Midstream Energy Stocks

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1 Research Update September 28, 2015 Midstream Energy Stocks The graphic below tracks the entry point for each of the four midstream energy stocks on the Buy List for the Managed Equity Dividend Strategy. The timing for each addition is overlaid against an index of midstream energy master limited partnerships, or MLPs, called the Alerian MLP Index (Bloomberg ticker: AMZ<Index>). Alerian MLP Index to KMI Buy 9/24/14 WMB Buy 9/13/13 OKE Buy 12/18/14 SE Buy 6/2/15 Source: Bloomberg As this graph shows, stocks in the midstream energy sector have been in a virtual free-fall since April. Two factors likely triggered the downturn. First and foremost has been a significant drop in the price of oil and natural gas in recent months following a short-term rally early this year that peaked in April. Second has been a rise in interest rates that triggered a selloff for many interest rate sensitive sectors like utilities, real estate investment trusts (REITs), and MLPs. The 10-Year Treasury yield hit a low of 1.65% in April, but it has since risen to around 2.2%. Yields have risen even more for corporate bonds, particularly among companies with sub-investment grade credit ratings. 1 The Alerian MLP Index tracks the price and yield performance of large-cap and mid-cap energy Master Limited Partnerships. The index is capitalization weighted among 50 MLPs.

2 As if conditions couldn t get any worse for the sector, today we get the announcement of a long-discussed merger between Energy Transfer Equity (ETE: ~$20) and Williams Cos. (WMB: ~$37) under terms that have investors scratching their heads. After rejecting an offer in June that valued Williams at around $60 per share, today the board accepted a revised offer that valued the company at $43.50 based on Friday s closing stock price for ETE. Following a double-digit decline in the price of ETE today, the deal currently offers WMB shareholders less than $40 per share. 2 The only justification we can think of for the board s decision is that they must believe the future is brighter for the combined entity than it would be for Williams on its own. Details for why this might be so will be forthcoming in future presentations from management of both companies. Based only on the information we have available to us right now, Capital Advisors will likely vote no to the deal. However, we expect to know much more about the business case for the merger by the time we cast our vote. Unfortunately for the midstream energy sector more broadly, today s news from Williams struck a knock-out punch to whatever confidence investors had left in the sector. Articles are already being written about the death of the MLP business model. We liken this sentiment to the last death of the MLP business model during the financial crisis in ; or the death of the REIT business model at that same time. During times of maximum uncertainty like 2009 for many industries, and today in the midstream energy space it is instructive to remember how quickly things can turn once investors fear of the unknown subsides. In 2009 the Alerian MLP Index and the MSCI US REIT Index 3 both bottomed out on March 9 th. By the end of April that same year, the MLP Index had recovered more than 26%, while the REIT Index advanced nearly 55%. As of year-end 2009, the MLP Index had surged more than 80%, while the REIT Index more than doubled to gain 123%. (Source: Bloomberg) It is impossible to know if today s panic selling across the midstream sector might put in a floor for at least a few stocks in the group. Even if we could be so lucky, we recognize that low commodity prices and the potential for higher interest rates will probably challenge business conditions for another year, if not longer. However, we also believe the latest swoon in these stocks represents an overshoot that should eventually prove to be excessive. As the experience of previous market overshoots has shown, stock prices can bounce back quickly well before business conditions in a downtrodden sector fully recover. 2 Under the terms of the transaction, Energy Transfer Corp LP ( ETC ), an affiliate of ETE, will acquire Williams at an implied current price of $43.50 per Williams share. Williams stockholders will have the right to elect to receive as merger consideration either ETC common shares, which would be publicly traded on the NYSE under the symbol ETC, and / or cash. Elections to receive ETC common shares and cash will be subject to proration. Cash elections will be prorated to the extent they exceed $6.05 billion in the aggregate, and stock elections will be prorated to the extent the full $6.05 billion cash pool is not utilized. Williams stockholders electing to receive stock consideration will receive a fixed exchange ratio of ETC common shares for each share of WMB common stock, before giving effect to proration. If all Williams stockholders elect to receive all cash or all stock, then each share of Williams common stock would receive $8.00 in cash and ETC common shares. 3 The MSCI US REIT Index is based on the MSCI USA Investable Market Index, which captures large, mid and small cap securities structured as real estate investment trusts. With 143 constituents, it represents about 99% of the US REIT universe.

3 We offer Oneok (OKE: ~$33) as a representative illustration of a stock that may have gone too far. Of the four midstream stocks on our Buy List, Oneok is the most challenged in terms of its business mix (more sensitive to commodity prices), and balance sheet leverage. We point this out to suggest that our selection of Oneok for this report is the opposite of cherry-picking. Oneok is a pure-play general partner that generates all of its cash flow from its ownership in Oneok Partners LP (OKS: ~$30). Among midstream MLPs, Oneok Partners (and by extension Oneok) is relatively more sensitive to commodity prices due to its gathering & processing (G&P) business in the Bakken formation in North Dakota and Wyoming. A combination of lower oil prices and reduced activity in the Bakken caused cash flow to drop below the dividend for Oneok Partners in the first half of the year. Investors have been wrestling with the question of when, or if dividend coverage can recover at Oneok Partners. If commodity prices remain depressed, and the company fails to achieve its volume targets for , a distribution cut could be a real possibility next year. We don t expect Oneok Partners to reduce its distribution. We further believe that investors will gain confidence in the sustainability of the distribution when the company reports third quarter earnings in late-october. At that time we expect management to report the results of ongoing contract re-negotiations among its largest customers in the Bakken formation. According to analyst reports and our own conversations with management, Oneok Partners has already completed a contract revision with one large customer, and it is in the final stages of revising up to nine more. The revised contracts allow Oneok Partners to earn higher and more stable fee-based revenue for its G&P services. Analysts at Barclays Capital recently estimated that contract renegotiations could add $100 million to cash flow at Oneok Partners next year ( Contract Renegotiations to Support Higher Coverage in 2016 Barclays Capital, ). The magnitude of this potential improvement begs the question why would their customers agree to this? There are several reasons. First, exploration & production companies operating in the Bakken need midstream infrastructure to take their product to market, and Oneok controls about half of the existing infrastructure in the basin for processing associated natural gas. Absent a rework of these contracts, there is risk that future spending on midstream infrastructure may not happen in a timely manner. A second reason is relative economics to both parties. A $100 million improvement in Oneok s cash flow amounts to about $10 million per producer (assuming renegotiation with the company s top-10 customers), which is a rounding error for each producer s total operation in the basin. It is important to note that dividend coverage at the general partner level (the stock we own) remains positive. We estimate Oneok can generate $125 million in surplus cash flow after dividends in 2015, and up to $200 million in 2016, representing a coverage ratio of 1.25 this year, and around 1.4 next year. Despite sufficient coverage of the dividend, we do not expect management to raise the dividend until coverage recovers at Oneok Partners. We suspect Oneok stock is priced to reflect a possible cut in the dividend next year, so a flat dividend payout in 2016 may be sufficient to improve the stock price relative to recent expectations for worse.

4 We added Oneok to the Buy List at approximately $48 per share on December 18, The stock was already down 32% from its high at that point, while the annual dividend was $2.36 per share, producing a yield of 4.9% from our purchase price. Today the stock is around $33, while the annual dividend has risen to $2.42 for a yield of 7.3% (Source: Bloomberg). In today s market climate of historically low interest rates a dividend yield of 7.3% looks too-good-to-be-true by comparison. Oneok is not alone with its eyebrow-raising dividend. The recent yields for Kinder Morgan (KMI: ~$28), Spectra Energy (SE: ~$26), and Williams Cos. (WMB: ~$37), are 7.1%, 5.6% and 7.0%, respectively, while the Alerian MLP Index shows a recent yield of 8.2% (Source: Bloomberg). Publically traded stock prices reflect a remarkable volume of collective knowledge, so we don t take it lightly that yields across the midstream energy sector look too good to be true. Even so, we believe the dividends from many midstream companies, including the four stocks on our Buy List, can survive the current downturn. We believe investors may gain confidence in the sustainability of these companies dividends when they report third quarter earnings in late-october/early November. If so, the combination of each company s generous dividend, plus a modest recovery in the stock price, can produce an attractive double-digit return from current trading levels. We must acknowledge that a double-digit return is needed just to get back to even with the entry price for these stocks on our Buy List. The point is that investors may return quickly to any company that demonstrates it can sustain its dividend through the cycle.

5 Disclosures Security Recommendations: The investments presented are examples of the securities held, bought and/or sold in the Capital Advisors strategies during the last 12 months. These investments may not be representative of the current or future investments of those strategies. You should not assume that investments in the securities identified in this presentation were or will be profitable. We will furnish, upon your request, a list of all securities purchased, sold or held in the strategies during the 12 months preceding the date of this presentation. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of securities identified in this presentation. Capital Advisors, Inc., or one or more of its officers or employees, may have a position in the securities presented, and may purchase or sell such securities from time to time. Additional information, including management fees and expenses, is provided on Capital Advisors Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Capital Advisors does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The investment return and principal value of an investment will fluctuate so that an investor s portfolio may be worth more or less than its original cost at any given time. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results. Capital Advisors, Inc. does not provide tax or legal advice and recommends you consult with your tax and/or legal adviser for such guidance. Please contact Capital Advisors for a list and description of all firm composites and/or copy of our most recent Form ADV part 2: Presentation is prepared by: Capital Advisors, Inc. Copyright 2015, by Capital Advisors, Inc.