Invesco SteelPath: Midstream dividends earning trust again

Investors have long sought equities that pay healthy dividends as those reliable payouts can meaningfully aid long-term total returns. Not long ago, midstream equities were often considered an important part of that equity pool. Then, over several years of energy market and midstream sector turmoil where many midstream companies cut their dividends, some investors understandably lost trust in the sector’s dividend attribute. However, healthy midstream equity performance in recent years, particularly over periods of broader energy volatility, suggests the sector has earned this trust back.

Why midstream lost its reliable dividend payer status

As shale production took off in the US, midstream energy companies invested hundreds of billions of dollars to meet the logistical demands of this new production. Raw production from far-afield oil and gas wells had to be gathered, treated, processed, transported, and stored by new facilities to ultimately reach consumers of energy in the right quality and at the right time. Originally, midstream companies were executing on these enormous capital spending requirements while also maintaining their high distribution rates through issuing new equity to fund this investment.

However, poor equity markets brought on by a series of commodity price cycles starting in late 2014 and capped off by the effect of the COVID-19-induced lockdowns in 2020 made issuing new equity too costly. Without reasonably priced access to fresh equity capital, many midstream companies chose to cut their distribution payouts to self-fund capital programs or to right-size borrowing levels from previous spending. This business model shift from dependence on outside equity to self-funding was unsettling for investors and made for poor price performance.

The return of the reliable dividend payer status

As seen in the charts below, midstream free cash flow, distribution coverage, and leverage metrics have improved materially over recent years. As a result, we believe the sector has now largely completed this transformation and, in fact, has embarked on a new period of distribution and dividend growth.

Over half of the midstream sector has grown its dividends since COVID-19, and the median increase has been approximately 15%.¹ Notably, a number of large-cap midstream companies grew their payout by more than 10% annually in 2023, including Energy Transfer LP, NYSE: ET (24%), Targa Resources Corp, NYSE: TRGP (42%), Plains All American Pipeline LP, NYSE: PAA (21%), and Western Midstream Partners LP, NYSE: WES (28%). We believe, over the coming quarters and years, additional midstream operators will begin to grow their dividends as well.

Importantly, it appears that investors have finally begun to trust the midstream sector dividend as well. The Alerian MLP Index (AMZ) has generated an annual total return of 32% since the beginning of 2021 through 2023. Further, the sector has been able to perform with relative resilience over periods of broader energy market volatility, an attribute that was also noticeable over the sector’s original phase of dividend trust. In fact, the quarterly correlation between crude oil and the AMZIX from 2Q22 –4Q23 was negative in four of the six quarters (below).² Further, since the beginning of 2014, the Alerian MLP Infrastructure Index (AMZIX) has outperformed oil every time that oil has had a negative return. The average outperformance during those periods has been 12.3%.²

While the midstream sector has performed well over the last few years, it continues to trade at historically low multiples (below). We are hopeful that as more yield-oriented investors begin to trust and add to midstream, the sector can also begin to improve the multiple at which it trades. Given a midstream sector yield of 7.04% relative to 4.08% for utilities, we believe midstream payouts may continue to earn investor consideration.³ We believe that continued dividend growth may help to gain further investor interest as well.