Once, idled drilling rigs were the thing to watch. Then it was the quickly dwindling storage capacity. Soon it might be the slippage in U.S. crude production.

Oil traders are still casting about for The One True Indicator foretelling crude’s course, while the unmoored market is likely — as markets tend to do — to take whichever meandering path frustrates the most participants for longest.

The producer pain crude’s current path is enforcing will eventually balance the still plentiful supply with tepid but improving demand. Unfortunately we’re only likely to realize that’s happened in retrospect.

In the meantime, let’s keep it as simple as possible. Storage builds represent a shortfall in current consumption relative to current production. At the moment and at current prices, there’s clearly a considerable gap, or inventories wouldn’t be growing so rapidly.


Source: Bespoke Investment Group

Seasonal factors and the rapid decline rates for U.S. shale wells mean inventories won’t be mounting at the recent pace for much longer. But there’s no guarantee that global demand growth will catch up to production soon or at significantly higher crude oil prices.

In the meantime,  the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP) representing smaller-cap shale drillers is testing the levels from late November, when U.S. benchmark crude was still around $70 a barrel, or 40% above its current price.

Two of the most successful large-cap Texas drillers, EOG Resources (NYSE: EOG) and Devon Energy (NYSE: DVN) are back to their levels in early October, when crude was still trying to stay above $80. We like these stocks as much as anyone, but they appear to be pricing in a significant rally in oil prices later in the year. It’s hard to believe share prices wouldn’t decline from current levels if crude’s still at $50 in November.

Ironically, midstream energy shippers and processors far less dependent on high crude prices than the drillers have made much more limited progress from recent lows. This is a dislocation worth exploiting, because much of the midstream sector makes its money by delivering energy to U.S. end users, whose demand for it has strengthened as fuel prices have dropped.


Source: Scotia Howard Weil


Source: U.S. Energy Information Administration

We’ve been adding midstream and downstream names to our portfolios for the past seven months on expectations that they will outperform in the current environment, and that’s been the case for many of our picks among refiners. But two of the more successful recommendations by our sister publication, MLP Profits, haven’t been featured here before. We’re going to fix that today. 

Fueling America

Magellan Midstream Partners (NYSE: MMP) is the leading domestic shipper of refined fuels, with a pipeline network spanning central U.S. from the Texas coast to the upper Midwest and from Chicago as far west as Wyoming and New Mexico. The master limited partnership also owns 80 product terminals along its pipelines and across the Southeast, a 1,100 mile ammonia pipeline, and five marine terminals capable of storing a total of 26 million barrels of crude and product.


Source: Magellan presentation

The refined products network is still Magellan’s mainstay, accounting for 68% of operating margin in 2014. But crude pipeline revenue jumped 74% last year to make up 23% of the profits, and is expected to remain the key growth driver. The producers in the Permian and Eagle Ford basins of Texas are not going away, and are in fact seeking more shipping capacity to the Gulf Coast and more processing of crude and condensate into value-added products.

The bulk of crude traversing Magellan’s wholly or partially owned new Texas pipelines is backed by long-term commitments; overall, 50% of the crude it moved last year was subject to long-term contracts with an average remaining term of four years as of year-end.

Long-term contracts of similar remaining length accounted for 47% of the refined product shipped last year. Fuel shipments are subject to regulated tariffs indexed to producer prices, increased 3.9% in mid-2014 and set to go up another 4.6% on July 1. Magellan’s fuel shipment volumes rose 4% excluding acquisitions last year and are forecast to grow 3% in 2015.

Source: Magellan presentation

The reason Magellan ranks as the #2 Best Buy in MLP Profits is its combination of organic growth and financial conservatism. The per-unit distribution grew 19% last year, is forecast to increase 15% in 2015 even if crude remains mired at $50 a barrel all year, and to grow at least another 10% in 2016.

And while the current annualized yield is relatively modest at 3.5%, it’s well covered by strong cash flow that exceeded last year’s distributions by nearly 50%. The investment-grade credit rating is supported by relatively modest debt leverage at 2.8x EBITDA, and Magellan recently said it doesn’t anticipate selling equity in the foreseeable future. And unlike so many MLPs, it does not pay onerous incentive distribution rights to its general partner.

These positives have helped Magellan essentially shrug off the entire energy sector slump, the unit price holding firm within a relatively narrow range at levels first achieved less than a year ago. And this ride has more fuel in the tank. We’re adding Magellan Midstream Partners to the Conservative Portfolio. Buy MMP below $90.

130 Years of Dividends and Counting

UGI (NYSE: UGI) is a midstream business even more heavily focused on end-users, deriving roughly a third of its income from a Pennsylvania gas utility and another third from midstream and marketing operations overlaying UGI’s service footprint in the Marcellus. Another third is divided between Growth Portfolio holding AmeriGas (NYSE: APU) — the propane distributor subsidiary MLP managed by UGI — and a European liquefied petroleum gas distribution business  built in recent years via acquisitions.

The utility and AmeriGas are reliable generators of steady income, while the Marcellus midstream unit holds the most growth potential. It’s already involved in gathering Marcellus gas and liquefying it in a small plant it owns for sale to utilities, and also in expanding the distribution of locally produced gas via extensions to the major gas trunk lines crisscrossing the region.

Source: UGI presentation

The company has paid a dividend every year since 1885, and has increased its payout annually for the last 27 years. The current yield is 2.5%, and UGU aims to raise it 4% annually while increasing earnings per share 6% to 10% each year.

UGI has an enterprise value of $9.5 billion and generated $1 billion on operating cash flow last year, of which capital spending consumed roughly half. The rest went to UGI dividends, AmeriGas distributions, share repurchases and debt repayments.

Source: UGI presentation

UGI’s footprint in the center of the Marcellus gas production boom is a strategic asset supporting a variety of recent growth projects. And AmeriGas is an underappreciated gem delivering predictable margin expansion almost regardless of the underlying commodity prices.

We’re adding UGI to the Conservative Portfolio; buy below $45.