The midstream is known for its high dividend yields, and given the increasing importance of income in these uncertain times, some investors might be interested in exploring the midstream. The midstream sector represents the energy infrastructure that connects the wellheads upstream to the clients downstream. As such, the business models aren’t dependent on the prices of oil and gas, but utilize fees and contracts.
The reason that midstream dividends are as generous as they are has to do with the tax structure of MLPs. Not unlike REITs, MLPs pay out generous dividends. The signs of inflation are becoming increasingly hard to ignore, and dividends make exceptional inflation hedges.
How the Midstream Makes Money
The midstream generates income through four basic services:
- Gathering & processing
- Fractionation
- Transportation
- Storage
Gathering and processing involves collecting fees through contracts with upstream producers. Midstream companies will gather hydrocarbons, transport crude oil through pipelines, and process natural gas to remove potential contaminants. Because these services are part of a contract, they are untethered from the price of oil and gas, making this a reliable income stream unlikely to tumble if commodity prices wobble.
Fractionation involves taking natural gas liquids and separating them out into their individual components of ethane, propane, butane, isobutane, and natural gasoline. This is done on a fee-for-service basis.
Transportation is the heart and soul of the midstream and the most common revenue generator. Pipelines collect tariffs from consumers per unit of hydrocarbon transported. These are also done through contracts that often utilize minimum volume commitments, further protecting investor income. Think of these pipeline contracts as similar to renting a storage unit or apartment. Regardless of how many things you store in the storage unit or how frequently you are home, the rent remains fixed. If there is a surge in demand and a company needs to transport more product, then additional fees can be implemented, further boosting the midstream — and the midstream investor’s — bottom line.
Storage is also a contract, fee-based model. Crude oil needs to be refined, and sometimes hydrocarbons need to be kept in reserve so that supply is available to meet demand spikes. These contracts typically last one to five years and have inflation clauses in them that allow for fees to escalate and meet inflation demands.
For exposure to the midstream energy space, investors can look to related ETF strategies, such as the ALPS Alerian MLP ETF (NYSEArca: AMLP), the JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ), the Alerian Energy Infrastructure ETF (ENFR), and the ETRACS Alerian Midstream Energy Index ETN (NYSEArca: AMNA). Other funds with exposure to the midstream include the VanEck Vectors Energy Income ETF (EINC) and the Global X MLP ETF (NYSEArca: MLPA).
For more news, information, and strategy, visit the Energy Infrastructure Channel.