Oil and gas industry overview: Midstream (Part 2)

Market Realist

Continued from Part 1

Factors to watch (continued)

3. Cash Flow Variability

Depending on what type of operations a midstream company’s involved with, the degree of variability in cash flow to the company can vary. For example, interstate natural gas pipelines usually have long-term, multi-year contracts, many of which are based on a fixed fee, regardless of the actual amount of gas being transported. Spectra Energy (SE) has a large natural gas transportation and storage business that it calls its “U.S. Transmission” segment, about which it states, “Transportation and storage services are generally provided under firm agreements where customers reserve capacity in pipelines and storage facilities. The vast majority of these agreements provide for fixed reservation charges that are paid monthly regardless of actual volumes transported on the pipelines or injected or withdrawn from our storage facilities, plus a small variable component that is based on volumes transported, injected or withdrawn, which is intended to recover variable costs.” In this case, cash flow variability in the segment should be very low.

(Read more: Why MLPs provide excellent risk-reward for investors)

 

On the other hand, some midstream operations have significantly more cash flow variability. For example, some midstream names have natural gas processing businesses that can be sensitive to fluctuations in commodity prices. Some contracts are designed so that these natural gas processors benefit when gas prices fall, and natural gas liquids prices rise. For more on this, see Natural gas processing contracts and how they affect profits and valuation.

Cash flow variability is a consideration because more variability in underlying cash flow inherently means a riskier business—and therefore a riskier investment. This is an especially important consideration for MLPs, which pay out significant amounts of cash in the form of distributions rather than keeping cash reserves.

Plus, many people invest in midstream MLPs for the distribution component of the security, and riskier businesses will have more volatility in cash flow. Most investors demand some sort of compensation for this volatility—usually through a higher distribution yield. That is, all else equal, between two potential investments, one with more volatility in cash flow or distributions and one with less, the distribution yield demanded by investors should be higher for the more volatile investment.

(Read more: An in-depth look at the mechanics of fractionation spreads and how they affect MLPs)

Upstream companies

To learn about upstream oil and gas companies, see Oil and gas industry overview: Upstream (Part 1).

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