Energy industry giant ExxonMobil (NYSE: XOM) offers an enticing 8.5% yield, but midstream-focused Magellan Midstream Partners' (NYSE: MMP) yield is an even higher 10%. If you are looking at the out-of-favor energy sector for income opportunities, these two historically conservative players are worth a closer look. Both are dealing with a delicate business environment, but one of these names appears to be in a better position than the other.
The oil giant
Exxon is one of the largest energy companies on Earth, with a diversified portfolio that runs all the way from the upstream (oil and natural gas drilling) to the downstream (chemicals and refining) segments of the industry. Historically that's provided a fair amount of balance to its business, with downstream operations usually benefiting from low oil prices that can put pressure on the upstream side of its business. However, both sides are under material strain today because of the supply/demand imbalance caused by the worldwide COVID-19-related economic shutdowns. To put it simply, Exxon is suffering.
Image source: Getty Images.
The company's balance sheet, however, is among the strongest of its direct peers. Although times are tough today, Exxon is highly likely to make it through this rough patch in one piece. Management has also made clear, most recently during Exxon's second-quarter 2020 earnings conference call, that it is dedicated to supporting the dividend, which has been increased annually for over three decades.
Offsetting these positives is the fact that Exxon's leverage has dramatically increased so far in 2020, with its debt-to-equity ratio jumping from around 0.24 times to over 0.38 times in just six months. That's still relatively low compared to most of its peers, but the balance sheet isn't quite as rock solid as it was in January. That's an issue because Exxon has undertaken a large investment program that it needs to complete to support its production over the long term. Notably, during the second-quarterearnings callmanagement stated that it didn't want to add more debt, which limits where it can find cash to support its spending plans. One option, if industry conditions remain unfavorable, would be a dividend cut. That's something Exxon would rather avoid, but investors need to keep this risk in the back of their minds.
XOM Debt to Equity Ratio data by YCharts
All in, Exxon's future hinges greatly on the direction of oil prices. If prices rise, Exxon and its dividend will likely survive. If prices remain weak or fall and linger at lower levels, Exxon may be forced to cut its dividend to keep its business running. This highlights a key point of differentiation between Exxon and Magellan.
Happily in the middle
While Exxon's business spans the spectrum of the energy sector, Magellan is focused entirely on the midstream segment. This master limited partnership owns a collection of pipelines and storage facilities that help to move oil refined petroleum products, and the products into which they are turned, from the well to the end markets they eventually serve. Roughly 60% of Magellan's assets move refined products, with the rest focused on moving crude oil. But the most important piece of the puzzle is that roughly 85% of its business is fee-based. That means it gets paid largely for the use of its assets. The prices of the products flowing through its system are less important than the demand for those products.
To be fair, demand fell off because of the economic shutdowns related to COVID-19. In fact, the partnership's distributable cash flow dropped by a third in the second quarter compared to the same period in 2019. That's not good news. However, Magellan's debt-to-EBITDA ratio has historically been at the low end of the midstream space. That remains true even though it has risen from around 2.4 times in mid-2019 to around 3.2 times today. It is built to handle adversity.
MMP Financial Debt to EBITDA (TTM) data by YCharts
Still, investors need to keep the increase in leverage in mind. Magellan's management team has stated that it will continue to support the current distribution through 2020, projecting distribution coverage of around 1.1 times for the year. That's below the partnership's target of 1.2 times. More troubling, however, is that Magellan hasn't provided guidance for 2021, so continued weak demand could potentially lead to a distribution cut if management wants to get the coverage ratio back to targeted levels. The difference is that demand is the main issue here, and that will be driven by economic recovery. Exxon could see demand increase with an economic rebound and still have to deal with low commodity prices.
And the winner is?
Both Exxon and Magellan are conservatively managed energy players facing notably difficult market conditions. There are material risks that each could end up cutting their disbursements because of the impact of COVID-19. Only more aggressive investors should probably be looking at this pair today. That said, of the two names, Magellan's demand-driven business could pick up again even if energy prices remain in the doldrums. For that reason, it has a slight edge on Exxon, where oil prices are the bigger wild card. Indeed, energy demand could return and oil prices could still continue to languish, leaving the integrated energy giant no better off than it was before.
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Reuben Gregg Brewer owns shares of ExxonMobil. The Motley Fool recommends Magellan Midstream Partners. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
