SRV: Increasing Leverage And Premium Valuation Are Both Concerns

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NXG Cushing Midstream Energy Fund offers a high yield of 12.56%, making it attractive to investors seeking high yields.The fund has outperformed the Alerian MLP Index and S&P 500 Index over the past ...

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It might be worth paying the small premium, but I would still prefer it to be cheaper.   spooh The NXG Cushing Midstream Energy Fund (NYSE:SRV) is a closed-end fund that focuses on investing in midstream energy companies and master limited partnerships. This fund has become one of the most popular funds in this category in recent years due to having a substantially higher yield than most of its peer funds. Its shares yield a whopping 12.56% at the current price, which easily places it well above the yield offered by the other funds in the sector. This is clearly seen here:   Fund Name Morningstar Classification Current Yield   NXG Cushing Midstream Energy Fund Equity-MLP 12.56%   ClearBridge Energy Midstream Opportunity Fund (EMO) Equity-MLP 6.67%   Kayne Anderson Energy Infrastructure (KYN) Equity-MLP 8.38%   Neuberger Berman Energy Infrastructure and Income Fund (NML) Equity-MLP 8.73%   Tortoise Pipeline & Energy Fund (TTP) Equity-MLP 6.67%   Click to enlarge Many investors who are attracted to the midstream sector in the first place are interested in receiving a very high yield from the money that they park into these companies. As such, a fund with a higher yield is likely to be more attractive than one with a lower yield. The fact that the NXG Cushing Midstream Energy Fund currently offers the highest yield in the sector (by a considerable margin) thus makes it pretty easy to see why this fund is fairly attractive to many potential shareholders. However, as I have mentioned in various previous articles, any time a fund has an outsized yield relative to its peers, it is a sign that it might not be able to sustain the distribution. This is very much the case here, which means that we need to pay special attention to the fund’s finances. As regular readers might remember, we previously discussed the NXG Cushing Midstream Energy Fund in the middle of May of this year. At the time, we had some concerns about the fund’s ability to sustain its distribution, but it did not appear that a cut is imminent. The midstream sector as a whole has been reasonably strong since that article was published, so that is probably still the case today. In addition, the strength in the midstream sector would lead us to assume that this fund has delivered a respectable performance since the publication date of my previous article on it. However, this fund’s performance since mid-May has not been particularly impressive. Its share price is only up 1.08%:   Seeking Alpha As we can see, the NXG Cushing Midstream Energy Fund significantly underperformed both the S&P 500 Index (SP500) and the Alerian MLP Index (AMLP) since the date that my previous article on this fund was published. Of the two, the underperformance versus the Alerian MLP Index is particularly disheartening because this fund specifically focuses on investing in the same types of companies as would be included in that index. Master limited partnerships historically underperform the S&P 500 Index, so the fact that this fund failed to keep pace is not especially surprising. However, the above chart does not tell the whole story. As I stated in my previous article on this fund: A simple look at a closed-end fund’s price performance does not necessarily provide an accurate picture of how investors in the fund did during a given period. This is because these funds tend to pay out all of their net investment profits to the shareholders, rather than relying on the capital appreciation of their share price to provide a return. This is the reason why the yields of these funds tend to be much higher than the yield of index funds or most other market assets. When we include the distributions that were paid out by the NXG Cushing Midstream Energy Fund as well as the index funds into the price performance chart since May 13, 2024, we get this alternative chart:   Seeking Alpha This certainly looks somewhat better for investors. The NXG Cushing Midstream Energy Fund managed to deliver a better total return over the past two-and-a-half months than the Alerian MLP Index. The fund did, however, still underperform the S&P 500 Index, but that is to be expected. The performance of most master limited partnerships is below that of the S&P 500 Index over most periods of time, but this is at least partially due to the industry collapses that occurred in 2015 and 2020. The NXG Cushing Midstream Energy Fund and the Alerian MLP Index both outperformed the S&P 500 Index on a total return basis over the past three years:   Seeking Alpha Unfortunately, it seems unlikely that either the NXG Cushing Midstream Energy Fund or the Alerian MLP Index will continue to deliver performance that beats the S&P 500 Index going forward. There is no real driver of organic growth right now, and those master limited partnerships that have delivered strong growth over the past three years have done it through acquisitions. However, given the yields of most master limited partnerships, they do not need much growth in order to deliver a total return that is in line with the 10% average annual increase in the S&P 500 Index. Thus, we can probably at least expect to make money with a fund like this. About The Fund According to the fund’s website, the NXG Cushing Midstream Energy Fund has the primary objective of providing its investors with a very high level of total return. This makes a lot of sense given the strategy description that the fund provides on its website: The Fund’s investment objective is to obtain a high after-tax total return from a combination of capital appreciation and current income. The Fund seeks to achieve its investment objective by investing, under normal conditions, at least 80% of its net assets, plus any borrowings for investment purposes, in midstream energy investments. The strategy description from the website is not at all clear on this, but based on the fund’s current holdings, the term “midstream energy investments” means common equity securities issued by midstream companies. According to the fund’s most recent semi-annual report, the fund was holding the following asset allocation on May 31, 2024:   Asset Type % of Net Assets   Common Stock 88.5%   MLP Investments and Related Companies 40.6%   Preferred Stock 2.9%   Money Market Funds 1.1%   Click to enlarge The “MLP Investments” category consists entirely of common equity units issued by various master limited partnerships. Here is a full list from the semi-annual report:   Fund Semi-Annual Report We can see that the fund has master limited partnership holdings in a few different categories. There are crude oil and refined products pipeline operators, giant pipeline partnerships that operate all different types of hydrocarbon pipelines, natural gas gathering and processing companies, an upstream exploration and production company, a coal producer, and a renewable energy partnership. These securities are all the common equity units issued by these companies, not the preferred or debt securities from those master limited partnerships that have such securities. The only securities held in this fund that are not common stocks or common equity partnership units are the 2.9% of net assets invested in preferred stock and the 1.1% invested in idle cash. There are only three preferred stock issues held by this fund:   Fund Semi-Annual Report We see here that the fund is only holding a very small position in the preferred stock issue of NGL Energy Partners, which is a midstream pipeline company that mostly operates in the state of New Mexico. It has a much larger position in the preferred stock issues of two large electric utilities. Unlike many other funds that might include preferred stock, there are no banks or other financial companies included in the fund. That makes sense given the fund’s energy sector theme. The NXG Cushing Midstream Energy Fund uses two different money market funds to manage its cash holdings:   Fund Semi-Annual Report As the screenshot shows, the fund’s cash is evenly split between the First American Government Obligations Fund (FGXXX) and the First American Treasury Obligations Fund (FXFXX). The only difference between the two is that the First American Government Obligations Fund includes agency securities that trade in the money market. The First American Treasury Obligations Fund is exclusively invested in U.S. Treasury securities and secured repos backed by U.S. Treasuries. It is unclear why the fund is using two money market funds for cash management purposes. Usually, government money market funds have slightly higher yields than Treasury-only money market funds. This is not the case with these two funds:   Fund Name Current Yield   First American Government Obligations Fund 5.25%   First American Treasury Obligations Fund 5.25%   Click to enlarge However, in many cases, the interest received from U.S. Treasury securities is exempt from state income tax. The interest received from agency money market securities is taxed by state governments. Thus, Treasury-only money market funds will frequently have a higher after-tax yield for those individuals who live in a state that has an income tax. As these two funds have the same current yield, it is unclear what advantage the fund actually derives from splitting its money between the two of them. As the yields are the same, it would make more sense for it to simply have all of its money in the Treasury-only fund due to the potential for lower taxation. As is the case with most midstream funds, the NXG Cushing Midstream Energy Fund only has a very small number of holdings. The semi-annual report lists 41 holdings, not including the two money market funds. CEF Connect states that the fund had 46 positions as of June 30, 2024, but it is unclear where that number came from. The fact sheet dated June 30, 2024, does not state how many positions the fund had on that date, neither does the website. The fund did not release a holdings report for the month of June. In any case, it is still very clear that the NXG Cushing Midstream Energy Fund does not have an especially large number of holdings. The fund’s website lists the following as the largest positions in the fund as of June 30, 2024:   NXG Cushing There have been two significant changes to the largest positions in the fund since the last time that we discussed it. This means that Western Midstream (WES) and Hess Midstream (HESM) were both removed from their former positions among the fund’s largest positions. In their place, we have DT Midstream (DTM) and MPLX (MPLX). It is hard to complain about the addition of MPLX to the largest positions in the fund. As subscribers to Energy Profits in Dividends are well aware, this has been one of the best companies in the midstream sector for several years now. The company’s cash flow was almost completely unaffected by the pandemic lockdowns that caused many other companies in the sector to cut their distributions back in 2020, and this is quite evident by the fact that MPLX has gradually grown its distribution over the past ten years:   Seeking Alpha This is one of the few midstream companies that has never cut its payout, despite the troubles that the sector went through over the past decade. The company’s market performance, when measured on a total return basis, has also outperformed the Alerian MLP Index over the past ten years:   Seeking Alpha Thus, we cannot complain about the fund adding this company to its largest positions. I will admit that I am less enamored with DT Midstream than I am with MPLX. However, this is mostly because DT Midstream has, in the past, traded at incredibly high valuations relative to its cash flow and dividends. The price is a bit more reasonable now, although the company’s 3.90% current yield is fairly low compared to most other midstream companies. Another thing that we noticed is that the fund’s common stock weighting has increased significantly since our previous discussion. As mentioned earlier, the NXG Cushing Midstream Energy Fund has 88.5% of its net assets invested in common stock. In the previous article, which used figures from the fund’s annual report, showed that the fund had 78.5% of its assets invested in common stock as of November 30, 2023. Interestingly, the fund’s weighting towards midstream partnerships remained relatively stable from the end of November until the end of May. Its preferred stock and money market fund weightings decreased over the period, which partially explains how this fund managed to fund the substantial increase in its common stock allocation. However, neither one of those positions was large enough to fund a 10% of net assets increase in the fund’s common stock allocation. Thus, it seems likely that this fund borrowed some money at some point during the period to use to fund additional investments. Leverage As is the case with most closed-end funds, the NXG Cushing Midstream Energy Fund employs leverage as a method of boosting the effective yield and total return that it earns from the assets in its portfolio. I explained how this works in my previous article on this fund:  In short, the fund is borrowing money and using that borrowed money to purchase the common equity of midstream companies. As long as the purchased assets have a higher total return than the interest rate that the fund needs to pay on the borrowed monies, the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this will usually be the case. It is worth noting that this strategy is much less effective at boosting the effective portfolio return today than it was three years ago. This is simply because borrowing money is considerably more expensive today than it used to be. However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not using too much leverage because that would expose us to an excessive amount of risk. I generally do not like to see a fund’s leverage exceed a third as a percentage of its assets for this reason.  As of the time of writing, the NXG Cushing Midstream Energy Fund has leveraged assets comprising 29.23% of its portfolio. This represents an increase over the 25.86% leverage that the fund had the last time that we discussed it. This fund had 14.07% leverage back on November 15, 2023, so we see a substantial increase in the fund’s borrowings since that date. This is not unexpected, given the comments that I made in the previous section about the fund’s allocation to common stock increasing dramatically since late November 2023. The leverage ratio of the NXG Cushing Midstream Energy Fund remains below the one-third of assets level that we generally consider to be acceptable for a fund like this. However, it is a bit above what some of its peers possess:   Fund Name Leverage Ratio   NXG Cushing Midstream Energy Fund 29.23%   ClearBridge Energy Midstream Opportunity Fund 29.34%   Kayne Anderson Energy Infrastructure 22.27%   Neuberger Berman Energy Infrastructure and Income Fund 17.45%   Tortoise Pipeline & Energy Fund 16.20%   Click to enlarge (all figures from CEF Data) As we can see, the NXG Cushing Midstream Energy Fund is more highly leveraged than all but one of its peers. This might be concerning considering that some of these funds have had some problems with leverage in the past. After all, leverage basically caused these funds to wipe themselves out in 2015 and 2020 when the sector collapsed. While the sector is now much stronger than it has ever been, there is still the fear that such an event could happen again. That is why most of these funds have lower levels of leverage than they used to. This fund obviously does not, and as such it could be riskier than some of its peers in the event of a sudden near-term correction. Distribution Analysis The primary objective of the NXG Cushing Midstream Energy Fund is to provide its investors with a high level of total return. However, midstream companies generally provide a significant proportion of their total returns to their investors in the form of dividends and distributions. This fund will pass that money through to its investors and thus provide a significant proportion of its total returns in the form of distributions. To that end, the NXG Cushing Midstream Energy Fund pays a monthly distribution of $0.45 per share ($5.40 per share annually), which gives it a 12.56% yield at the current price. Unfortunately, the NXG Cushing Midstream Energy Fund has not been especially consistent with respect to its distributions over the years:   CEF Connect From my previous article on this fund: We can see that the fund has made a few cuts over the years, notably in response to oil price collapses in 2015 and 2020. While these events did not impact the cash flows of most midstream companies, they did cause their share and unit prices to collapse. That resulted in losses for this fund. In addition, some midstream companies slashed their distributions in response to the market turning against their equity in order to reduce debt and become financially independent of the market. That reduced the fund’s income. As such, it makes sense that the fund would slash its own distribution since it needed to avoid destroying its net asset value too much. Let us have a look at how well this fund is covering its distribution today. After all, as mentioned in the introduction, its current yield is well above most of its peers, which is a sign that the market believes that the distribution may not be sustainable. As of the time of writing, the most recent financial report that is available for the NXG Cushing Midstream Energy Fund is the semi-annual report for the six-month period ending on May 31, 2024. A link to this document was provided earlier in this article. This is a much newer report than the one that was available the last time that we discussed this fund, which is nice because it should be able to provide us with an update on the fund’s financial situation and distribution coverage. For the six-month period that ended on May 31, 2024, the NXG Cushing Midstream Energy Fund received $5,164,012 in dividends and distributions along with $173,259 in interest from the assets in its portfolio. However, some of this income came from master limited partnerships, so it is considered to be a return of capital as opposed to investment income. We subtract out the return of capital to arrive at a total investment income of $2,766,994 for the period. The fund paid its expenses out of this amount, which left it with $342,678 available for shareholders. That was not sufficient to cover the $7,540,636 that the fund paid out to its shareholders in distributions over the period. Fortunately, the fund was able to make up the difference through capital gains. For the six-month period ending on May 31, 2024, the fund reported net realized gains of $7,346,357 along with net unrealized gains of $14,096,864. That was more than sufficient to cover the distributions and still leave the fund with a substantial amount of excess returns. In fact, the net realized gains plus net investment income were sufficient to fully cover the distribution. This is very nice to see, and it is a clear sign that this fund is not over-distributing. Overall, we should not need to worry about this fund’s ability to sustain its distribution. Valuation Shares of the NXG Cushing Midstream Energy Fund are currently trading at a 0.77% premium on net asset value. This is a fairly small premium, and it is slightly better than the 0.81% premium that the shares have had on average over the past month. However, it does still mean that anyone purchasing the shares is slightly overpaying for the actual assets represented by the shares. It might be worth paying a small premium given the fund’s high yield and the fact that it can apparently sustain it. However, I would still prefer to get the shares at a discount. The fact that the premium is so small might mean that this is a possibility at some point. Conclusion In conclusion, the NXG Cushing Midstream Energy Fund is one of the most popular midstream closed-end funds for a good reason. The fund boasts a very high distribution yield, and it appears able to sustain it. The fund has been increasing its leverage, though, which might be a risky proposition given the volatility that oil prices can exhibit. The fact that it is selling for a premium is another downside here, but at least it is a small one.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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