As energy continues to dominate as the best-performing sector in the S&P 500, investors may be surprised to find out that valuations for popular midstream/MLPs funds are still below pre-pandemic levels despite a strong outlook for the space.

The energy sector has grown from 2.28% of the S&P 500 (as of the end of 2020) to 4.2% (as of the end of April). In 2021, the S&P 500 Energy index outperformed all other sectors, with annual return amounting to 54.6%. The momentum has continued into this year, with energy up 50.3% year-to-date, as of May 23.

Energy has rallied significantly since the end of 2020, but that performance is off a low base, given years of weakness even before the pandemic roiled energy markets, according to Stacey Morris, CFA, head of energy research at VettaFi. Assuming current macro trends continue (inflation, rising interest rates, a preference for value over growth) these should all continue to bode well for energy stocks, including midstream, Morris said.

In mid-May 2019, the Alerian MLP Infrastructure Index (AMZI), which is tracked by the Alerian MLP ETF (AMLP), was trading at 9.9x on a forward EV/EBITDA basis, compared to a forward EV/EBITDA multiple of 8.9x at the end of April 2022, according to Morris.

Meanwhile, distribution trends have improved since 2019 with more examples of growth, Morris said. Looking at the most recent quarter, 80.3% of the AMZI by weighting had grown distributions on a year-over-year basis. There have been no distribution cuts among AMZI constituents since the second quarter of 2021 (distributions paid in August 2021), when one constituent cut. In 2019, however, there were distribution cuts among AMZI constituents for the first and fourth quarters of the year, according to Morris.

Energy companies’ focus on free cash flow generation and returning cash to shareholders through dividends and buybacks may also be supportive for performance.

Comparing today to 2019, free cash flow generation is much more prominent among AMZI constituents, which has supported widespread adoption of buyback programs. Today, over 70% of the AMZI by weighting (eight constituents) has a buyback authorization, whereas only two constituents, or roughly 20% weighting, had buyback authorizations in 2019, according to Morris.

Another metric to consider is the significant progress made with ESG reporting, emissions reductions, and governance since 2019.

Energy companies’ balance sheets have also improved, with several AMZI constituents prioritizing debt reduction in recent years, according to Morris. 

MLPs’ growth opportunities over the last three years have largely shifted from big, newbuild pipeline projects to capacity expansions, adding shorter pipelines that connect into a larger system, export terminals, and processing capacity for natural gas and natural gas liquids, for example, Morris said. 

For more news, information, and strategy, visit the Energy Infrastructure Channel.

vettafi.com is owned by VettaFi, which also owns the index provider for AMLP. VettaFi is not the sponsor of AMLP, but VettaFi’s affiliate receives an index licensing fee from the ETF sponsor.