Global Energy Demand Fuels Midstream Outlook

Key takeaways

• Midstream energy infrastructure should continue to capitalize on the need to ensure power grid stability and meet energy demand from a variety of sources, such as artificial intelligence (AI) and data centers.

• The sector remains well-positioned to benefit from growing US hydrocarbon production volumes while maintaining limited commodity price exposure.

• Increased mergers and acquisitions (M&A) activity under a new presidential administration could provide a catalyst for investors to embrace the new midstream energy business model, while any move toward less stringent permitting for pipelines would also be a positive.

The United States asserts itself as an energy superpower

The drivers of strong performance for midstream energy infrastructure in 2024 look to be just as relevant for 2025. Investors are recognizing the strong growth outlook for pipelines, in particular natural gas pipelines, which is being driven by the need to ensure power grid stability and meet energy demand from a variety of sources, such as AI and data centers, as well as from the potential for increased liquified natural gas (LNG) exports, especially to European countries looking to reduce exposure to Russian production.

Demand for US oil and gas is increasing, meanwhile, amid continued concerns about geopolitical risks in the Middle East and Europe. The United States has surpassed Russia and Saudi Arabia in production of crude oil, and it is seeing substantial growth in LNG exports as it asserts its growing presence as an energy superpower. In addition, we expect the new federal administration to be less onerous in its regulatory framework, with less stringent controls on exports as well as pipeline permitting, all of which give us a fair degree of confidence in the future of US oil and gas production growth and the placement of midstream to capture value.

Other drivers of global energy demand include the transition from coal to natural gas power plants, electrification of a wide range of goods for which natural gas stands to benefit as a backup to renewable energy sources, and reshoring of manufacturing—in all of which natural gas will aid grid stability.

Such hydrocarbon production growth is positive for midstream energy, which is well-positioned to benefit from growing volumes while maintaining limited commodity price exposure. Production growth, combined with capital discipline on the part of midstream companies, makes us constructive on free cash flow, revenue, distribution and EBITDA growth in the sector as a whole, which has moved from being free cash flow negative to free cash flow positive, while balance sheet leverage (debt/EBITDA) has decreased significantly, strengthening capital profiles. With little to no need for midstream companies to access capital markets for the foreseeable future, we expect excess cash flow (above and beyond capital spending and dividends/distributions) to be used for incremental share buybacks and further raising dividends/distributions.

Meanwhile, midstream energy valuations remain attractive, in our view. For example, using EV/EBITDA as one valuation metric, the Alerian MLP Index is still trading at modest multiples, especially compared to its long-term history. In addition, based on current distribution yields, the Alerian MLP Index not only screens attractive on a relative and absolute basis compared to yields in other equity asset classes, but also against high-quality fixed income securities.

The sector would also stand to benefit from deregulation. An environment of greater M&A and capital markets activity broadly, which we expect to inflect higher with the arrival of the incoming US administration, would add another catalyst to the stocks. M&A activity could provide an incentive for investors to embrace the new midstream energy business model, while any move toward less stringent permitting for pipelines would also be a positive.

One potentially overlooked benefit of midstream energy is its low correlation to other asset classes, including to bonds and interest rates, and its powerful role as a portfolio diversifier.

Recommending a quality approach to midstream opportunity

We view the best way to take advantage of this opportunity is with an active diversified portfolio emphasizing fundamental characteristics such as balance sheet strength, asset footprint diversity and quality, while employing only prudent leverage. The midstream opportunity combined with the fundamental strength of these companies supports our conviction that they are poised to not only maintain distributions but exhibit growth over time.

With high relative yields, expected growth in income, limited interest rate risk and limited commodity exposure, energy infrastructure stocks remain well positioned. The transformed midstream business model, including emphasis on free cash flow after dividends/distributions, balanced sheet delivering, share buybacks and dividend/distribution increases, is still in the early innings of being recognized by investors. This, coupled with high current yields, could allow for the midstream sector to experience cash flow multiple expansion (relative to today’s undemanding multiples).

While the energy market remains volatile—oil supply is adequate but faces heightened geopolitical risks due to tensions or conflict in the Middle East and Russia/Ukraine—such risks can be managed by emphasizing the strong fundamentals outlined above. We continue to believe that, in the long term, sustained hydrocarbon production increases bode well for high-quality midstream companies as volumes to be processed increase over time, and midstream energy infrastructure represents an attractive investment opportunity as the U.S. further cements its status as an energy superpower.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is no guarantee of future results.

Equity securities are subject to price fluctuation and possible loss of principal.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Diversification does not guarantee a profit or protect against a loss. Dividends may fluctuate and are not guaranteed, and a company may reduce or eliminate its dividend at any time.

Companies in the infrastructure industry may be subject to a variety of factors, including high interest costs, high degrees of leverage, effects of economic slowdowns, increased competition, and impact resulting from government and regulatory policies and practices.

Investment strategies which incorporate the identification of thematic investment opportunities, and their performance, may be negatively impacted if the investment manager does not correctly identify such opportunities or if the theme develops in an unexpected manner. Focusing investments in information technology (IT) and technology-related industries carries much greater risks of adverse developments and price movements in such industries than a strategy that invests in a wider variety of industries.

Source: Franklin Templeton