Published January 16th, 2017 by the Financial Canadian
In recent years, commodity prices have experienced a tremendous amount of volatility. In particular, oil prices have declined significantly from their 2014 highs.
Many oil and gas MLPs have struggled. It has not been uncommon for MLPs to slash distributions and sometimes even cease operations due to lacking profitability.
Companies that have weathered this tough operating environment can be viewed as the best-of-breed.
There exists one large-cap company with a significant ownership of one of the largest publicly-traded oil & gas MLPs, giving them indirect exposure to the inevitable rebound in commodity prices.
The parent company trades at a 4.4% dividend yield, has strong growth prospects and has been consistently increasing their dividend since 2002 – which makes the company a Dividend Achiever (10+ years of dividend increases).
You can see the entire list of all 272 Dividend Achievers here.
The company I’m describing is ONEOK, Inc. (OKE) The company’s impressive long-term total returns can be viewed in the following diagram.
This article will discuss the investment prospects of ONEOK in detail.
ONEOK, Inc. was founded in 1906 as the Oklahoma Natural Gas Company. After decades of expansion in the midstream oil & gas industry, the company was renamed ONEOK Inc. in 1980.
OKE is the sole general partner of the publicly-traded limited partnership ONEOK Partners L.P. (OKS) in which it has a 41.2% stake. OKS is one of the largest publicly-traded MLPs in the United States. The MLP is involved in the gathering, processing, transportation, storage, and distribution of natural gas and liquid natural gas (LNG), and operates in three segments:
- Natural Gas Liquids
- Natural Gas Gathering & Processing
- Natural Gas Pipelines
Operationally, OKE’s earnings are generated through their ownership of OKS. OKS pays distributions to OKE which are then paid to OKE shareholders as dividends.
OKS’ portfolio of assets is impressive. With a 37,000-mile network of liquids & gas pipelines, the MLP is an integral part of the energy transformation ecosystem.
Source: ONEOK Investor Presentation, Wells Fargo Securities 2016 Symposium, slide 6
Owning such a large proportion of the underlying MLP means that OKS’ growth will be reflected in OKE’s business results. This is logical, but the magnitude of the relationship might surprise you.
Nearly 70% of each dollar of ONEOK Partners’ adjusted EBITDA flows directly to ONEOK as distributions to the general partner. Almost all uses of the distributions from OKS to OKE are used either for capital improvements (paying down debt or repurchasing stock) or in OKS-related ways – including providing capital support to OKS and purchasing additional units of OKS.
Source: ONEOK Investor Presentation, Wells Fargo Securities 2016 Symposium, slide 6
OKS & OKE are intertwined in a mutually beneficially relationship.
OKS benefits because they can use OKE as a source of liquidity during hard times. For example, OKS issued a $650 million private placement to OKE in 2015 when the MLP was facing liquidity concerns due to the tough operating environment for commodity MLPs.
OKE benefits from their large ownership because they have significant influence in the operations of the MLP.
ONEOK’s business growth will be driven by the underlying growth in ONEOK Partners L.P.
Fortunately, the MLP’s growth prospects remain robust, and historically they have been very successful in deploying capital. The following slide outlines the MLP’s investment of $9 billion of capital in the ten years preceding 2016.
Source: ONEOK Investor Presentation, Wells Fargo Securities 2016 Symposium, slide 9
Looking forward, there are numerous elements that I expect to drive growth for OKS. One of the priorities of the MLP is to continue to grow their fee-based earnings. These earnings are less volatile than commodity or differential earnings and are thus preferred by management (and investors).
Source: ONEOK Investor Presentation, Wells Fargo Securities 2016 Symposium, slide 10
Increases to fee-based earnings contracts will benefit OKS by de-risking their business model and strengthening the reliability of their distributions to OKE.
OKS also has number large projects underway that will grow revenues once completed. Key among these projects are:
- The Permian Basin gas transmission pipelines
- Two major infrastructure projects in Oklahoma: South Central Oklahoma Oil Province (SCOOP) and the Sooner Trend Anadarko Canadian Kingfisher (STACK)
Once these projects are completed, there will be a significant boost to the MLP’s cash flows. Note that this is only a portion of OKS’ project development pipeline.
Altogether, OKE’s growth prospects appear positive.
Competitive Advantage & Recession Performance
A risk assessment of ONEOK should place a great deal of emphasis on the underlying MLP, ONEOK Partners. This is because ONEOK’s cash flows are distributed to the company from the MLP. If the MLP cuts distributions, it is nearly inevitable that ONEOK will cut its dividends to investors as well.
ONEOK Partners L.P. has a distinct competitive advantage that comes from their high-quality, well-diversified portfolio of natural gas assets. This is evident in their previous recession performance. OKE performed well during the 2008-2009 recession, with only a single year of minor earnings shrinkage.
Consider the company’s EPS during this time:
- 2007: $1.40
- 2008: $1.48 (5.7% increase)
- 2009: $1.44 (2.7% decrease)
- 2010: $1.55 (7.6% increase)
- 2011: $1.67 (7.7% increase)
The company has suffered more during the current downturn in commodity prices. Investors became so bearish on OKE’s stock that the stock dropped substantially, dramatically increasingly their dividend yield to 12.8%. Those who bought at the bottom of this stock decline would have been handsomely rewarded.
OKS (the MLP) is taking measures to ensure the company’s ability to weather future economic difficulties. The company currently has investment-grade credit ratings from both of the major agencies (BBB from S&P and Baa2 from Moody’s) which they are committed to maintaining by reducing leverage metrics.
OKS has been reducing its GAAP Debt-to-EBITDA (a key metric of financial leverage) consistently over the past few years, from 4.8x in 2013 to 4.2x currently. Over the long term they are aiming to reduce this ratio below 4.0x.
OKS’ overall credit situation is outlined in the following slide.
Source: ONEOK Investor Presentation, Wells Fargo Securities 2016 Symposium, slide 32
Altogether, OKE’s ability to withstand both the great recession and the current downturn in commodity prices without ever cutting their dividend gives me faith in the business’ recession resiliency.
Valuation & Expected Returns
Shares of OKEOK have traded in a reasonably narrow band in recent times after absolutely surging during the first half of the year. Investors may be concerned that the stock is overvalued, which can be addressed by comparing the company’s current dividend yield against its historical dividend yield.
Over the past five years, ONEOK has traded at a dividend yield between 2.4% and 12.8%. However, this spread is perhaps a bit misleading because the extra-high dividend yield came during the market turmoil of late 2015 and early 2016.
The more realistic metric to consider is the company’s average dividend yield. Over the past five year, the company’s mean dividend yield has been 4.4%, which is actually equal to their current dividend yield. It is reasonable to assume the company is fairly valued.
The rest of ONEOK’s shareholder returns will be driven by the company’s growing earnings. Looking at the company’s historical earnings and growth prospects allows us to estimate their long-term EPS growth.
Source: Value Line
Between 2000 and 2016 (expected earnings), the company grew per-share earnings from $0.74 to $1.70, which is good for a CAGR of 5.3%. Notice that historically, the company’s earnings growth has been lumpy. Notable earnings growth outliers include -22% and +65%. It is not reasonable to expect smooth earnings growth from this company.
Over the long-run, total expected shareholder returns for ONEOK will be composed of:
- 4.4% dividend yield
- 4%-6% earnings growth
Giving an estimated return of 8.4%-10.4% per annum for ONEOK shareholders.
ONEOK offers indirect exposure to the oil & gas MLP ONEOK Partners L.P.
The best time to buy this stock would have been in December 2015, when the yield was north of 12%. However, the company is fairly valued with strong growth prospects. Upside remains despite the stock’s fantastic performance year-to-date.
For investors looking for exposure to the oil & gas industry with current income, ONEOK presents a fairly valued buy-and-hold option.