MLPs and Energy Infrastructure: Q1 Market Review & Outlook
Midstream energy’s “yo-yo” behavior continued in the first quarter, rebounding strongly after an extremely difficult fourth quarter. Midstream energy stocks (as measured by the Alerian MLP Index) jumped 16.8% on a total return basis in the quarter, nearly erasing the 17.1% loss of the prior quarter. A big rebound in oil prices and strong outperformance by large-cap midstream C-Corps helped the sector easily outpace the 13.6% gain in the broader market (as measured by the S&P 500® Index).
After being extremely oversold in December, the sector rallied hard in January, stalled in February, and moved higher again in March. Oil prices were clearly a catalyst. After closing 2018 at $45.41 a barrel, oil moved steadily upwards throughout the quarter, closing March at $60.14, a 32.4% gain. Like the midstream sector itself, oil was very oversold, having fallen 38% in the fourth quarter. Prices rallied as production cuts orchestrated by Saudi Arabia and OPEC drove down supply. These cuts were further aided by the ongoing issues in Venezuela and the new sanctions placed on the country by the Trump administration. Overall, global crude inventories rose far less than expected in what is typically the weakest demand quarter of the year.
Energy infrastructure stocks also continued to benefit from improving fundamentals. The sector continues to screen cheap given high distribution yields and improving coverage ratios. With a number of the already announced simplification transactions closing in the first quarter, most of the distribution cuts are in the rearview mirror. UBS is still projecting that the sector should see 3.7% real distribution growth in 2019. Pipeline capacity remains very tight in most markets, and we expect to see higher volumes of oil, natural gas, and natural gas liquid production in 2019.
Admittedly, fourth quarter earnings were more mixed than what we saw in the first three quarters of 2018. The sharp oil price downturn in the fourth quarter combined with some key pipeline and plant outages impacted the earnings of some midstream companies. In addition, a handful of companies were penalized for disappointing guidance. Often, this disappointment was driven by high capital expenditure projections. As we saw with many of the exploration and production companies, energy investors have become hyper-focused on free cash flow generation and are encouraging companies to live within their means. This same sentiment carried over to the midstream sector, and companies, such as Targa and ONEOK, which put forth aggressive capital plans, saw their stock prices get hit.
The sector does seem to be attracting some new buyers. Sell-side analysts are almost unanimous that most of this new money is focused on the large-cap c-corporations, and performance in the quarter would seem to back this up. The Alerian Midstream North American Index (AMNA) outperformed the Alerian MLP Index (AMZ) by 5.3% (22.1% vs. 16.8%) and the five largest midstream C-Corp companies outperformed the five largest MLPs by nearly 12% (28.2% vs. 16.3%). Investors also seem to be steering away from companies with high leverage and MLPs with incentive distribution rights (IDRs).
The biggest negative in the quarter was ongoing legal and regulatory issues around new pipelines outside of the Gulf Coast. Midstream projects received a slew of negative rulings. Construction of both the Atlantic Coast Pipeline (majority-owned by Dominion and Duke) and the Mountain Valley Pipeline (majority-owned by Equitable Midstream) was halted around permits to cross the Appalachian Trail. Two Enbridge pipelines, Line 3 in Minnesota and Line 5 in Michigan, ran into issues with the respective state governors. Energy Transfers’ Mariner East pipeline in Pennsylvania continues to face problems as the public utility commission and the courts push back on the company. Perhaps the only good news on the regulatory front came on the last day of the quarter as President Trump re-issued the permit for the Keystone XL Pipeline. The new permit will hopefully clear up the legal issues in Montana, and now owner TransCanada only needs the blessings on its route from the Nebraska Supreme Court before it can finally move forward with the pipeline after a 10-year regulatory process.
With the second quarter well underway, the midstream energy sector appears to have its feet firmly back underneath it. Nevertheless, we are well aware that the sector has been unable to sustain a meaningful breakout over the last three years. We are cautiously optimistic that perhaps this time things will be different. We feel the heavy lifting has been done on the restructurings, balance sheets are in very good shape, and valuations remain attractive. We continue to feel good about the outlook for oil prices. Inventories are low, and the Saudis seem determined to keep the oil supply in check. U.S. production also looks like it will grow enough to be a catalyst for midstream, but not so much that it will negatively impact global supply.
We are a bit warier about prices for natural gas liquid (NGL) and global natural gas, both of which are experiencing seasonal weakness. Despite the move up in oil prices, NGL prices are largely flat with NGLs as a percentage of oil trading at a 52-week low. Both propane and ethane prices have been weak. Propane should rally as we move out of the spring shoulder period. Similar to last year, we expect ethane prices to surge as the next wave of ethane crackers comes on line. Recall that last year ethane spiked to 60.75 cents/gallon (almost triple where it is currently) as two new world-scale ethane crackers started up. Four additional plants are scheduled to start up over the rest of this year, which should lead to higher ethane prices. Global natural gas prices have also fallen, which is putting pressure on liquefied natural gas (LNG) shipments. Nevertheless, we would expect Asian natural gas prices and spot LNG shipping rates to run back up in the summer and fall as Asian buyers once again look to make sure that they have enough gas for the winter.
The rest of the year will also see a number of major pipeline projects come online. These pipelines are desperately needed to relieve some of the constraints we are seeing across the country, but especially in the Permian basin. As an example, on April 3, natural gas at the Waha hub in the Permian Basin traded at -$4.63, meaning producers were paying to get their gas taken so that they could continue to produce oil. The new pipelines will not only relieve this congestion, but will also provide an attractive return for the midstream companies that have been constructing them for the past few years.
We expect the midstream C-Corps to continue to outperform. The combination of better liquidity, better corporate governance, and no K-1 tax forms is more appealing to new capital, especially from overseas. We believe that the valuation discrepancy between the C-Corps and the MLPs is not nearly wide enough to entice investors to switch from C-Corps to MLPs. We also remain wary of companies with incentive distribution rights (IDRs). Despite the recent price weakness, we still like energy infrastructure companies with exposure to both LNG and NGLs. The expected trade deal with China is likely to boost both of these, and we strongly believe that the recent price weakness will prove both seasonal and temporary.
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The Alerian MLP Index is a composite of the 40 most prominent energy master limited partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index, which is calculated using a float-adjusted, capitalization-weighted methodology, is disseminated real-time on a price-return basis (NYSE: AMZ) and on a total-return basis (NYSE: AMZX). The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and is not available for direct investment.