Last year was a roller coaster for DCP Midstream (NYSE: DCP). Units of the midstream master limited partnership (MLP) were up more than 25% at one point before plunging to end the year, finishing down more than 25%. As a result of that sell-off, DCP Midstream now has a cheaper valuation and a higher yield that's currently up to 9.3%.
While that payout certainly looks attractive, income seekers need to know that this high yield comes with a higher risk profile. In light of that, it might not be the best option for their portfolio.
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Drilling down into DCP Midstream
DCP Midstream is one of the largest gathering and processing companies in the country, with operations spanning across several fast-growing oil and gas producing regions, including the Permian Basin, DJ Basin, and STACK/SCOOP play of Oklahoma. It's also one of the largest producers of natural gas liquids (NGLs).
What sets the company apart from many others in the midstream sector is how it makes its money. While most midstream MLPs mainly collect fee-based income as volumes flow through their systems, a significant portion of DCP Midstream's revenue comes from commodity-based margins, which is the difference between what it pays for a raw commodity like liquids-rich natural gas and the price it sells higher-valued products like NGLs. Those margins tend to ebb and flow with commodity prices, which can have a big impact on DCP Midstream's cash flow.
Overall, DCP Midstream gets about 60% of its earnings from fee-based assets and the other 40% from margin-based activities. That's a much higher percentage than most midstream companies, which target getting less than 15% of their income from commodity margins. While DCP Midstream uses hedging contracts to cut its commodity price exposure in half, it still has greater exposure to price volatility than most peers. Last year's plunge in oil prices sent units of DCP Midstream plummeting since those lower prices will have a negative impact on the company's cash flow.
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Working hard to reduce this exposure
In addition to hedging half of its commodity price exposure, DCP Midstream has taken several other steps to reduce the risk that a prolonged slump in commodity prices would force the company to cut its lucrative dividend to investors. One way it has done that is by maintaining conservative financial metrics. For example, the company covered its distribution by a healthy 1.35 times during the third quarter, which is well above the 1.2 times target of most MLPs. In addition, DCP Midstream's leverage ratio stood at a comfortable 3.6, while many peers aim for a leverage ratio of 4.
Meanwhile, the company has focused on investing in fee-based expansion projects to further reduce its exposure to commodity price changes. For example, DCP Midstream and its partner Phillips 66 Partners (NYSE: PSXP) recently completed a $300 million expansion of their Sand Hills Pipeline, backed by 10- to 15-year fee-based contracts. The company is also working with Kinder Morgan (NYSE: KMI) and fellow gathering and processing company Targa Resources (NYSE: TRGP) to build the Gulf Coast Express pipeline, which will move natural gas from the Permian Basin to the Texas coast. The $1.75 billion project, which should start up this October, has secured fee-based contracts with shippers for over 10 years. Finally, the company has the option to buy a 30% interest in two NGL fractionators currently under construction by its co-parent Phillips 66 (NYSE: PSX) that should start up by the end of next year. The facilities, which turn raw NGLs into higher-valued products like ethane and propane, secured fixed-fee contracts for their anticipated volumes.
These moves should help expand DCP Midstream's fee-based earnings in the future. However, the company has a long way to go before it catches up to rivals. While it's closing in on Targa Resources, which only gets 67% of its earnings from fees, it's well behind companies like Kinder Morgan (91% fee-based) and Phillips 66 Partners (100% fee-based). Because of that, its cash flow will remain more susceptible to swings in commodity prices.
Not worth stretching for this high yield just yet
DCP Midstream's outsized exposure to commodity prices makes it a higher-risk option for investors. While they can earn a higher yield of more than 9%, compared to 4.4% at Kinder Morgan and 6.4% at Phillips 66 Partners, investors need to steel themselves to the possibility of greater volatility in the company's unit price when commodity prices make a big move. Furthermore, while DCP Midstream is working to grow its fee-based income stream, the company likely won't increase its distribution to investors anytime soon since it needs to maintain a more conservative financial profile as a cushion against volatility in commodity prices.
That higher risk level and lack of income growth make DCP Midstream a less-than-ideal option for income-focused investors. While I don't think its stock is worth buying right now, if the company can significantly increase its percentage of fee-based income and starts growing its distribution once again, then it would be worth considering.
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