Magellan's Distribution Remains Well Covered But Energy Transition Uncertainty Weighs on Sentiment

While many energy stocks have experienced a strong recovery from pandemic lows, midstream providers have struggled to keep up. This underperformance has even included industry leaders like Magellan, which trades with an attractive dividend yield of over 8%.

The market's failure to reward Magellan triggers questions about what risks have kept hesitant investors at bay.

To be sure, some quality midstream operators are trading at higher valuations and with lower and more reasonable dividend yields. However, Magellan boasts one of the industry's highest credit ratings (BBB+) and is coming off what proved to be a good year for the MLP.

Refined transportation volumes, which drive about 70% of the MLP's income and represent fuels such as gasoline, were up 14% in 2021 – even setting a quarterly record to finish the year as domestic travel continued its rebound.

In addition to last summer's 3% tariff hike, which is the price shippers pay for transportation across Magellan's network of pipelines and terminals, these increased volumes contributed to a solid 7% growth rate in the firm's distributable cash flow last year.

Furthermore, the company plans to issue 6% tariff hikes this summer as a sign of confidence in the volume outlook and hopes distributable cash flow will fully recover to pre-pandemic levels.

Although Magellan's heavy exposure to refined fuels has minimal long-term contract commitments, volumes tend to remain fairly steady regardless of oil prices, being more correlated to vehicle miles traveled which have proven resilient over time.

Even so, around 30% of Magellan's income is generated from crude oil pipelines and storage, which are more sensitive to energy prices and drilling activity.

Most of the firm's pipelines are backed by take-or-pay contracts with an average remaining duration of four to six years. But with oil production not yet returning to pre-pandemic levels, this part of the business could face less favorable renewal terms and throughput as the midstream industry grapples with excess capacity.

Meanwhile, crude storage has struggled thanks to a phenomenon known as backwardation, where the current price of oil is higher than what you can buy it for down the road using a futures contract. It's hard to find customers who want to pay to store something that is expected to be sold for less money in the future.

While this situation is pressuring Magellan's margins, it's unlikely to be a long-term concern or a threat to the firm's distribution coverage, which remains healthy and consistent with pre-pandemic levels.
Source: Simply Safe Dividends

Taking a longer view, some investors worry that demand for gasoline and diesel will fade as fuel efficiency increases and electric vehicles become commonplace. Magellan's refined products pipelines are directly exposed to these risks and have few obvious alternative uses.

That said, we expect the firm's refined fuels business to remain in demand for some time. A growing population and expanding middle-class should continue to depend on gasoline, which remains cheaper and more scalable than "green" alternatives.

And electric vehicles made up only 2% of auto sales in America last year. It will likely take many years to achieve mass production and adoption. As such, we expect the resulting decline in transportation fuel demand to happen gradually in the decades ahead.

Given the industry's mature growth profile, Magellan's entrenched infrastructure is unlikely to be challenged by new rivals. As one of the more conservative and well-established players, the company could further strengthen its position as industry consolidation occurs, too.   

Recognizing the firm's improved outlook, healthy payout ratio, and relative strength within the industry, we are reaffirming Magellan's Safe Dividend Safety Score.

However, conservative investors wanting exposure to midstream operators but desiring even more stability may consider Enterprise Products Partners, an MLP with most profits tied to take-or-pay contracts, exposure to a broader commodities mix, and a more diversified network of assets.

We'll continue to monitor Magellan's pipeline volumes and America's electric vehicle adoption and provide updates as needed.

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