumptions now gone, traders have targeted midstream stocks on the same order as E&P companies. Gibson Energy Inc., Inter Pipeline Ltd., Keyera Corp., and Pembina Pipeline Corp. have all declined in share price by 20 per cent to 35 per cent since September.
The long-haul pipelines – TransCanada Corp. and Enbridge Inc. – meanwhile, have fared somewhat better as a result of investors favouring larger names, as well as, in Enbridge's case, a financial restructuring and dividend increase.
Valuations are certainly more attractive now as a result of the correction, but are still above historical averages, Mr. Young said.
The selloff has opened up what might be considered compelling entry points for Gibson, Inter Pipeline, Keyera and Pembina, based on yields in the 4.5 to 5 per cent range and dividend growth of about 10 per cent, but with one big caveat: that oil prices stop falling, Mr. Kwan said.
"If oil keeps falling, we see potential for up to 20 per cent more downside for the midstreamers."
Tim Shufelt