Paul Morigi
Warren Buffett’s Berkshire Hathaway (BRK.A)(BRK.B) has been taking advantage of the latest dip in energy prices to load up on one of his favorite energy stocks of the moment: Occidental Petroleum (OXY). In this article, we look at Buffett’s bullish call on energy (XLE) and our top picks in the sector.
Buffett’s Bullish Energy Call
Thanks to the recent dip in OXY stock prices, Buffett has been purchasing shares aggressively over the past few weeks:
As a result of these latest purchases, Berkshire now owns roughly one quarter of the company’s equity. Why is he buying OXY so aggressively?
Well, while energy prices have been falling lately due to concerns about economic weakness in China and OPEC policy uncertainty, Warren Buffett is taking a longer view on the sector. While he likely picked OXY in particular for its valuation, growth potential in the Permian Basin and elsewhere, and shareholder friendly capital return policies, he is also clearly bullish on the long-term outlook for the energy sector given the size of his stake in the company and in energy at large. The bottom line is that OXY’s fortunes will largely rise and fall with energy prices over the long term, so Buffett clearly is a believer that hydrocarbon energy prices have a fairly bright long-term future.
Our Top Energy Picks
We largely share Buffett’s enthusiasm for the energy sector’s long-term prospects for several reasons:
- There has been underinvestment in hydrocarbon energy production for years. Meanwhile, growing global geopolitical and domestic political tensions and economic challenges are threatening to slow the advance of renewable energy production and adoption. As a result, the value of current hydrocarbon energy production and infrastructure assets and businesses is likely higher than it was recently thought to be.
- Energy has proven to be an exceptional hedge against inflation. With inflation remaining stubbornly high due to a tight job market (with no relief in sight) and persistent pressures from government deficit spending and overseas geopolitical conflicts, and the Federal Reserve running out of room to fight it with interest rate hikes, it appears likely that inflation will remain higher for longer.
- Balance sheets in the sector are stronger than they have been in a long time thanks to companies adopting a more conservative approach to leverage in response to the COVID-19 scare for the industry as well as the rapid growth of the ESG-themed investing movement which has reduced their access to capital. Moreover, the uptick in energy prices over the past few years has given energy companies plenty of cash with which to pay down debt.
- Valuations remain quite attractive and companies are returning a lot of cash to shareholders via dividends and buybacks.
With all of that said, there remains tremendous volatility in energy markets, with wild swings in prices. While we do think that there are several E&P energy companies that should provide attractive risk-adjusted long-term returns (including OXY), as high yield focused investors who value reliable passive income from investments, we are finding the best risk-adjusted opportunities to be in the midstream (AMLP) sector today. This is because their business models generate much more stable cash flows thanks to the long-term, fixed-fee, commodity price resistant, take-or-pay nature of their pipeline contracts.
As a result, midstream businesses can generally pay out very large and sustainable distributions/dividends to investors regardless of where commodity prices are at the moment. Moreover, midstream MLPs are particularly attractive because they pay no corporate taxes and distributions are just about always tax deferred, making them excellent investments for taxable accounts.
With that in mind, here are three of our top picks in the midstream space today:
#1. Enterprise Products Partners (EPD)
Overall, EPD is probably the single best stock for retirees, with a management that runs the partnership in a very conservative manner while also returning generous amounts of capital to unitholders. It offers investors stable and growing highly attractive income (current yield of 7.75%) alongside good long-term total return potential with low fundamental and balance sheet risk.
Its Q1 FY 2023 results demonstrated this clearly. EPD’s leverage ratio came in at 3.0x, right in the middle of its new, ultra-conservative leverage ratio target range. Moreover, its $4 billion in liquidity and 20-year weighted average term to maturity of its debt provides it with enormous financial flexibility. The financial strength of the partnership was recognized by S&P, which upgraded them from BBB+ to A-, giving them the best credit rating in the midstream sector.
EPD continues to repurchase units opportunistically and grow the distribution. Management emphasized that it will be evaluating a second hike of the quarterly distribution in the coming months similar to what they did last year.
EPD should continue to see solid growth, thanks to the abundance of capital projects that it will be bringing online in the coming quarters. This in turn will likely continue to push its leverage ratio lower, which could prompt EPD to increase its distribution faster, make additional acquisitions, and/or possibly even pay out a special distribution/accelerate the unit buyback program. You can read our exclusive interview with EPD here and our full investment thesis here.
#2. Western Midstream Partners (WES)
WES is not as conservative of an investment as EPD is, but it still has a lot going for it, not the least of which is the fact that its top client is Buffett-backed OXY. If Buffett is bullish and heavily invested in OXY, that means that WES’ contracts with them should be quite dependable, making its cash flow stream very attractive.
During its latest quarter, WES achieved full investment grade status and also took several steps to push out debt maturities and increase liquidity. The leverage ratio stood at 3.2x, in-line with management’s end-of-year target level.
WES also declared a substantially enhanced distribution that will be paid to unitholders later this month while still repurchasing ~$7 million of units during the quarter. While this was a meaningful deceleration in the cadence of unit repurchases, management reiterated on the earnings call that unit repurchases will be executed on an opportunistic basis and that there fewer opportunities to do so during Q1. WES also meaningfully lengthened its contract terms with OXY, giving it a substantial cash flow runway.
Overall, WES offers investors a double-digit capital return profile between its regular distribution, enhanced distribution, and fairly aggressive unit repurchase program. With stable cash flows, a decent growth profile, a solid investment grade balance sheet, and a generous capital return profile, there are certainly worse places to invest right now. You can read our exclusive interview with the company here. and our full investment thesis here.
#3. TC Energy (TRP)
For investors who for various reasons do not want to deal with K-1 tax forms (that both EPD and WES issue), TRP is a great alternative in our view. The stock is clearly undervalued relative to its historical EV/EBITDA multiples and offers an attractive and safe dividend that should continue to grow at a mid single-digit CAGR for many years to come. Moreover, it has a robust growth pipeline and owns world-class midstream assets.
Its Q1 FY 2023 results reflected these strengths, with Q1 comparable EBITDA up by a whopping 16% year-over-year, with particular strength in its natural gas pipeline business.
Management also announced solid progress on its capital projects and said that it is making good progress towards executing $5 billion plus in asset sales this year. Completing these new projects as well as completing these asset sales will help it achieve its leverage ratio target of below 5x.
Moving forward, management has guided for no more than $7 billion in annual capital spending (including maintenance capital expenditures) while targeting closer to $6 billion per year for CapEx. It plans to use the cash savings from this high-graded capital program to accelerate debt reduction and – once its leverage ratio target is achieved – potentially accelerate opportunistic share buybacks.
TRP remains a low risk investment for us that combines very high-quality assets with solid long-term growth potential and an attractive and growing current yield. We expect that once management closes its proposed asset sales at attractive valuations and closes in on its leverage target that the stock price will move meaningfully higher back closer to historical norms, delivering substantial risk-adjusted alpha for shareholders. You can read our full investment thesis here.
Investor Takeaway
Legendary investor Warren Buffett has been buying energy stock OXY hand-over-fist recently, which only strengthens our conviction in the sector. As high yield investors focused on sustainable and attractive income alongside opportunistic capital recycling to deliver long-term total return outperformance alongside attractive current income, we find the midstream sector to be our favorite place to gain exposure to the energy sector. With a large portfolio of midstream stocks that includes EPD, WES, and TRP, we are generating substantial, sustainable, and growing passive income for years to come.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.