Managing Director and Portfolio manager, Brian Kessens (pictured), of Tortoise Advisors writes on current issues in the energy sect
Managing Director and Portfolio manager, Brian Kessens (pictured), of Tortoise Advisors writes on current issues in the energy sector
1.What is driving current performance in the energy sector?
The recent selloff in pipeline related investments coincided with a downturn in the price of crude oil, which currently is the key driver of energy market sentiment. Energy investors continue to see inventories build in the US despite OPEC’s reduction in crude oil supplies.
Saudi Arabia’s rhetoric is unclear about whether the OPEC cuts through the first half of the year are likely to be extended to the second half. At Tortoise we think the rhetoric is about maximizing OPEC member compliance, and expect the cuts to be extended. The previous OPEC strategy to maintain market share lasted two years. We do not think there is a willingness to give up on this one after just six months.
This more recent macro oil news overshadowed what we think was a good earnings season for pipeline companies to start the year. In our view, guidance for 2017 was constructive and new project announcements were healthy on the heels of the producer community outlining growth plans for the year.
2.Should oil prices drive the stock prices of pipeline companies?
We believe the current narrative driving down oil prices is that the US will be growing oil production too fast which is actually bullish near-term for pipelines volume and the midstream more generally.
From a fundamental perspective the daily movements up or down in oil prices should not be driving pipeline returns but alas they are right now.
3.What should we look for over the short term in energy right now?
Seasonally it is spring which is a period when refinery maintenance peaks. Basically, refineries reconfigure their operations to change over from producing a winter grade of gasoline (that includes more butane) to producing a summer grade. During this period, crude oil inventories increase as refineries just use less. Recently, the market’s been trying to discern whether rising inventories are due to too high of supply globally or simply lower refinery utilization.
As we look into April, we expect refineries to come out of maintenance and to increase their demand for crude oil in the second half of the month. We think inventories should then start to fall.
And looking forward to May, OPEC is set to meet on the 25th. We expect a lot of commentary between now and then from OPEC ministers threatening to end the production agreement, yet ultimately we expect the cut to be extended to the second half of the year because global inventories are not yet at historical levels which is one of the aims of the cut.
These items are likely to drive energy sentiment. For pipelines, we believe you should look for new project announcements, another good earning season that starts in mid-April, and the capital markets. We expect at least one MLP IPO to price in the second quarter.
4.Do you think the Trump administration will be good for oil and gas companies?
Putting aside politics and many of the common narratives, by almost any measure the eight years of the Obama administration were a great time for the oil and gas industries. In 2008, the year Obama was elected, but hadn’t yet taken of office, domestic production of natural gas was about 55 Bcf/day and domestic crude oil production was about 5.0mm bpd. In 2016, obviously Obama’s last year in office, domestic gas production was up to 72 Bcf/ day, that is up 30 per cent over the course of his administration, while oil production was 8.9mm bpd, up almost 80 per cent.
We think the Trump administration will be good for oil and gas as long as the regulatory environment does not get worse. If the administration can make some moves to intelligently lessen the regulatory burdens, we think that would just be gravy for the industry.
5.How big a part of the energy story is natural gas, and are the dynamics for gas similar to oil?
We believe that natural gas is a huge part of the energy story. Different from oil which is global, natural gas is largely a domestic market. The US has had more natural gas than needed for the past couple of years, and 2016 in particular was notably poor from a demand perspective due to the warm winter of 2015-16. Consequently, there’s been little production growth over the past two years. That’s now changing as new sources of demand emerge.
Last year, the US exported natural gas in the form of LNG for the first time. And with two LNG facilities coming on-line last year, three more are expected this year. We also anticipate more exports to Mexico, coal to natural gas switching to continue in the power generation sector and more industrial activity to drive demand for gas. By the end of the decade, we believe demand is likely to be about 15 Bcf/d or approximately 20 per cent higher from current levels. This will require not only more production, but more pipeline takeaway capacity from areas like the Marcellus in the Northeast, and even the Permian basin in West Texas.
6.Looking long term what do you believe is the opportunity for energy pipelines beyond the next year?
The phenomenal successes of the oil and gas sector over the last 8 years won’t be ending anytime soon. We are not calling for another 30 per cent or 80 per cent growth in the next eight years, but we do not believe domestic production peaking at our current levels. The infrastructure build that accompanied that rapid rise in production is still on-going. We are effectively upgrading and re-plumbing many areas of the country to bring hydrocarbons from where we’re finding them to where they need to go to be utilized. As production continues to grow, we continue to need to build and improve the pipes and tanks that move and store this production.
In January, the US Energy Information Administration (EIA), published their Annual Energy Outlook for 2017. In reviewing that document, one of the key takeaways was the US moves from being a net importer of energy to a net exporter of energy by 2026. We’ve been a net importer of energy since 1953 and every President since at least Nixon has talked about “energy independence” and now it seems to exist, if only just over the horizon.
To bring that independence to reality, we are going to need more infrastructure; certainly more LNG export infrastructure, more refined product export infrastructure and more pipes and tanks that bring the hydrocarbons from the wellhead to the exporter or the consumer.
We believe the pipeline system is not overbuilt. We see strong drivers for increasing utilization and continued infrastructure investment for many years to come.
7.How will MLPs and pipeline companies perform in light of higher interest rates?
History tells us there are 13 periods since 2000 when the 10-year Treasury increased by 50 basis points or more. In those periods, bond returns averaged a negative -1.4 per cent, no surprise there. The S&P 500® Index is higher by an average of 6.5 per cent and the performance of pipelines as measured by the Tortoise North American Pipeline IndexSM is similar, higher by an average of 5.6 per cent.
We think there’s a few reasons for this: (1) pipeline company dividend and distribution growth allows the stocks to grow through higher rates, (2) generally, higher interest rates are associated with better economic growth which means energy demand, and the volume moving through pipelines, is higher in better economic periods, and (3) higher interest rates also imply higher inflation.
And many pipeline companies have an ability to pass along inflation in the form of higher tariffs pegged to the rate of inflation.
So to the extent the Fed increases rates two or three more times this year, we think that implies the economy is growing and expect pipeline companies to perform well in that scenario.
8.What is your outlook for pipeline companies the rest of this year?
We expect total returns of low double digits for pipelines in 2017, with a mix of both current income where MLPs now yield about 7 per cent and growth of 5 per cent-7 per cent. New project announcements have started after slowing in 2016 and we expect that trend to continue, especially in the Permian Basin related to gathering and processing, crude oil and even new natural gas pipelines. We’re also seeing more activity in Oklahoma and the Haynesville shale. And certainly, the export infrastructure build continues as well.
We also expect more M&A activity this year as the bid-ask between buyers and sellers narrows. In front of that, potential buyers are simplifying their organizations through IDR buybacks to lower their overall cost of capital to be better positioned to make accretive acquisitions. We believe that companies are also taking the view that having a C-Corp and an MLP security is not a bad thing as it provides two options to raise capital.
With the markets as disrupted as they were in early 2016, there was just a lot of fear if not outright panic in the energy market.
Warren Buffett famously wrote in an op-ed piece in the New York Times in October of 2008 that among other things to “be greedy when other are fearful.” Investors who bought or at least did not succumb to the fears of the market in early 2016 have done very, very well.
While the valuations may not be where they were in early 2016, to us, they still seem very attractive compared to historical averages, really on almost any measure.
If you like to buy things when they are on sale it feels like the pipeline stocks are on sale. Could they go lower? Sure. But over the next six, 12, or 24 months if the trends we mention play out you will see this was an attractive entry point in the market.
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