How Russia's Invasion of Ukraine Affects Energy Income Strategies

Amid ongoing strength in the energy sector – it was the best-performing group in the S&P 500 last year and that status is being retained in the first quarter – it wouldn't be surprising if advisors are fielding more inquiries from clients about accessing the latest oil bull market.

On that front, there's a particular corner of the energy patch that could be catching clients' attention and advisors should be prepared for this. That being energy income stocks and funds, also known as the midstream. This is a practical client response to renewed oil bullishness.

After all, bond and equity dividend yields are low while the dividend yield on the Alerian MLP Infrastructure Index is a tantalizing 7.76%. That while the index is up 17.35% year-to-date – a vastly superior showing against the S&P 500.

Of course, clients are curious about rising oil prices, feeling that pain at the pump and pondering how the Russia/Ukraine conflict is affecting energy-related investments, including midstream.

Client Conversations

Obviously, the primary source of allure with a benchmark like the aforementioned Alerian MLP Infrastructure Index is yield. However, against the backdrop of geopolitical tensions, it's worth noting that pipeline operators primarily store and transport North American-produced crude and natural gas.

Still, it's important to note that despite the midstream's reputation for not being heavily correlated to spot crude prices, sentiment matters.

“That said, rising oil prices are constructive for energy sentiment, and oil prices above $100 per barrel bring more interest to the sector broadly,” says Alerian analyst Stacey Morris. “Combined with the oil price level, strong equity performance and ongoing inflation concerns are likely forcing investors that had been on the sidelines to reconsider the energy space. With improving performance, a greater weighting in the S&P 500 will also likely drive more interest in energy.”

Another selling point with midstream equities and funds is that these companies are increasingly cash- and cost-conscious. Amid the threats from renewable energy, pipeline operators are eschewing major projects, opting to fortify their balance sheets and bolster free-cash-flow. Recently, there's evidence that some of that cash is being used to fund buybacks and restart or grow distributions.

“The energy industry had hoped that free cash flow generation and shareholder returns would bring generalist investors back to this space, but it seems that $100+ oil arguably accelerated generalists’ return,” notes Morris. “As energy becomes relevant again for generalists, perhaps the steps taken in recent years to improve investability – the focus on capital discipline and returns – will keep investors interested beyond the current period of elevated oil prices.”

Long-Term Implications to Consider

Traditionally, midstream assets are more slow-moving than say exploration and production and oil services stocks. That's the price of admission for harnessing big dividends and lower volatility. That also means clients need to take the long view of midstream to ride out inevitable declines in energy commodity prices.

On the upside, the crisis in Ukraine is laying to bear Western Europe's dangerous, long-running dependence on Russian natural gas.

Put simply, the U.S. has an over-abundance of natural gas that, with the right infrastructure investments here and in Europe, can be turned into liquefied natural gas (LNG) and shipped to our European allies. Should governments on both sides of the Atlantic wake up to these facts, the midstream could offer clients substantial long-term promise.

“Benchmark Dutch natural gas prices have reached record highs in the wake of Russia’s invasion. Unlike oil, there are no strategic reserves for natural gas, and European inventories were already tight this winter,” concludes Morris. “(Admittedly, the 60-million-barrel strategic release announced last week did not stave off higher oil prices, representing only ~60% of what the world consumes in a day.) While it will take time, Europe can reduce its dependency on Russian natural gas through the ongoing shift towards renewables and by purchasing LNG. To facilitate this, additional import capacity may be needed with Germany recently committing to the construction of two LNG import terminals.”

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