Energy Transfer Stock: Bulls Are Losing Steam (NYSE:ET)

Introduction

On Christmas Day last year, I wrote about the mid-stream O&G sector analyzing the InfraCap MLP ETF (AMZA). My view was that fresh expansions on upstream would eventually happen and when that starts to pick up, mid-stream O&G players would be a good play.

In this article, I take a closer fundamental look at Energy Transfer (NYSE:ET), which has the largest weight (20%) in the AMZA ETF.

Background Info

To understand the leading indicators of ET’s business, it is important to understand the underlying demand drivers of natural gas:

According to EIA, 37% of natural gas consumption is used by electric power and 33% is used by industrial sectors. Specifically, pulp and paper, metals, chemicals, petroleum refining, stone, clay and glass, plastic, and food processing industries make up for over 84% of total industrial use of natural gas.

These two main consumption sectors; electric power and industrial sectors are linked to activity in the broader economy and industrial activity. This makes leading indicators of the economy such as the yield curve and US Manufacturing Purchasing Managers Index (PMI) useful for forming a view on the demand volume prospects of natural gas.

Thesis Summary

I am bullish/bearish ET due to 3 key reasons:

1. Demand indicators suggest volume headwinds
2. EBITDA levels may have peaked
3. Reduced confidence in prices discourages upstream volume expansions

Demand indicators suggest volume headwinds

Broader Economic Outlook

One of the best indicators of a slowing economy and recession is the inverted yield curve.

My preferred way to represent the yield curve situation is to plot the difference between the US 10yr yield and US 2yr yield (a long yield and a short yield). This is called a yield spread and when this is below zero, that indicates yield curve inversion, which is one of the best leading indicators of a slowing economy and recession.

More details on this key leading fundamental indicator is explained in my article on mREITs here.

As can be seen in the chart above, the yield spread stands deeply in negative territory at -0.637% indicating economic slowdown and hence natural gas and crude oil volume demand headwinds. Not good for ET.

US Industrials Outlook

November 2022’s Manufacturing PMI numbers posted 49. As this number is below 50, it signals economic contraction. This would imply a dampened demand outlook for natural gas from the industrials sector.

EBITDA levels may have peaked

Midstream, natural gas liquids or NGL and crude oil segments make up most of ET’s EBITDA mix:

In Q3 FY22, 28.1% of the company’s EBITDA came from midstream, 20.5% from NGL and refined products, and 14.9% from crude oil transportation and storage. This helps us identify which are the most important margin profiles to track:

In Q3 FY22, ET posted a QoQ EBITDA decline of 3.9%. The 4-quarter moving average is also ticking down.

In the same quarter, NGL and refined products saw an even sharper sequential EBITDA fall of 16.9%.

The same story applies for the crude oil transportation and services segment, which has posted two consecutive quarters of de-growth in EBITDA.

Overall EBITDA is also on the decline for two consecutive quarters, with the decline accelerating in 3Q FY22. Considering the weaker economic environment outlook and lower volumes associated with that, I believe this is unlikely to stage much of a reversal in the quarters ahead.

Reduced confidence in prices discourages upstream volume expansions

Only 10-15% of ET’s EBITDA is exposed directly to commodity prices. However, there is also an indirect, longer term impact of low commodity prices on ET’s business. This is because upstream O&G players are more discouraged to undertake volume expansions in weak pricing environments, thus reducing chances of midstream companies such as ET benefiting from a block of new volume expansions.

As the chart above shows, Natural Gas Futures have fallen by 41% since the end of the last reported quarter. I believe this makes ET’s ability to benefit from a longer term cycle of virtuous volume expansions more of a pipe dream (pun intended).

Technical Analysis

If this is your first time reading a Hunting Alpha article using Technical Analysis, you may want to read this post, which explains how and why I read the charts the way I do, utilizing principles of Flow, Location and Trap.

Relative Read of ET vs SPX500

The relative chart of ET/S&P 500 shows prices reacting at a key monthly resistance level. I believe there will be a print of an equal high, signaling the slowdown of the incumbent uptrend. I anticipate a ranging structure to develop over the upcoming months, suggesting neutral performance vs the S&P 500 (SPY) (SPX).

Standalone Read of ET

The standalone chart of ET paints a similar picture. Price has been on an uptrend, but it is now encountering resistance at $12.75. My base case is that prices will visit the monthly support at $10.99 and range for the next few months.

Note that my chart settings here are adjusted for dividends. In other words, this neutral view is after taking into account the benefits of dividends.

Takeaway & Positioning

I think ET has reached a temporary peak. A weak macro backdrop as evidenced by an inverted yield curve and contracting print on the manufacturing PMI translates to dampened volumes outlook for natural gas. EBITDA levels seem to be peaking out. And the chances of the upstream O&G sector players infusing fresh volumes is reduced due to a weaker pricing environment. Thus, I believe ET is a hold.