In February, although the entire market was rocked by coronavirus worries, the master limited partnership (MLP) and energy infrastructure sector underperformed the S&P 500 Index. However, midstream energy infrastructure company fundamentals may not be as bad as they seem. As earning season wraps up, operating performance has been better than expected with EBITDA (earnings before interest, taxes, depreciation and amortization) coming in 1.1% higher than consensus expectations and 7.7% higher than the previous quarter. Furthermore, free cash flow is expected to dramatically increase for these companies over the next five years.
Midstream MLPs, as measured by the Alerian MLP Index (AMZ), ended February down 15.1% on a price basis and down 14.0% once distributions are considered. The AMZ results underperformed the S&P 500 Index’s 8.2% total return loss for the month. The best-performing midstream subsector for February was the Propane group, while the Gathering and Processing subsector underperformed, on average.
For the year through February, the AMZ is down 20.7% on a price basis, resulting in a 18.9% total return loss. This compares to the S&P 500 Index’s 8.6% and 8.3% price and total return losses, respectively. The Propane group has produced the best average total return year-to-date, while the Marine subsector has lagged.
MLP yield spreads, as measured by the AMZ yield relative to the 10-Year U.S. Treasury Bond, widened by 292 basis points (bps) over the month, exiting the period at 1060 bps. This compares to the trailing five-year average spread of 569 bps and the average spread since 2000 of approximately 387 bps. The AMZ indicated distribution yield at month-end was 11.8%.
Midstream MLPs and affiliates raised no new marketed equity (common or preferred, excluding at-the-market programs) and $0.4 billion of marketed debt during the month. MLPs and affiliates announced $1.2 billion of asset acquisitions over the month.
Spot West Texas Intermediate (WTI) crude oil exited the month at $44.76 per barrel, down 13.2% over the period and 21.8% lower year-over-year. Spot natural gas prices ended February at $1.79 per million British thermal units (MMbtu), down 6.3% over the month and 39.7% lower than February 2019. Natural gas liquids (NGL) pricing at Mont Belvieu exited the month at $16.99 per barrel, 16.3% lower than the end of January and 36.1% lower than the year-ago period.
Another MLP Eliminates IDRs. Shell Midstream (NYSE: SHLX) announced an agreement with its sponsor, Royal Dutch Shell (NYSE: RDS), to eliminate SHLX’s incentive distribution rights (IDRs) and acquire interest in the Mattox Pipeline in exchange for common and preferred units collectively valued at $3.8 billion. RDS also agreed to waive $20 million of common unit distributions per quarter for four quarters, anticipated to begin with the distribution made for the second quarter of 2020. SHLX noted that its distributions will be held at the current level of $0.46 per common unit per quarter, with the intent to build distribution coverage.
EQT Complex Getting Less Complex. Equitrans Midstream (NYSE: ETRN), EQM Midstream Partners (NYSE: EQM), and EQT Corp (NYSE: EQT) announced a series of transactions that will ultimately simplify the overall corporate structure. Portions of the transactions include new 15-year gas gathering agreements between EQM and EQT and new minimum volume commitments, as well as ETRN’s intent to purchase and retire 25.3 million ETRN shares from EQT and ETRN acquiring all outstanding public units of EQM.
Fourth-quarter earnings reports season coming to a close. Fourth quarter reporting season was nearing completion by month-end. Through February, 56 midstream entities had announced distributions for the quarter, including 22 distribution increases, 4 reductions, and 30 distributions that were unchanged from the previous quarter. Through month-end, 53 sector participants had reported fourth quarter financial results. Operating performance has been, on average, better than expectations with EBITDA coming in 1.1% higher than consensus estimates and 7.1% higher than the preceding quarter.
Thought of the month
Monday, March 9 was a tough day for most investors. The energy sector took a severe spill as the Saudi-Russian price war became the proverbial “Patient Zero” for the market’s newfound discontent. In light of yesterday’s events, we have replaced our usual “Chart of the Month” series with a “Thought of the Month” to add some perspective to the situation.
Late last week, OPEC held discussions to reduce the supply of crude oil against the lower demand caused by COVID-19. Like past production curbs, OPEC wanted Russia to participate (the coalition referred to as OPEC+) but they declined. Saudi Arabia retaliated by increasing crude oil supply and reducing prices for customers around the world, namely in Europe where 2/3rd of Russian crude oil is sold. As we noted in a recent blog, Energy infrastructure outlook amid the coronavirus outbreak, crude oil demand for the first quarter of 2020 was already dampened by COVID-19, and the threat of adding more crude oil to the global supply ultimately pushed prices lower. Sector participants are now waiting to see how much crude oil supply will need to be absorbed before managing the rest of 2020 and beyond. The OPEC+ situation remains fluid. Considering Saudi Arabia and Russia need higher crude oil prices to balance their budgets, it is in their best interests to reach a deal. In the near term, though, there will likely be some more posturing and more volatility in the market.
Impact to midstream
Midstream energy is a must-run link connecting production (upstream) to demand centers (downstream), and their business operations do not move with daily equity price movement. Even though we are witnessing unprecedented market conditions, it’s not Armageddon. Crude oil and natural gas will continue to be produced, transported, and consumed. However, crude oil production in the US is likely to decline some while demand remains depressed from COVID-19 related travel restrictions. Accordingly, we estimate some midstream assets will experience a small decline in volume over the coming months. However, we also think that midstream companies will be well insulated:
- Crude oil will continue to be produced and some of it placed into storage facilities operated by midstream providers. Notably, produced volumes typically trail rig declines by six months or more.
- Many midstream companies are natural gas or refined product (gasoline, diesel, etc.) focused and, therefore, have less exposure to slowing US crude oil focused drilling activity.
- Midstream operators have been operating far more conservatively than in previous years with average distribution coverage of approximately 1.5x. We routinely stress our expectations for commodity prices and believe most midstream operators will deliver relatively stable results with certain operators benefiting from recently completed or soon-to-be completed projects.
- Most counterparty risk should be minimal since, volumetrically, most midstream customers are larger E&P companies that can withstand low crude oil price environments.
We certainly did not place high odds on OPEC entering a market share battle with Russia while a potential pandemic causes demand destruction fear. But in the end, this environment is similar to the late 2015, early 2016 period when we saw forced selling push share prices to levels that were disconnected from even a fundamentally weaker picture. If crude oil prices remain at these levels, we see the potential for modest volume contraction over the next 12 months versus modest volume growth for those moving oil. This is similar to 2016 when the financial impact to most was modest. Obviously, the picture for natural gas centric sector participants is less affected and may even improve as oil related natural gas production should be less pronounced, thereby aiding the natural gas supply/demand dynamic. Refined product demand, subsequent to any economic efforts to contain the virus, would similarly be unchanged and perhaps improved as lower prices help demand over time. Notably, most midstream names are entering this price collapse with much better coverage and credit metrics than in early 2016 as well.
All data sourced from Bloomberg L.P. as of February 29, 2020 unless otherwise stated
The opinions referenced above are those of the author as of March 15, 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.
Energy infrastructure MLPs are subject to a variety of industry specific risk factors that may adversely affect their business or operations, including those due to commodity production, volumes, commodity prices, weather conditions, terrorist attacks, etc. They are also subject to significant federal, state and local government regulation.
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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.
The Alerian MLP Index is a float-adjusted, capitalization-weighted index measuring master limited partnerships, whose constituents represent approximately 85% of total float-adjusted market capitalization. The S&P 500 Index is a broad-based measure of domestic stock market performance. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.
Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. Diversification does not guarantee profit or protect against loss.
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