26 March 2020
In May 2019, we published a Global Matters article titled The changing face of US midstream assets which outlined our views on:
We concluded that based on improvements made to midstream companies’ risk exposures, contractual protections and financing structures, the sector exhibited the defensive characteristics of infrastructure assets and should be included in the 4D core investment universe.
In March 2020, crude oil prices plunged dramatically on the back of a double shock – namely the global contagion of the novel coronavirus (COVID-19) and a demand/supply imbalance created by conflicting Saudi/Russian production targets. The midstream names share prices crashed with the crude price.
In this follow up article, 4D Senior Investment Analysts Peter Aquilina and Mark Jones revisit the North American midstream thesis, and stress test assumptions for a dramatically lower commodity price environment and an overall slower global growth scenario – to determine whether in reality the fundamentals/earnings will prove to be infrastructure (or not) and if this collapse represents a buying opportunity.
We at 4D define the ‘midstream’ sector as the infrastructure used in the transportation, storage, extraction and refining of natural gas, Natural Gas Liquids (NGLs) and crude oil. Midstream is the ‘glue’ between upstream exploration & production (E&P) and downstream refining / distribution.
The graphic below shows that there can be an extensive infrastructure value chain to transport commodities from the site of extraction via gathering lattice networks to processing plants, and to downstream markets via large volume transportation pipelines. At downstream terminals the commodities can be transported to the end customer via pipeline, rail or ship; refined at fractionation facilities; and stored or further manufactured.
Source: 4D Infrastructure
As shown in the table below, assets under the midstream umbrella perform a number of functions and have differing business risks and characteristics.
Source: 4D Infrastructure
Midstream assets are therefore heterogeneous by nature. For 4D, the investability of these stocks is determined by whether the asset characteristics meet our infrastructure definition.
As a recap, 4D defines ‘infrastructure’ as the owners and operators of regulated and/or user pay assets with the following attributes:
In our earlier article we assessed the players according to this definition, considering both pre and post 2015/2016 business models. We highlighted what had gone wrong for the midstream companies in 2015/2016 and how management responded in restructuring business models to a point that the assets exhibited many, if not all, the characteristics we look for in infrastructure assets.
We concluded that the ‘new’ midstream asset profile had many of the necessary characteristics; such as monopolistic market positions, visible and resilient earnings, strong cash generation, long dated assets and acceptable levels of gearing.
We also concluded that the listed market had not fully recognised the changes that had occurred in the structure of the midstream sector, and the stocks were still moving in sync with commodity prices. It was – and is – our belief that over time, the earnings disconnect of the midstream players with commodity prices should be recognised by the market, leading to a sector re-rating towards fundamental value.
In the same article, we identified a subset of midstream companies which represented strong investment propositions for investors with reasonable growth profiles and strong cashflow generation, and which had been under-appreciated by the market on a fundamental valuation basis. This included Cheniere and Kinder Morgan, with their low price and volumetric exposures to commodity prices, significant cashflow generation and undervaluation by the market.
So given little sector re-rating and more recently the dramatic sell off – what did we get wrong, or does the market still have it wrong?
Through 2019, global oil and gas demand was maligned – in part as a result of the trade war between the US and China, and in part due to concerns of overall slowing global growth. The investment community thought there were signs of potential improvement when in January 2020 the Chinese and US governments signed Phase 1 of a trade deal between the countries, which reduced tariffs on some Chinese imports into the US in exchange for Chinese commitments to purchase more US agriculture, energy and manufacturing goods; and address some US complaints about intellectual property (IP) practices.
Unfortunately for the sector, following the announcement of Phase 1 of the trade deal, global demand for oil and gas remained maligned in Europe and Asia as a result of a relatively mild winter across the northern hemisphere; and the arrival of COVID-19 in China, which rapidly spread to other parts of Asia, followed by Europe and then the globe. As the Chinese government took drastic measures to curb the spread of the disease by shutting down entire cities, they also put a halt to industrial and commercial activity for a period, significantly impacting oil and gas demand. This was subsequently followed by other economies across the globe as the disease crossed borders and continents.
In the context of a declining demand for oil, the Organisation of the Petroleum Exporting Countries (OPEC) held an Extraordinary meeting of OPEC countries on 5 and 6 March. However, the OPEC and OPEC+ countries, led by Saudi Arabia and Russia respectively, couldn’t come to an agreement on planned production cuts of 1.5 million barrels per day (Mbbl/d). There are a few suggestions as to why Russia would not agree to the production cuts, two of which are:
Saudi Arabia reacted to Russia’s refusal to agree to the production cuts by launching a price war, lowering its official April crude export prices by $6-$8 per barrel. It also pledged to increase its own daily production to 12.3 Mbbl/d by April, up from around 9.7 Mbbl/d (a 27% increase in planned production). This resulted in US crude prices (as measured by West Texas Intermediate, or WTI) falling 26% to $31.13/bbl on 9 March (Brent crude prices fell to $34.36/bbl), the lowest level since February 2016, with fears that the crude price as measured by WTI could actually fall below $30/bbl – which it subsequently did on 16 March. This did not prove to be a floor, with subsequent falls on successive days. At the time of writing (20 March 2020), the WTI oil price was sitting at $22.63/bbl (Brent crude price at $29.00/bbl), having nearly touched $20.
Analysts believe that at these prices, neither Saudi Arabia, Russia or US players can be cashflow positive for extended periods of time. Some players may have short time mitigants which keep their drilling operations cashflow positive, such as utilising existing well inventory or having price hedges in place, but these dissipate over time. Therefore, economic rationalism translates this to a temporary, short-run ‘price shock’. So the question that no one can answer with certainty is who will blink first? Or when will the parties come back to the table to negotiate production cuts and improved crude prices?
The combination of the demand side (COVID-19 and a mild winter) and supply side (OPEC fallout) impacts on oil and gas prices has resulted in significant declines in midstream share prices. A summary of share price declines for key players is depicted in the following chart.
Source: Bloomberg as at 20 March 2020
Assuming economic rationalism prevails, current crude prices are a short/medium term phenomenon. The impact of this still generally raises the following concerns for midstream companies:
a) Counterparty risk (e.g. financial distress of producer customers operating in low productivity basins)
b) Direct impact of (lower) crude oil prices
c) Indirect impact of prices on (lower) crude oil volumes, and
d) Deferral of growth capital.
In our previous article, we outlined that following the restructuring of companies post 2015/16, recommended core investment holdings are in a much better position to withstand the risks created by a short-term commodity price slump. Therefore, it is our view that for the reasons discussed in detail below, the prevailing market share price reductions depicted in the chart above are an overreaction and don’t properly reflect the sector’s ability to withstand short-term oil and gas price shocks.
We revisited our midstream companies to assess the credit quality exposure of their counterparty customers; and the quality of basins that the midstream companies operate in, as determined by the production cost to drill oil and/or gas (lower cost – higher quality). This information is summarised in the table below.
Source: Company presentations and 4D Infrastructure
On balance, we believe many of the midstream investment companies are not significantly exposed to poor credit quality customers. During historical crude price collapses like 2015/2016, when midstream counterparties have encountered financial distress and/or filed for bankruptcy, if those counterparties operated in lower production cost (higher quality) basins (Tier 1 and Tier 2), the bankruptcy administrator has continued drilling operations through the process. With time, another E&P player has taken over operations with little to no detrimental contractual impact for the midstream operator.
The outlier above in terms of basin quality is Williams Company, operating in a Tier 3 oil directed basin. However, oil directed drilling only contributes a small percentage to overall gross margin (14% or less); so while a portion of this margin is at risk, the overall contribution to value is small and has been more than factored into current share prices.
Our midstream investment companies have limited direct price exposure to either crude or gas prices. The contract structures through which most companies are remunerated are fee-based, often with minimum volume or take-or-pay provisions. Where companies do have direct price exposure, there is a policy to reduce this exposure through the utilisation of financial hedges. The ‘Commodity mix’ column in the table below outlines our investment companies’ contractual exposure directly to commodity prices, and indirectly to volumes serviced.
Source: 4D Infrastructure
The contractual terms are a key component to our midstream ‘infrastructure’ thesis, as they underpin the earnings resilience of the assets even in volatile commodity environments. The types of contracts commonly used in the sector to immunise from commodity prices are summarised below.
Although the midstream oil/gas sector does have indirect volumetric exposure to crude prices, during historical periods of crude oil price weakness the sector has experienced relatively minor volume and earnings reductions, if any at all (company dependent). Crude price weakness in 2015/2016 concluded a crude price super cycle that began in the early 2000s, and was contributed to by increasing supply from the US shale boom which began around 2010/2011. During the 2015/2016 period of price weakness, the WTI crude price fell as low as US$24.45/bbl and the period of sub US$50/bbl prices lasted for approximately 12 months. Through this period, most midstream companies maintained volumes serviced or experienced only small declines.
Historically, companies have largely been able to maintain oil/gas volumes serviced.
We expect the E&P players will again instigate optimisation methods and in the absence of the entire sector going bust, volumes of those financially stressed E&P players will eventually find a home elsewhere – as long as the cost curve is met by prevailing crude prices, which varies depending on the basin drilled.
Midstream sector assets are capital intensive / long-lived, with capital allocation based on long run return requirements. Companies are likely to target stronger cashflow generation through deferral of growth projects, or alternatively reviewing existing projects with higher return requirements. This is to sure up cashflows in this uncertain time, and strengthen the balance sheet in a period of plateauing or even falling operational earnings.
To date we have already seen a number of midstream companies announce cuts or deferral of growth capital projects. Pembina announced it was deferring C$0.9 - $1.1 billion in capital projects in 2020 (representing 40-50% of 2020 forecast capex) to support free cashflow generation in the year. Similarly, Targa Resources announced it was cutting its 2020 capital investment guidance by US$400 million (representing 30-35% of budget), and also significantly cutting its dividend.
Despite cuts to capital projects, E&P companies are still incentivised to endorse midstream sector capital investment due to:
In light of the market sell-off of energy and midstream companies resulting from weak crude prices following the expected short-run demand/supply imbalance, we have reviewed the extent to which our investment companies are exposed to the weak commodity price; and undertaken downside scenario testing to understand the potential for financial distress and resulting valuation impact. Our conclusions are as follows.
A summary of YTD return performance and resulting quantitative and qualitative ratings under revised base cases are summarised in the table below. We have also included return analysis of worst-case scenarios against base cases.
Source: 4D Infrastructure
We also conclude that none of our portfolio names are at a significant probability of financial distress unless this irrationally low crude price is maintained well into 2022. The most at risk is Targa Resources, and even though the worst-case scenario shows an IRR variance of more than -20%, the company is still investible in this scenario and avoids financial distress.
We have undertaken detailed case studies for a selection of the midstream names. Our fundamental analysis, stress testing and conclusions can be found here, but a summary follows.
Download a copy of this article here.
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