Bloated debt burdens and strained balance sheets are among the reasons the energy sector is slumping this year, but investors can look to the midstream and the Alerian Energy Infrastructure ETF (ENFR) for more compelling cash flow-generating prospects.

Free cash flow is the cash a company has left over after accounting for capital spending and it’s a vital evaluation metric in capital-intensive industries, such as energy. Fortunately, the outlook on this front is bright for midstream names.

“A key component of increasing free cash flow generation for midstream is moderating capital spending, which was underway prior to COVID-19,” writes Alerian analyst Stacey Morris. “Companies are reaping the cash flows from years of hefty investments and are now spending less. Macro headwinds resulted in further cuts to capital budgets as companies prioritized financial flexibility and recalibrated budgets to a changing production outlook.”

ENFR tracks the Alerian Midstream Energy Select Index (CME: AMEI). ENFR acts as a type of hybrid energy infrastructure ETF, which could help investors capture some of the high yields from MLPs but limits the tax hit from solely owning MLPs

Why It’s Important

Investors should consider how a midstream operator’s free cash flow shapes up after shareholder rewards are accounted for.

“To better appreciate the financial flexibility of free cash flow, it is helpful to evaluate on an after-dividend basis,” adds Morris. “For midstream, free cash flow after dividends is particularly useful given the generous income provided by these companies. The money left over after dividends is what can be used to reduce debt or even repurchase shares.”

Master limited partnerships and midstream companies have been reducing leverage as of late, but what are the benefits of this move? Midstream companies are involved in the gathering, processing, storage, and transportation of oil and gas.

Additionally, the midstream space is usually more defensive and less volatile than other energy segments due to steady, reliable cash flows.

“More broadly, dividend growth going forward will still be supported to some extent by growth projects, but it will also be supported by increasing free cash flow as growth spending moderates from the very high levels required to facilitate the shale revolution over the last several years, and companies reap the cash flows of past projects,” according to Morris.

Other MLP funds include the Global X MLP ETF (NYSEArca: MLPA) and the JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ).

For more on cornerstone strategies, visit our ETF Building Blocks Channel.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.