An age-old investment principle is that it is better to buy the companies that produce the picks and shovels rather than the businesses that mine the gold.
This is not just applicable to gold and other mining companies, but to organizations across the market, from health care to oil and gas and even financial services.
A simple idea
The idea behind this principle is pretty simple. A single business does not have much diversification outside of its traditional market. Therefore, if the sector as a whole runs into trouble, there is going to be a risk the crisis will take the company down with it.
This is particularly true in volatile cyclical sectors. It is just as hard to pick winners in one sector as it is to pick winners in the whole market.
However, investors can spread their bets by investing in one company that supplies a whole range of businesses in one sector or industry.
For example, buying a company that produces microchips will provide exposure to the whole tech sector. That way, one does not have to pick tech sector winners. As long as money continues to flow into the industry, the company producing the microchips should see an increase in demand.
And the same relationship can be found between oil and gas companies and hydrocarbon transportation businesses like, in this case, pipeline operators.
A booming market
Oil has been one of the market's hottest sectors this year. It is not hard to understand why. Russia's war with Ukraine sent oil prices surging to a multiyear high, generating windfall profits for these businesses.
But now, the price of black gold is retreating and producers are no longer guaranteed profits as demand is falling in the face of growing economic headwinds.
Oil and gas stocks are suffering as their outlook darkens. Investors who bought into the sector following its robust profits in the first half of the year may now be left with losses.
This is not the first time investors will have been caught out by global macro trends in the commodity sector. It has happened before, and it will happen again.
With that being the case, I thought it might be interesting to compare the returns of some of the largest listed midstream pipeline operators in the U.S. with some of the largest oil producers to see if investors would be better off buying the pipelines with their steady, predictable cash flows or the producers, which have the potential to generate windfall profits as well as losses.
Comparing returns
The four largest public hydrocarbon transportation companies are (in order of market value) Enbridge Inc. (ENB, Financial), Enterprise Products Partners LP (EPD, Financial), TC Energy Corp. (TRP, Financial) and Kinder Morgan Inc. (KMI, Financial). An equally weighted portfolio of these stocks would have produced a total return of 7.4% per annum over the past 15 years.
Meanwhile, the four largest publically traded pure-play oil producers in the U.S. are EOG Resources Inc. (EOG, Financial), Occidental Petroleum Corp. (OXY, Financial), Pioneer Natural Resources Co. (PXD, Financial) and Marathon Petroleum Corp. (MPC, Financial).
I have excluded the big oil companies from this list as they usually have large trading and transportation divisions attached, which would skew the results.
An equally weighted portfolio of these stocks would have produced a total return of 7.8% per annum over the past 15 years.
For comparison, the oil and gas exploration and production industry as a whole has returned 3% per annum, including dividends, during the past decade compared to 7.2% for the midstream industry.
So, on the whole, it seems as if midstream stocks are the better investment in the long run. Investing across the sector rather than picking stocks would have yielded the best performance during the past 12 months. Although the biggest and best producers outperformed, the gap was insignificant.
