Three trends could trip up oil and gas pipeline companies. Here's how to trade them

Key Points
  • Pipeline companies are facing operational challenges in a shifting oil and gas market, Bain & Co. says.
  • Stranded assets, contract negotiations and a flood of private equity money are some of the concerns.
  • Portfolio managers say diversified energy infrastructure companies are best positioned to weather the turbulence.
Brad Quick | CNBC

Pipeline and energy infrastructure companies face operational challenges in the coming years even as U.S. oil drilling recovers and a natural gas export boom gets underway, consulting firm Bain & Co. says in a new report.

While there is demand for new infrastructure, three trends in the industry could trip up pipeline companies, Bain said in a report released Wednesday. Oil and gas drilling is subdued in some areas, contract renewals may lead to lower rates, and private equity competition is eating into profit margins.

This will make it harder for so-called midstream companies, which transport, store and process oil and gas, to squeeze profit out of their projects, according to Bain.

This matters to investors because investing in midstream companies became a source of reliable dividends as pipeline construction ramped up during the U.S. shale oil and gas boom. Pipelines and other infrastructure produce steady income, allowing midstream companies to ratchet up payouts to investors.

The 10-year average annual distribution growth for master limited partnerships, a common structure for energy infrastructure companies, was 6.8 percent through 2015, according to Alerian, which operates funds linked to MLPs.

Alerian MLP Index distribution growth

"There's a starvation for yield right now because the 10-year [U.S. Treasury] is barely over 2 [percent]. Utility and REIT yields are really, really low. You can go buy energy infrastructure stocks that have 5.5, 6.5 percent yields that are growing," Rob Thummel, portfolio manager at Tortoise Capital, told CNBC's "Power Lunch" on Tuesday.

Stranded assets

Oil and gas from some regions that would have moved through pipes are now stranded in the ground because they're too expensive to extract, pipeline executives told Bain.

Some low-cost regions like Texas' Permian basin have rebounded quickly. But sharp production declines in other basins, like North Dakota's Bakken, have not yet reversed significantly. The focus on sweet spots could reduce production in places like the Rockies, lowering the need for pipelines and other infrastructure.

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Portfolio managers say they're keenly focused on this issue.

"It's kind of like real estate. It's all about location, location, location when investing in some of these MLPs," Thummel told CNBC in a separate interview Wednesday.

"The way we mitigate that is making sure our companies have diversified assets. You've got to be careful investing in just concentrated positions in concentrated areas," he added.

Two of Thummel's top diversified picks are Enterprise Products Partners and EQT Midstream Partners, which yield 6.7 percent and 5.1 percent, respectively.

Tougher contracts

Another worry that Bain flags is the coming expiration of favorable contracts that pipeline companies signed with their customers during a construction boom. Contract provisions that guaranteed a minimum payment no matter how much product flowed through their lines have protected their revenue.

Pipeline operators will likely have to agree to lower volumes and rates when they negotiate new contracts, Bain says. That's a problem, especially for companies that pipe oil and gas out of basins where production is falling, according to Bain.

While this midstream sector hasn't entirely resolved this issue, concerns about contracts have already been priced into midstream stocks and MLP units, said Jay Hatfield, a portfolio manager for InfraCap's AMZA exchange-traded fund, which tracks midstream companies.

He notes that companies began tackling the issue over the last two to three years, altering the terms of contracts when those terms became uneconomical due to low oil and gas prices.

"It's good for everyone because transport companies can invest more in pipelines and gathering and processing, and probably more gas is going to flow," Hatfield said.

MLPs are now one of the cheapest assets classes in the yield sector, according to Hatfield.

Private equity problems

The flood of private equity money into the space also raises concerns, according to Bain. Private equity-backed firms are agreeing to more aggressive contract terms than traditional midstream companies typically accept.

Bain sees this happening particularly in the processing and gathering parts of the midstream chain. Companies in the processing segment transport oil and gas short distances from the wellhead to long-haul lines and processing facilities. Companies in the gathering operations prepare natural gas to be shipped through lines by stripping out impurities and natural gas liquids.

Processing and gathering are becoming less profitable not only because of the influence of private equity, but because of the concentration of drilling in a few places. Long-haul lines that move oil and gas out of low-cost basins like the Permian are still attractive, but Bain cautions that growing competition in these regions could push down pipeline companies' profit margins.

Thummel says rates for long-haul pipelines are not a major concern because they are supported by five- to 10-year contracts, but the short-distance operations are more exposed to commodity price fluctuations and subject to rate negotiations.

Again, he notes that firms with a diverse portfolio of projects like Energy Transfer Partners are best positioned to deal with challenges in different parts of the chain.

Bain said midstream companies need to set realistic cost reduction goals to make their portfolios more resilient, focus on becoming more efficient and plan for growth beyond the typical three-year horizon.

"Doing so will allow them to gain a clear understanding of the cost structures they will need to adopt in order to thrive even amid industry turbulence," Bain partner Riccardo Bertocco said in a statement.

Disclosure: Tortoise Capital owns shares of Enterprise Products Partners, EQT Midstream Partners and Energy Transfer Partners. Rob Thummel does not personally hold shares of the companies.