Exploration-and-production companies are “showing more capital discipline,” he adds, reducing the risk of a short-term boom-bust cycle. Capital expenditures in the midstream sector should also be slightly lower in 2019. He expects capex to decline by an average 3%, compared with 2018, as the pace of new pipeline and other project development slows.
Balance sheets also look healthier as debt ratios come down and firms fund more of their capital expenditures from internal cash flows. The sector should fund an average 42% of capex from retained cash flows this year, up from 29% in 2018, he estimates.
All this should bode well for free cash flow and dividend increases. Gershuni expects two of the largest C-corps— Kinder Morgan (ticker: KMI) and Williams Companies (WMB)—to announce dividend increases in April or May. Overall, he expects distributions in the midstream sector to increase by 4% this year, after a 0.3% increase in 2018.
Among MLPs, Gershuni’s top stock picks include Plains All American Pipeline (PAA) and its parent entity Plains GP Holdings (PAGP), both yielding 4.9%. He also favors Enterprise Products Partners stock (EPD), yielding 6%; Energy Transfer (ET), yielding 8%; and Crestwood Equity Partners (CEQP), yielding 7%.
Among C-corps, he recommends Kinder Morgan, Williams Companies, Cheniere Energy (LNG), and Targa Resources (TRGP). Kinder yields 4%, and Williams pays 5.3%. Cheniere doesn’t pay a dividend; it is more of a play on rising demand for liquefied natural gas exports. Targa yields 9.1%, making it one of the highest-yielding stocks in the midstream space.
Investors should be aware that these stocks are likely to falter if oil and gas prices decline or the energy sector falls out of favor.
MLPs pose complex tax issues too. They issue complicated K-1 tax forms, rather than standard 1099 forms. Their distributions tend to be treated as nontaxable return of capital. But that creates a deferred tax liability. MLP distributions reduce the cost basis of the units (the equivalent of shares), and investors may owe tax at ordinary income rates on the sale of the units if they hold them in taxable accounts.
Investors can hold MLPs in a retirement account like an IRA, but their distributions are then subject to “unrelated business income tax,” essentially wiping out their tax-deferral benefits. Companies structured as C-corps, meanwhile, may pay standard dividends or distributions that are treated as return of capital.