Outlook for Midstream Energy
Friday, April 17, 2020
Summary:
- The energy markets are rapidly changing day-to-day. Our priority and focus in the current environment is to continuously stress test the names in our midstream energy portfolios.
- We are examining contracts, debt maturities, balance sheets, and cash flow in order to identify potential weaknesses, and evaluate the durability of our holdings.
- We are also stress testing our models to determine how a prolonged period of depressed oil prices might impact our companies.
Energy Macro Environment
So far in 2020, we have seen two oil shocks—one to demand, and one to supply. The current oil price environment is unsustainable. US shale wells are not economic and Saudi Arabia and Russia’s fiscal budgets are stretched. The market remains under severe pressure due to lower demand.
Demand Shock: We estimate oil demand destruction from the COVID-19 containment efforts to be roughly 30 million barrels per day. However, we may be starting to see some light at the end of the tunnel based on improving global trends among daily reported deaths, hospitalizations, and ICU admissions associated with COVID-19. It is unclear, if the trends will continue to improve, but we view these as encouraging data points.
Supply Shock: As the prior OPEC+ oil production cuts agreement was expiring, Russia walked away from the table, and Saudi Arabia retaliated by oversupplying and repricing their oil production. Saudi Arabia decided to essentially trade pricing for increased market share.
On April 12, Saudi Arabia and Russia agreed to slash oil production again after a month of disagreement. The agreement cuts production by 9.7 million barrels a day in May and June, and slowly increases production until April 2022, when the agreement expires. We feel that the re-instatement of the production cut agreement will help support oil prices should demand-pressures start to ease.
Lower oil prices may be a positive for natural gas prices. We view this as supportive for natural gas producers in the Northeast because as oil production goes off-line, there will be less supply of low-cost associated gas coming out of the Permian Basin.
Recent Performance
Beyond the decline of crude, midstream energy investors are taking a hit. Funds are facing margin calls, Fitch Ratings downgraded 10 midstream closed-end funds in March, and fatigued retail investors are contributing to outflows. While funds deleveraging unquestionably put significant pressure on midstream energy share prices, the pricing spreads between higher-quality versus lower-quality companies indicates this pressure may be abating.
Although this does not bring much solace, the midstream sector has outperformed other energy sectors, including those in the oil field services sector (PHLX Oil Service Sector Index), natural gas infrastructure and producers (the ISE-Revere Natural Gas Index), and oil and gas exploration and production companies (S&P Oil & Gas Exploration and Production Index) (as of 3/31/2020).
Our Consistent Focus on Quality Companies
Our selection process across our midstream energy strategies prioritizes financial strength. We typically prefer larger cap names with integrated systems. We believe these firms will weather this storm and eventually grow stronger as the space recovers. As it stands right now, we believe our MLP Strategy owns the highest quality names in the universe.
In the current environment, we continue to stress test the names in our midstream portfolios. We are examining contracts, debt maturities, balance sheets, and cash flow in order to identify potential weaknesses, and evaluate the durability of our holdings. We are also stress testing our models to determine how a prolonged period of depressed oil prices impacts volumes and the commodity-exposed parts of their businesses.
Looking at liquidity and near-term debt maturities for the companies in our MLP Strategy, we believe every holding has enough liquidity to pay down 2020 maturities, and only a few names face limited refinancing difficulty in 2021. For those with tighter liquidity in 2021, we see additional levers for management to pull, such as lowering capex spending. This is assuming sub-$30 per barrel oil prices and the associated financial pressures persist.
When it comes to the resiliency of cash flows, we look at contract structure, in particular. Fee-based contracts are when a Master Limited Partnerships (MLP) earns a predefined rate to ship commodities, but the company does not take ownership of the commodity (i.e., it does not have direct commodity exposure but does have volumetric exposure). Take-or-pay contracts require the upstream shipper to pay a minimum amount to the midstream company whether they ship or not. Specifically looking at the numbers for our MLP Strategy:
- Average fee-based exposure across our holdings is about 95%. This median is fairly consistent with the narrow range of roughly 85%-100% by individual name within the portfolio.
- Average take-or-pay exposure is approximately 58%, Here, looking across portfolio holdings, the range is wider, with the highest name having 83% take-or-pay.
Additionally, we look closely at leverage for our holdings. Prior to the downturn, we already favored companies with below 4x leverage, and we saw positive leverage trends with our companies focusing on financial strength heading into 2020. We believe our high-quality companies are better-situated than other MLPs in the Alerian MLP Index. Looking forward, we believe that if leverage for midstream companies were to improve to be below 3.0x, investors would have more confidence in the space and share/unit price performance would improve.
Midstream Energy Distributions
We have seen several names in our MLP Strategy announce that they are keeping quarter-on-quarter distributions flat, so that has been a good outcome. We saw one holding cut its distribution recently. The company could, conceivably, have continued to pay its existing distribution, but the environment for midstream companies has changed. MLPs are now cognizant of market desires for fiscal discipline and investors have rewarded companies that make financial discipline a priority. We believe this company is now in a better financial position for an eventual recovery.
The space was historically focused on income and growth of income, but that has shifted to financial strength and discipline in recent years—prior to the downturn. Most companies don’t have to cut, but we are assessing willingness and ability to pay current distributions.
MLPs and midstream energy companies generally declare dividends in the months of January, April, July, and October. Companies will start to report earnings in April and lasting into May. We have heard from management teams that 1Q and 2Q earnings will be ugly, but the second half of 2020 is expected to improve if economic activity ramps up again.
For midstream, what if oil did stay below $30/barrel for the next 3 years? We would expect producers to slash their capex budgets, resulting in production declines for the first time in years. On the midstream side, reduced capital spending would help support balance sheets and free cash flow at the expense of future volumes.
Distribution policy is one of the bigger question marks. We suspect midstream companies would take the opportunity to forgo distribution increases and potentially cut distributions in order to maintain debt metrics. Financial strength will be instrumental in attracting a larger group of investors once things return to a more normalized state.
Because we tend to invest in the highest quality midstream companies, we believe our portfolio is well-positioned to withstand the current environment if the supply/demand balance starts to normalize in the second half of 2020. However, if we see a prolonged low commodity price environment, the industry could look different.
Counterparty Risk and Contracts in Midstream Energy
Counterparty risk and contracts are two of the most important items that we monitor. Even before this recent downturn, we had re-assessed exposure to Chesapeake Energy Corporation across our holdings. Because the majority of the companies in the strategy are large and diversified, counterparty risk is spread out.
As far as contracts, this is one of the metrics we use in our proprietary Financial Risk Scorecard during our bottom-up fundamental research process. We look at both the percent of contracts that are fee-based and the percent that are take-or-pay to identify high quality contracts.
Producers that have take-or-pay contracts will have to pay midstream companies, even if they stop producing or cut production. That being said, stressed producers often ask midstream companies for rate relief in exchange for extending the number of years in the contracts. We expect renegotiations to take place again, negatively impacting near-term EBITDA forecasts.
Commodity Storage Constraints
During the month of March and in early-April, storage was in high demand with the crude price curve in contango (i.e., the futures price of oil is higher than the spot price), driving producers to store their products to sell at a higher price in the future. We are aware that storage is filling up quickly. Limited storage would likely lead to forced shut-ins by producers, and we view storage constraints as a near-term risk to monitor. The recent OPEC+ agreement should help alleviate storage constraints but is not a panacea.
For midstream companies with storage, it is a positive, but likely not as much as the market would think. For many companies, storage is already contracted, so there is not much available space. We may see some benefits from midstream energy’s storage business lines during the 1Q and 2Q earnings calls.
What are the Positives in the Midstream Energy Space?
- The oil price environment is unsustainable for all producers, not just for US shale.
- Improved capital discipline and financial positioning was already in place coming into 2020.
- MLPs offer tax-deferred income, with distribution yields well-above many other asset classes.
- Shale production is “short cycle”, so when economic activity eventually picks up, US production will come back and exports will resume.
John R. Cusick, CFA, focuses on midstream energy including master limited partnerships (MLPs). Before joining Miller/Howard in 2013, he was a senior vice president and research analyst at Wunderlich Securities Inc. in New York, covering energy in North America including midstream companies focused on natural gas, liquids, and exploration & production. Prior to that, John spent more than a decade at Oppenheimer & Co. beginning his career as a junior analyst on the energy team, covering major oil companies, refiners, and exploration & production companies, and then as a senior research analyst specializing in the midstream sector. He earned his BA in Finance and Marketing from Temple University, and an MBA in Finance from Fordham University School of Business in New York City.
Adam Fackler, CFA, focuses on infrastructure companies including utilities, telecommunications, and midstream energy/master limited partnerships (MLPs). Prior to joining Miller/Howard in 2016, Adam spent 10 years in equity research, including five years at Rodman & Redshaw, KLR Group, and MLV & Co. where he covered exploration & production companies and MLPs. Adam holds a BS in Business Administration with a minor in Economics from Bucknell University.
