“Off-the-charts-whacky” is how one analyst described it…

Back in 2020, with much of the world on lockdown, demand for energy commodities disappeared virtually overnight.

You might remember what happened next.

Steady supply meeting disappearing demand had a predictable consequence. In February of that year, one barrel of WTI crude traded for nearly $53. By April, one barrel was going for $17.

That’s not a downturn. That’s a crash.

Then, things got “whacky.”

With above-ground storage disappearing, oil futures traders were getting desperate to offload their positions. So desperate, in fact, that WTI’s futures briefly went negative that year. In essence, traders were paying people to take the contracts off their hands to avoid taking physical delivery.

By the end of that year, energy was the worst-performing sector. The S&P 500 Energy Index printed a -33.7% when it was said and done.

And while energy in general was battered, midstreams were bloodied…

The oil and gas industry is typically divided into three sectors. They are:

  • Upstream: The process of searching for underground energy reserves, drilling, and operating the wells to extract the commodity.

  • Midstream: This is the process of storing and transporting the raw energy commodities.

  • Downstream: This is the process of refining, processing, and distributing the purified product.

Midstreams – as the name suggests – exist right in the middle. They’re often referred to simply as “pipeline companies.” They move commodities from point A to point B, collecting a nice fee along the way.

And for a group of companies traditionally known for steady, reliable cashflows, the demand shock of 2020 was not kind.

Three of the largest midstreams in the country – Energy Transfer (ET), Kinder Morgan (KMI), and Enterprise Products Partners (EPD) – were all cut in half in the span of a few weeks.

But while most investors were running for cover, we saw an unprecedented buying opportunity. Here’s what my team published to our readers in April of 2020:

Energy Transfer: The Best Buying Opportunity in The MLP’s History

One of our high conviction safe midstream recommendations is off a staggering 85% from its 2015 highs (when it was about 35% overvalued). The stock price is literally at levels not seen since the February of 2009, during the darkest days of the Financial Crisis. The valuation, whether you look at yield or price-to-cashflow, is at the most attractive in history.

That turned out to be spot-on. ET has returned 177% since then.

And even now – years later – we are still interested in the best midstream players. And every income-minded investor should be as well.

An Equilibrium Forms

I took the liberty last week to ask an associate of mine about the situation with midstreams. Leo Nelissen is an analyst who focuses on supply chains, infrastructure, and commodities.

He knows his stuff. And he’s excited about the possibilities going forward. The pandemic and lockdowns, while terrible for the stocks short-term, were a catalyst for longer-term growth.

Before the world shut down, MLPs were overall “horrible investments,” he told me. U.S. energy production had expanded way too much, way too fast, requiring hundreds of billions in capital expenditures.

The result put enormous pressure on free cash flow.

So, when energy demand tanked in 2020, those investors who hadn’t already bailed got out. The risks were just too high.

Now though? “Things are different,” Leo says.

Energy demand is very strong… and output growth has slowed in the U.S. In other words, the total demand for midstream assets is still rising. However, growth is not so high that energy prices are prone to steep declines.

What Leo is describing is something of an equilibrium forming in the midstream space. Anybody who has ever traded commodities knows that soaring prices can be a double-edged sword. It can lead to short-term trading gains. But it also makes the prices prone to collapse as new suppliers are incentivized to come online. The cure for high prices is high prices, as the old timers might say.

But that’s not the case now. Midstream services remain in demand, but the demand is not high enough to create the volatile conditions in a raging commodities bull.

And there’s another factor to consider…

AI Runs on Energy – Lots and Lots of It

The importance of energy as it relates to artificial intelligence (AI) is a topic my Wide Moat Research colleague, Nick Ward, brought up on Friday. “You might be surprised to learn that asking ChatGPT a single question consumes 10x the amount of energy compared to a typical Google search,” he wrote, adding:

The type of computation performed by generative AI might seem like magic. But that process must happen somewhere. And that ‘somewhere’ is in data centers around the country and world.

And that means a demand for energy… a lot of it.

We’re not the only ones seeing this.

Last month, BlackRock CEO Larry Fink had some interesting things to say about future energy demand as a result of data center growth:

These AI data centres are going to require more power than anything we could ever have imagined. We at the G7 do not have enough power. I think this is going to create a real competitive challenge for countries.

Today, some 69% of U.S. energy consumption comes from petroleum or natural gas. There’s every indication that this will be the case for the foreseeable future. And that means the midstream services will stay in demand for years to come.

And the midstream companies are being upfront about all this.

During Q1 earnings last month, Energy Transfer co-CEO and CFO Tom Long had this to say:

There are grid problems all over the country, and Texas is no exception. A lot of people are moving in Texas, a lot of data centers, a lot of AI data centers, crypto miners are still coming in, industrial growth. I mean, it’s just — we’re so optimistic for natural gas-fired generation. So, it’s something that we will continue to look at, and we will — it will be highly unlikely that we don’t announce more [power plants] as each quarter goes on.

But much of that hype has been based on theoretical possibilities and beta tests that haven’t really gone mainstream yet. As Morningstar wrote a few weeks ago, we haven’t seen nothin’ yet.

The ripples from the boom in artificial intelligence are expected to spread across the economy, far beyond technology stocks. That includes even the energy companies that supply utilities delivering power to AI-focused data centers.

Not that these stories are making the same kind of splash Nvidia is. Nobody – or at least very few – are drooling over the midstreams.

And that’s one of the reasons we’re so interested in the space. Paid-up readers can expect to hear more in the months ahead.

Regards,

Brad Thomas
Editor, Intelligent Income Daily