Energy Transfer: Attractive 20% Yield But Know The Risks

Image Source: Pixabay

Energy stocks can be extremely volatile, especially during recessions. Oil has long been known as a “boom-and-bust” industry, a reputation that is well-deserved considering the volatile fluctuations of oil prices.

In the current environment of the coronavirus pandemic and falling oil and gas prices, investors need to understand the risks before buying oil stocks. High-yield MLP Energy Transfer (ET) is highly appealing on the surface due to its nearly 20% yield. Not surprisingly, ET is favored by retail and institutional investors such as Knighthead Capital.

While ET’s extremely high yield is attractive for income investors, there is an elevated risk as well that investors should consider before buying.

Business Overview

Energy Transfer MLP is a Master Limited Partnership or MLP. It operates in the midstream space, meaning it focuses on transportation and storage of oil and gas. It owns and operates one of the largest and most diversified portfolios of energy assets in the United States. Operations include natural gas transportation and storage along with crude oil, natural gas liquids, and refined product transportation and storage totaling roughly 83,000 miles of pipelines.

Energy Transfer also owns the Lake Charles LNG Company, as well as stakes in publicly traded Sunoco LP (SUN) and USA Compression Partners (USAC). The current environment is highly challenged for ET. While it enjoys some protection against commodity prices due to its ownership of transportation and storage assets, it is negatively impacted by falling demand. ET reported a $1.3 billion goodwill impairment in the 2020 second quarter due to decreases in commodity prices and market demand.

Adjusted EBITDA was $2.64 billion, down $100 million year-over-year due to crude oil, natural gas liquids, and refined products inventory valuation adjustments totaling $213 million. Management announced steep additional cuts to growth capital expenditures and stated that it is unlikely that they will add any major organic growth projects to the backlog for 2021.

Another important factor is that ET has exposure to natural gas and is not entirely exposed to oil. Energy Transfer operates a “toll booth” model of transporting energy, with natural gas being particularly interesting. Eventually, the world may move away from fossil fuels, but for the foreseeable future, that is not the case. In the meantime, natural gas is a cleaner, more efficient, and often cheaper alternative –something we have seen play out in the last decade as U.S. electricity production has shifted dramatically away from coal and toward natural gas.

Distribution Analysis

As previously mentioned, ET had a difficult start to 2020. Revenue and cash flow have declined significantly due to the coronavirus pandemic. Still, distributable cash flow covered the distribution by 1.72x during the quarter, yielding excess distributable cash flow of $594 million. This is a positive sign that the distribution is well-covered.

One risk is ET’s elevated debt. Debt-to-adjusted EBITDA levels are getting close to the company’s target range of 4.5x to 4.0x, but there is still some additional work to be done. On a positive note, Energy Transfer anticipates a distribution coverage ratio of nearly ~1.8x moving forward, which translates to a distribution payout ratio in the 50%-60%range.

For now, ET is highly appealing due to its nearly 20% distribution yield. The payout appears secure, although a further deterioration in the company’s financial results could endanger the payout. ET qualifies as a high-risk, high-return dividend stock. For investors not afraid to take the risk of buying oil stocks, ET could be a strong investment for income investors.