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By Michael Clarfeld | Chris Eades
A Strong Volume Environment for Pipelines
Market Overview and Outlook
Global economies continued to face multiple headwinds in the third quarter, led by a combination of stubbornly high inflation, rising geopolitical uncertainty and lingering supply chain and policy impacts from the COVID-19 pandemic.
In the U.S., the Fed’s attempt to constrain inflation led to two more 75 basis point rate hikes in the quarter, following the one in June, with an indication that more hikes are likely in coming quarters. At the same time, Russia’s invasion of Ukraine has helped create a spiraling energy crisis in Europe as some of its natural gas supplies have been cut off heading into the winter. Finally, China has experienced slowing growth as the country continues to enact strict measures to reduce the spread of COVID-19.
Consequently, markets have begun pricing in a reasonable chance of recession, both domestically and abroad. Oil prices declined throughout the quarter as fears of a global recession, continued rate hikes, the strengthening U.S. dollar, U.S. and Europe releases of strategic oil reserves and COVID-19 sanctions in several of China’s biggest cities sent prices to nine-month lows. The price per barrel of WTI crude fell from $105.76 at the beginning of the quarter to $79.49 at the end.
Yet even amid lower oil prices, energy prices remain stubbornly high following the fallout from Russia and will likely remain in a tight supply and demand market even if economies slow down meaningfully. This backdrop will continue to support pipelines over the medium term as energy producers slowly respond to the higher price environment and increase production. This makes for a solid volume environment for pipelines, reflected in the Alerian MLP Index’s gain of 8.05% in the third quarter, outdistancing the S&P 500 Index’s energy sector return of 2.35%.
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. Again, while painful like in 2016, this final transformation leaves midstream companies in uncharted waters. The sector was free cash flow positive after dividends and distributions in 2021 for the first time. 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.
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. However, global oil demand has been rebounding and will likely enter 2023 at all-time highs.
In early October, OPEC+ announced a surprise two million barrel per day reduction in their quota. This quota reduction was in response to softening prices in crude oil futures over the past three months despite a continued tight physical market. However, it is important to note that such a quota reduction will likely not result in a two million barrel per day reduction in actual production as OPEC+ actual oil production was roughly three million barrels per day below the previous quota.
Russia’s invasion of Ukraine has made a tight supply and demand balance even tighter, increasing the value U.S. oil, which should continue to drive increasing drilling activity in the U.S.
The pathway to U.S. oil production approaching pre-pandemic levels is through increasing drilling activity. With crude oil futures currently discounting roughly $77 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 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 612—approaching levels seen before the pandemic.
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 over the remainder of 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 underperformed its Alerian MLP Index benchmark during the third quarter. In terms of absolute performance, four of five subsectors in which the Strategy is invested made positive contributions, with the gathering/processing subsector contributing the most. The exploration & production subsector detracted slightly; the Strategy had one holding in this subsector after it received, and subsequently sold, shares of Diamondback Energy (FANG) after the company acquired portfolio holding Rattler Midstream LP.
On a relative basis, the Strategy underperformed primarily due to stock selection effects. Stock selection in the gathering/processing and natural gas transportation & storage subsectors detracted the most, while an overweight to the natural gas transportation & storage subsector and an underweight to the liquids transportation & storage subsector proved beneficial.
In terms of individual holdings, DCP Midstream LP (DCP), Cheniere Energy Partners LP (LNG), Energy Transfer LP (ET), Plains All American Pipeline LP (PAA) and Western Midstream Partners LP (WES) were the main contributors, while Enbridge (ENB), TC Energy (TRP), Williams Companies (WMB), ONEOK (OKE) and Hess Midstream LP (HESM) were the main detractors.
During the quarter, in addition to transactions outlined above, we exited a position in DCP Midstream LP.
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Past performance is no guarantee of future results. Copyright © 2022 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Alerian MLP Index. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Standard & Poor’s. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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