March MLP performance reflected the unprecedented combination of significant and abrupt crude oil demand destruction, due to rapid efforts to contain COVID-19 globally, and the threat of surging crude oil supply from the unanticipated Saudi-Russian crude oil market share battle. Amid the weakness, midstream sector participants have taken proactive steps to protect their balance sheets in order to benefit once these dual threats have passed.
MLP market overview
Midstream MLPs, as measured by the Alerian MLP Index (AMZ), ended March down 47.2% on a price basis and after distributions were considered. The AMZ Index underperformed the S&P 500 Index’s 12.4% total return loss for the month. The best performing midstream subsector for March was the Propane group, while the Gathering and Processing subsector underperformed, on average.
For the year through March, the AMZ is down 58.2% on a price basis, resulting in a 57.2% total return loss. This compares to the S&P 500 Index’s 20.0% and 19.6% price and total return losses, respectively. The Propane group has produced the best average total return year-to-date, while the Gathering and Processing subsector has lagged.
MLP yield spreads, as measured by the AMZ yield relative to the 10-Year U.S. Treasury Bond, widened by 922 basis points (bps) over the month, exiting the period at 1,980 bps. This compares to the trailing five-year average spread of 592 bps and the average spread since 2000 of approximately 393 bps. The AMZ indicated distribution yield at month-end was 20.5%.
Midstream MLPs and affiliates raised no new marketed equity (common or preferred, excluding at-the-market programs) and $1.7 billion of marketed debt during the month. MLPs and affiliates announced $100 million of asset acquisitions over the month.
Spot West Texas Intermediate (WTI) crude oil exited the month at $20.48 per barrel, down 54.2% over the period and 65.9% lower year-over-year. Spot natural gas prices ended March at $1.71 per million British thermal units (MMbtu), down 4.5% over the month and 37.4% lower than March 2019. Natural gas liquids (NGL) pricing at Mont Belvieu exited the month at $9.65 per barrel, 43.2% lower than the end of February and 60.9% lower than the year-ago period.
Industry taking proactive steps to protect their balance sheets. Most sector participants in the midstream energy industry have announced proactive strides to protect their balance sheets amidst the ongoing supply and demand imbalance caused by the COVID-19 outbreak and crude oil market share battle between Saudi Arabia and Russia. While most capital expenditure budgets were already lower for 2020 than 2019, most sector participants have announced further reductions in planned spending because of expectations for reduced upstream drilling activity. Furthermore, several sector participants have announced intentions to reduce their cash distributions to further preserve cash and protect balance sheets. DCP Midstream (NYSE: DCP) reduced its distribution by 50%, Enable Midstream (NYSE: ENBL) cut its distribution by 50%, EnLink Midstream (NYSE: ENLC) reduced its distribution by another 50% after a 34% haircut in January, Golar LNG Partners (NYSE: GMLP) lowered its dividend by 95%, Noble Midstream (NYSE: NBLX) reduced its distribution by 73%, and Targa Resources (NYSE: TRGP) cut its dividend by 90%.
Delek still doing drops. Delek US Holdings (NYSE: DK) and Delek Logistics Partners (NYSE: DKL) announced an agreement for the dropdown of the Big Spring gathering system to DKL for total consideration of $100 million in cash and 5.0 million DKL common units. DKL intends to finance the cash component of the transaction via cash on hand and borrowings on its revolving credit facility. The Big Spring Gathering System is an approximately 200-mile crude oil gathering system with about 350,000 barrels per day throughput capacity located in Howard, Borden and Martin Counties, Texas. It connects to the Delek US terminal located near Big Spring, Texas and to a third-party pipeline system.
Thought of the month
Efforts to contain the spread of COVID-19 have disrupted global demand for petroleum products to an unprecedented degree. We believe that until virus containment efforts begin to wane, crude oil prices are likely to be highly volatile and may experience extreme weakness as the physical markets react to the mismatch between demand, which has abruptly and dramatically fallen, and supply, which continues to flow from existing wells even as future drilling plans have been put on hold. As a result, North American and international producers may experience short-term curtailments as storage options fill. Crude oil-focused midstream operators may experience a decline in volume transported while storage assets become highly utilized.
Further complicating the outlook for crude oil pricing is the disintegration of the OPEC+ alliance following Russian refusal to aid OPEC efforts to stabilize crude pricing during the virus-induced demand weakness. In retaliation, Saudi Arabia announced plans to capture Russia’s market share through aggressive pricing and production efforts. In the near-term, the OPEC+ drama pales in comparison to the COVID-19 demand response but could act as a medium-term price headwind.
We believe that as societal and business activities resume following the massive, global virus containment efforts, demand for petroleum products will likewise return to form. However, the current price environment is unsustainably below global break-even pricing for every major oil basin as well as the fiscal break-evens of every Petro state.
For context, crude pricing also dipped below global breakeven levels over the 2014-2016 crude oil price collapse, but US tight oil efficiency gains quickly materialized allowing US production to emerge as the only global basin to deliver meaningful production growth to help offset declines elsewhere. Current pricing, however, is resulting in a near cessation of North American producer drilling plans. While US breakeven levels may move marginally lower in response, a repeat of the dramatic improvement in break-even levels seen over the 2014-2016 period is highly unlikely. Further, global activity over the last several years does not appear sufficient to support any meaningful future supply growth from legacy fields. Accordingly, we believe the time frame over which crude oil pricing can remain below US shale breakeven levels of approximately $40 per barrel is limited, once COVID-19 containment efforts abate.
For US energy infrastructure, in the near term, potential requirements to curtail crude oil production in the face of storage limits and the lack of demand for transportation fuels may impact the operating performance of certain midstream operators with assets focused on these products. While storage requirements will also spike, and thus provide incremental revenues, we believe the potential loss of transportation income will be greater. Further, energy credit markets are currently in disarray and the incentive for management teams to quell credit fears is acute. As a result, several midstream operators have already announced significant distribution/dividend reductions and we believe additional cuts are likely.
However, as COVID-19 containment efforts abate, we believe the impact on transportation fuel movements will similarly subside. As a result, we believe the financial impact of these near-term setbacks to ultimately reverse and, therefore, likely be discounted as “one-time” in nature by equity market participants once the COVID-19-induced “crisis” passes. Bloated crude and product inventory levels, as well as unresolved OPEC+ production disputes, may continue to weigh on oil pricing post the COVID-19 crisis as well and, therefore, may limit a rapid rebound in domestic drilling activity. However, the impact on volumes produced and transported through crude oil-focused midstream assets should reflect slow and modest declines in contrast to the sharp equity price declines witnessed in recent weeks.
Additionally, we estimate approximately two-thirds of midstream EBITDA is generated by assets focused on natural gas production or refined products (gasoline, diesel, etc.) logistics which, post COVID-19, should be little impacted by crude directed drilling plans. Notably, the longer crude oil pricing remains below $40 to $50 per barrel, the price range required to incentivize US crude oil production growth, US natural gas basins and the midstream assets, which serve those fields, could be expected to benefit as associated gas or natural gas produced from oil directed drilling will be in decline and need to be replaced by increased volumes from natural gas focused fields.
All data sourced from Bloomberg L.P. as of March 31, 2020 unless otherwise stated
Credit: MenzhiliyAnantoly / iStock
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The opinions referenced above are those of the author as of April 11, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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The S&P 500 Index is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.
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