onurdongel
Market Overview and Outlook
A quickly changing interest rate environment, growing fears of a recession and geopolitical uncertainty made for a volatile second quarter of 2022.
Disruptions in global supply chains stemming from COVID-19 lockdowns in China, the Russian invasion of Ukraine and commodity shortages continued to propel inflation higher. A worse than expected 8.6% Consumer Price Index reading for May caused the Fed to raise rates 75 bps in June, the most aggressive hike since 1994, and project ambitious tightening through the rest of 2022. The 10-year Treasury yield climbed 67 bps to finish the quarter at 3.01%, near its highest level in four years. The U.S. economy contracted in the first quarter and the outlook for GDP growth has tempered as more liquidity leaves the financial system.
Energy prices continued their march higher as sanctions imposed on Russian exports resulted in further reduced global inventories and contributed to U.S. gasoline prices reaching a 10-year high mid-quarter. However, demand destruction fears and the potential for a hard landing found their way into the commodity market with oil selling off in late June. The price per barrel of WTI crude rose from $100.28 at the end of March to close out the period at $105.76.
Against this backdrop midstream energy infrastructure outperformed equities for the quarter, with the Alerian MLP Index retreating 7.38% compared to the S&P 500 Index’s decline of 16.10%.
“Importantly, the number of rigs drilling for oil increased in June despite the downturn in oil prices during the month.”
The COVID-19 pandemic forced midstream companies to complete their business model transformation to generating free cash flow after dividends/distributions. Some midstream companies chose to reduce dividends/distributions, others reduced capital spending while some companies did both. While painful like in 2016, this final transformation left the sector free cash flow positive after dividends and distributions for the first time in 2021.
This true free cash flow yield will likely widen in 2022 and 2023. Midstream companies won’t need access to equity capital markets, nor to debt capital markets, to finance capital projects. They will also have excess cash flow after dividends and distributions.
Midstream management teams will now be able to naturally deleverage balance sheets, buy back stock and increase dividends and distributions, as we have seen recently with an announced buyback from Enbridge (ENB) of $1.5 billion, Kinder Morgan (KMI) noting $750 million in opportunistic buyback potential in 2022 and MPLX likely to complete its $1 billion buyback in 2022 with $337 million of shares remaining to be repurchased.
The evolved business model has driven meaningful improvements in relevant midstream financial metrics. Free cash flow yield (after capital spending and dividend/distributions) should approach 5% in 2023 after perpetually being negative in years past — driving increasing share buybacks, balance sheet deleveraging and dividend/distribution increases. Dividend/distribution coverage should be in excess of 2x going forward, after consistently sitting in the 1.1x–1.2x range in the past.
This should greatly insulate midstream companies from being forced to reduce payouts to investors in the event of an unexpected downturn in business fundamentals. Balance sheet improvements have also been notable with debt/EBITDA ratios expected to finish 2022 below 3.5x, after averaging nearly 5.0x before the business model evolution.
One offset to this more stable and durable business model is slower dividend/distribution growth than in the past. The old business model drove dividend/distribution growth in excess of 10%. The new business model will likely lead to 3%–6% annualized dividend/distribution growth for the sector.
After reaching an all-time high of 100.9 million barrels per day during the fourth quarter of 2019, global oil demand plummeted with the onset of the COVID-19 pandemic. By the second quarter of 2020, global oil demand had fallen to 82.9 million barrels per day — an 18% decline from the peak. This sudden decline in demand left the global oil market grossly oversupplied and oil prices fell from roughly $60 per barrel to below $20 per barrel in less than four months. With COVID-19 vaccine rollouts and the reopening of the global economy, global oil demand is expected to approach previous peak demand in 2022.
Russia’s invasion of Ukraine made a tight supply and demand balance even tighter. With reports of crude oil buyers refusing to take some Russian barrels, front-month crude oil futures have recently been well above $100 per barrel. This only increases the value to U.S. oil and should continue to drive increasing drilling activity.
The pathway to U.S. oil production approaching pre-pandemic levels is through increasing drilling activity. With crude oil futures currently discounting roughly $83 per barrel over the next two years, there should be sufficient economic returns to expect a continued increase in the number of rigs drilling. Top-tier acreage in the Permian Basin of West Texas requires roughly $40–$45 per barrel to earn back the cost of capital. Large publicly traded oil and gas producers have asserted they will not significantly increase drilling activity, even with crude oil and natural gas prices at current levels.
Their stated modus operandi is to return free cash flow to investors rather than increase production. This is in direct contrast to previous energy cycles. Yet, despite assertions from large U.S. oil producers that they will not accelerate drilling, the number of rigs drilling for oil in the U.S. has rebounded from 172 in August 2020 to a current 595. Importantly, the number of rigs increased by 21 (or 4%) in June despite the downturn in oil prices during the month.
Perhaps contrarian, our view remains that if economic returns are there (and they are), capital will find its way to drilling more wells. Rig count acceleration may be slower than in prior cycles, but we believe economic returns will drive capital toward increasing the number of wells drilled.
This should result in a continued recovery in U.S. production volumes, which should drive growing cash flows for U.S. midstream companies in both 2022 and 2023. It is also important to note that a continued recovery in U.S. production volumes will come with little capital spending requirements on the part of midstream companies. The infrastructure systems are largely built out.
Our base case remains that global oil demand continues to recover to pre-pandemic levels during 2022 — driving the need for more oil supply on the global market. This increased level of drilling activity, in turn, should increase throughputs across energy infrastructure systems in the U.S. — allowing growing cash flows to fully display the benefit of the evolved U.S. midstream business model.
Portfolio Highlights
The ClearBridge Energy MLP Strategy had a negative return for the second quarter, underperforming its benchmark. In terms of absolute performance, all four subsectors in which the Strategy is invested made negative contributions, with the natural gas transportation & storage subsector detracting the least. The diversified energy infrastructure subsector detracted the most in absolute terms.
On a relative basis, the Strategy underperformed due to stock selection and sector allocation effects. Stock selection in the diversified energy infrastructure, liquids transportation & storage and gathering/processing subsectors and an overweight to the natural gas transportation & storage subsector detracted the most. Conversely, stock selection in the natural gas transportation & storage subsector contributed positively.
In terms of individual contributors, PBF Logistics LP (PBFX) was the sole positive contributor, while contributions from Western Midstream Partners LP (WES), Magellan Midstream Partners LP (MMP), DT Midstream (DTM) and Holly Energy Partners LP (HEP) were the least negative. ONEOK (OKE), Targa Resources (TRGP), Genesis Energy LP (GEL), Cheniere Energy Partners LP (CQP) and MPLX LP (MPLX) were the main detractors.
During the quarter, we initiated new positions in Hess Midstream LP (HESM) and Crestwood Equity Partners LP (CEQP).
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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