Hess Midstream Partners LP (HESM) is much smaller and less diversified than some of the leading midstream MLPs but it is quickly expanding its footprint in the Bakken shale play. The Houston, Texas-based Hess Midstream has recently announced an acquisition and it’s ramping up its natural gas processing capacity. I expect the MLP to significantly grow its earnings and distributable cash flows in the coming quarters, which will allow it to continue growing distributions.

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The last few months have been tough for the energy sector. The oil prices have fluctuated in the past six months but have largely gone downhill. The WTI crude oil price dropped from more than $66 a barrel in April to $54.67 at the time of this writing. The increase in tensions in the Middle East following an attack on oil facilities in Saudi Arabia which knocked out 5% of the global supplies pushed the commodity to over $60 in September. But the gains were short-lived as the Kingdom quickly restored production and the market’s focus shifted back to the ongoing trade war with China, sluggish global economic growth, and growing oil supplies.

This weakness has fueled a sell-off in the energy sector. The markets have punished several energy companies, healthy and unhealthy alike, as well as the midstream sector which has no direct exposure to oil prices. The energy industry’s benchmark fund SPDR Energy Select Sector ETF (XLE) has fallen by 13.6% in the last six months and the Alerian MLP ETF (AMLP) – which is the largest MLP ETF in terms of assets – dropped by 10.5% in the same period. Hess Midstream Partners’ units have fallen by 3%, but the MLP’s future outlook is looking bright.

Hess Midstream Partners was created by the Bakken-focused oil and gas producer Hess Corporation (HES) to own and operate energy infrastructure assets located in the core of the Bakken shale play in the Williston Basin area of North Dakota. Hess Midstream is a small MLP valued at $1.05 billion. It operates in just one oil-producing region and mainly serves just one customer – its parent Hess Corporation. In terms of size and scale, Hess Midstream is substantially smaller than the industry titans such as Enterprise Products Partners (EPD) valued at $62 billion or Energy Transfer LP (ET) with a market cap of $34 billion. Both Enterprise Products and Energy Transfer serve diverse customers and have a large asset base – including pipelines, storage plants, processing facilities, and export terminals – that’s spread across multiple shale oil and gas producing regions. But what I like about Hess Midstream is that it is still a young MLP, formed in 2014, that can grow its earnings and distributable cash flows by double digits.

Remember, Hess Midstream has a rock-solid balance sheet with extremely low levels of debt. Most MLPs try to maintain a debt ratio (debt/adj. EBITDA) of around 3.0x to 4.0x which helps them in getting an investment-grade credit rating. Enterprise Products had a leverage ratio of 3.3x at the end of the second quarter. Magellan Midstream Partners (MMP) boasts a superior balance sheet than Enterprise and many other MLPs, thanks to a leverage ratio of 2.8x. Hess Midstream’s debt ratio, however, is just 0.5x – one of the lowest in the industry. An under-levered balance sheet allows Hess Midstream to pursue additional opportunities, which is exactly what it has done.

Hess Midstream has recently announced that it will spend around $6.2 billion to buy its parent Hess Infrastructure Partners, which is a joint venture between Hess Corp. and Global Infrastructure Partners. Hess Midstream will assume $1.15 billion of Hess Infrastructure’s debt, issue approximately 230 million units, and pay roughly $550 million in cash. In return, Hess Midstream will get Hess Infrastructure’s 80% interest in the former’s midstream assets, Hess Infrastructure water services business as well as the outstanding general partner interest and incentive distribution rights.

I think Hess Midstream Partners has taken a big step in the right direction. In one move, it has significantly increased its interest in its midstream assets and expanded into the water services business, more than doubling its enterprise value to $7.25 billion. At the same time, it has simplified its structure and eliminated the IDR overhang. Currently, Hess Midstream’s general partner Hess Midstream Partners GP LP holds incentive distribution rights which entitle it to receive an increasing share of the incremental cash distributions. The general partner gets 25% of the distributions but within a couple of years, I think the GP’s share would have climbed to 50% as quarterly cash distributions exceed $0.45/unit which might have necessitated an IDR buyout.

The acquisition will fuel significant growth in volumes and relatively modest growth in earnings and distributable cash flows on a per unit basis (due to dilution). But the growth will likely accelerate moving forward. Hess Midstream expects the acquisition to deliver 6% DCF per unit growth in 2020 and more than 15% growth in 2021 and 2022. Moreover, with the absence of any IDRs, all of the benefits of earnings, DCF, and distribution growth will go directly to the ordinary unitholders.

But what’s great about Hess Midstream is that it is not just relying on acquisitions or drop-down transactions for growth. The MLP is also working on organic growth projects to capture higher volumes from Hess Corp. as well as third parties. The MLP has recently completed work on a major project – the Little Missouri 4, or LM4, gas processing plant was placed into service in the second quarter. That has substantially increased Hess Midstream’s gas processing capacity from 250 million to 350 million cfpd. The facility is well-positioned to serve oil and gas producers in the Bakken field who are forced to flare the resource due to a shortage of gathering pipelines and processing plants. Hess Midstream will gradually ramp up gas processing volumes throughout the remainder of 2019 and I expect the plant to be operating close to full capacity before the end of the year.

Hess Midstream is also expanding the capacity of its Tioga plant from 250 million to 400 million cfpd. The MLP will start major construction work from early next year and expects to complete the project by mid-2021. That’ll push its total gas processing capacity to 500 million cfpd.

Image: HESM, Investor Relations Presentation, August 2019.

This will help Hess Midstream in serving Hess Corp. which plans to increase its total oil equivalent production at a CAGR of 20% from 2018 to around 200,000 boe per day by 2021. Moreover, the expansion of processing capacity has put Hess Midstream in a better position to diversify its customer base by serving other oil and gas producers besides its parent. The MLP has already done a decent job of expanding its customer base. In the second quarter, third-party customers accounted for 30% of Hess Midstream’s gas volumes and 15% of oil volumes. This diversification will likely continue in the future.

For these reasons, I believe Hess Midstream can meaningfully grow its volumes in the future which will drive earnings and cash flow growth. The growth in distributable cash flows will help the MLP in growing cash distributions to unit-holders. Hess Midstream has recently reported its second-quarter results in which it posted adjusted EBITDA of $24.2 million and distributable cash flows of $23.3 million, nearly flat on a year-over-year basis. However, the MLP increased distributed cash flows by almost 19% to $22.8 million. With flat DCF and higher distributions, Hess Midstream’s coverage ratio dropped from 1.24x to 1.02x, which isn’t a good sign. However, I expect the coverage ratio to climb back up in the coming quarters as the LM4 plant drive volume and DCF growth. The MLP will likely end the year on a high note, with LM4 operating close to full capacity which can drive earnings and DCF growth in 2020.

Strong earnings and DCF growth will allow Hess Midstream to grow distributions. The MLP announced a 15% year-over-year increase in distributions for the second quarter to $0.3970 per unit and will likely announce additional double-digit hikes in the future. Hess Midstream plans to grow distributions by 15% over the long-term and with support from strong DCF growth, I believe it can achieve this target while maintaining a decent coverage ratio of more than 1.1x.

Hess Midstream currently comes with a distribution yield of 7.5%, which is higher than the yields of around 6% to 7% offered by many large MLPs such as Magellan Midstream, Enterprise Products, and Plains All American. Hess Midstream’s yield can easily climb to more than 8% within a year (at current price) as it continues growing distributions by 15%. In my view, Hess Midstream is a great MLP which investors should consider buying.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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