Nando Vidal
By Michael Clarfeld, CFA | Chris Eades
Expecting Oil Demand Growth in 2023
Market Overview and Outlook
Hopes for a soft landing in the U.S. and a renewal of Chinese economic activity boosting energy demand helped the energy sector to lead the broad market in the fourth quarter and supported strong returns for midstream energy infrastructure. The Alerian MLP Index rose 10.11%, ahead of the S&P 500’s 7.56% gain.
Global economies continue to face multiple headwinds, 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 continues to tighten monetary conditions and we are beginning to see the dampening effects on the economy. 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 due to strict measures enacted to reduce the spread of COVID-19. Consequently, equity markets have begun pricing in a reasonable chance of recession, both domestically and abroad.
Crude oil prices have fallen from in excess of $120 per barrel in June 2022 to a current $80 per barrel. Recession fears have left oil market traders fearful of global demand downdrafts for crude oil in 2023, much like those witnessed during the Global Financial Crisis (GFC). A strengthening U.S. dollar has also driven downside in crude oil prices. Finally, large-scale releases of crude oil from the U.S. Strategic Petroleum Reserve (SPR) further pressured oil prices over the last six months.
During the GFC, global oil demand declined by two million barrels per day (or 2%) and oil prices fell from $140 per barrel to less than $50 per barrel. We see several notable differences between the current environment and the GFC. First, due to Russia limiting natural gas supplies to Europe, there has been and will likely continue to be large-scale switching from natural gas to oil to generate electricity in Europe. This could add 0.8 million barrels per day of oil demand compared to prior to Russia’s invasion of Ukraine. Second, the U.S. releases of crude oil from its SPR are coming to an end. These withdrawals added more than one million barrels per day of supply into the market over the last six months but soon will no longer do so. Further, the barrels of oil removed from the SPR will ultimately have to be replaced — potentially resulting in a meaningful demand uplift for crude oil heading into 2023 and 2024. Third, Russian crude oil production is expected to fall between 0.5 to 1.0 million barrels per day, largely due to lack of investment in its resource base as money is being diverted to fund its war machine.
The combination of these three factors leaves the crude oil market more insulated from a recession driving down global demand than in prior economic downturns. As such, most oil market watchers still expect global oil demand growth in 2023 by one to two million barrels per day (driven largely by emerging markets).
Despite recent pressure, crude oil prices in the U.S. remain well above levels that would lead us to expect a decline in drilling activity. Barring a fall in oil prices below $60 per barrel, we would expect the number of rigs drilling for oil to continue slowly moving higher. Even with the recent fall in oil prices, the number of rigs drilling for oil in the U.S. has increased from 574 to a current 621.
The pathway to U.S. oil production approaching pre-pandemic levels (and driving midstream company cash flows higher) is through increasing drilling activity. Recent increases in drilling activity give us confidence in a growing cash flow profile for midstream companies looking into 2023.
“Valuation for U.S. midstream companies remains well below the levels seen before the pandemic.”
Valuation for U.S. midstream companies remains well below the levels seen before the pandemic. Entering 2020, enterprise value to EBITDA (EV/EBITDA) multiples stood at roughly 10.5x. Despite the rebound the sector has experienced since the March 2020 lows, the sector today trades at 8.6x — despite what we view as a vastly better business model today than entering 2020. Dividend/distribution coverage has moved from 1.1x to more than 2.0x. The sector has moved from being free cash negative to free cash flow positive (increasingly so in 2023) and balance sheet leverage (debt/EBITDA) has moved from in excess of 5.0x to below 3.5x. With no need for midstream companies to access capital markets for the foreseeable future, we increasingly expect excess cash flow (above and beyond capital spending and dividends/distributions) to be used for increasing share buybacks and further increasing dividends/distributions.
With improving financial metrics and continued low valuations, we still see solid upside potential for the U.S. midstream sector despite strong performance in 2021 and 2022.
Portfolio Highlights
The ClearBridge Energy MLP Strategy outperformed its Alerian MLP Index benchmark during the fourth quarter. In terms of absolute performance, all four subsectors in which the Strategy is invested made positive contributions, with the diversified energy infrastructure subsector contributing the most and the natural gas transportation & storage subsector the main laggard.
On a relative basis, the Strategy outperformed due to stock selection effects. In particular, stock selection in the gathering/processing subsector added to relative returns, while stock selection in the natural gas transportation & storage and liquids transportation & storage subsectors detracted.
In terms of individual holdings, ONEOK (OKE), Targa Resources (TRGP), Plains All American Pipeline LP (PAA), Williams Companies (WMB) and MPLX LP (OTCPK:MPLXP) were the main contributors, while PBF Energy (PBF, the parent company of holding PBF Logistics LP, the outstanding shares of which it bought during the quarter, and whose shares we received and did not retain), Equitrans Midstream (ETRN) and Crestwood Equity Partners (CEQP) were the detractors, while TC Energy (TRP) and DT Midstream (DTM) were also bottom contributors.
Michael Clarfeld, CFA, Managing Director, Portfolio Manager
Chris Eades, Managing Director, Portfolio Manager
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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.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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