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Depressed midstream valuations more than reflect the rise of renewables

Depressed midstream valuations more than reflect the rise of renewables

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Lost in election season and pandemic news flow has been the relative stabilization in energy macro and midstream fundamentals since March. At the same time, midstream operators have aggressively cut costs and drastically reduced capital expenditure plans. As a result, many midstream companies are expected to generate substantial free cash flow over the coming quarters and years that can be deployed to further reduce balance sheet debt or be returned to equity investors through buybacks or distributions.

Despite the confluence of these factors, midstream equities, though well off their lows, are still trading at historically depressed levels. This weak equity performance is likely a result of the general level of investor anxiety surrounding the impact of COVID-19 containment efforts on economic activity and the uncertain timeframe for a return to normal economic activity. However, adding to COVID-19 related anxiety in our view is an increase in concern that rapid adoption of electric vehicles (EVs) and renewable energy may severely impact future midstream earnings.

Unfortunately, we cannot provide any unique insight into the timing of post-COVID-19 economic normalization. However, within this blog, we provide some perspective on the potential impact of decarbonization efforts and suggest current valuation levels appear to already and materially over this risk.

Macro Update

Since the depths of the global economic retraction associated with COVID-19 containment efforts, we believe economic activity and energy fundamentals have exhibited steady improvement towards normalization. For example,

  • Road travel trends have reached or exceeded pre-pandemic levels across much of the globe.1
  • Though US gasoline demand is 9% below pre-pandemic levels, the 42% decrease experienced in April proved much shorter lived than feared at the time.2
  • While airline travel remains depressed, truck loading data has rebounded to above pre-pandemic levels helping to increase the demand for diesel.2
  • Deliveries of natural gas to US LNG export facilities, as well as LPG and ethane exports, have returned to pre-pandemic levels.3, 4

As a result,

  • Crude oil pricing has traded at $35 per barrel or higher since June. While most producers may not pursue production growth until pricing recovers further, we believe most may seek to maintain current volumes.5
  • Natural gas pricing has rallied well past pre-pandemic levels to near $3.00 per mcf. Notably, the majority of midstream assets serve natural gas production.6

As a result of these trends, well shut-ins that occurred earlier in the summer in reaction to the extreme price shock across energy commodities have now largely been reversed. The domestic rig count appears to have reached a bottom and well completion activity has been improving (completing a drilled well allows the well to produce and is more indicative of production trends). 

All of these factors suggest that midstream operating performance should also be rebounding. And, in fact, early third quarter operating results are confirming this trend. Further, this firming of operating performance is occurring while operators are instituting significant cost and capital spending plan reductions. As a result, over the coming quarters we expect midstream operators to potentially generate significantly higher free cash flow available for debt reduction or to return to equity holders through buybacks or distributions as seen in Exhibit 1 below.  In total, Wells Fargo estimates MLPs to generate in excess of $30.0 billion in free cash flow after distributions from 2021 through 2025.5

Source: Wells Fargo October 2020.  “A” stands for actual.  “E” represents estimates. Estimates may not come to pass. Free cash flow is defined as distributable cash flow less growth capital expenditures and acquisitions, where distributable cash flow represents cash flow generated by the company’s operations reduced by expenditures to maintain the assets. Midstream operators and companies are engaged in the transportation, storage, processing, refining, marketing, exploration, and production of natural gas, natural gas liquids, crude oil, refined products or other hydrocarbons. An investment cannot be made into an index.  Past performance is not a guarantee of future results. 

Decarbonization

While we do not doubt that the political will to pursue decarbonization is real and that progress will surely be made, we believe justifying today’s valuations on this premise of broad and rapid hydrocarbon substitution is misplaced.

First, let’s consider the macro trends at work. Energy demand, according to most prognosticators, will continue to grow briskly as the billions of people that live in non-developed and developing economies continue to strive to improve their standard of living. While decarbonization efforts within developed economies are likely to result in muted growth or shrinking hydrocarbon demand regionally, global hydrocarbon demand is likely to continue to grow.  Similar to the Energy Information Administration’s (EIA) forecast, a recent UBS report projects energy demand in 2050 will increase 45% from 2018 levels (see Exhibit 2 below.)  Meeting this demand will most likely require both significant traditional and renewable energy expansion.

Source: The State of the Global Energy Transition (2020) Aurora Energy Research report commissioned for UBS.  “Btoe” is billion ton of oil equivalent (toe).  Toe is a unit of energy defined as the amount of energy released by burning one ton of crude oil. ”E” represents estimates.  Estimates may not come to pass.   Past performance is not a guarantee of future results.

Therefore, while renewable energy development is sure to accelerate, demand for traditional fuels is likely to continue to grow for some time as well. Consider that only certain locations on the planet provide for efficient wind and solar placement (consistent wind or sunshine) and developing these solar or wind turbine assets as well as the infrastructure to support broad transmission, distribution, and storage of generated power represents massive, long lead-time investment. However, we believe populations will continue to seek quality-of-life improvements that result from access to cheap energy nonetheless. Hydrocarbons such as natural gas and propane are growing rapidly in emerging economies today precisely because they are both immediately actionable and practical – they improve quality of life and the environment and do so very cost-effectively.7 

Secondly, developed nations, even where wind and solar are well suited, may face a very complex and costly path to significant hydrocarbon substitution.  Though these challenges receive little attention, gauging the potential pace at which traditional energy demand in developed countries may decline requires an examination of these challenges.

We encourage readers to review our previous blog, “Unpopular but essential – petroleum products improve lives in unappreciated ways”.  Within we provide greater detail of the incredibly broad range of products which depend on petroleum products as a feedstock and for which alternatives are few and typically much more energy intensive.

Further, even substitution within transportation through electric vehicles presents significant challenges as it simply results in a shift from internal engine power to electric grid power demand. This additional call on electric power is likely to veer towards evening when solar derived power is unavailable and evening wind resource is only reasonably consistent in a few geographies. Therefore, meaningful growth in electric vehicle adoption would stress traditional generating capacity as well as current electric grid design and capacity. Solving both would require massive and long-lead time investment.

Even before additional load requirements associated with EV growth emerge, in our view, simply replacing coal and natural gas with renewables at current load levels would also require massive investment. First, additional wind and solar, where practicable, would be required on an enormous scale. Further, areas that can utilize wind and solar are expected to require enormous new energy storage solutions to provide grid stability particularly for nighttime power consumption and for periods when the weather is simply poor proving for limited light or wind. Notably, the scale of energy storage required to accommodate renewable intermittency and to provide grid reliability is often overlooked but appears difficult to solve barring significant new technological breakthroughs. Consider that today’s total annual global lithium battery production would only be able to store approximately seven minutes of global electricity usage.7

To be clear, we are not advocating against decarbonization efforts. In fact, given the growth in global energy demand discussed above and the significant reduction in oil and gas development outside of the US since 2016, we believe material growth in renewables will be needed. However, we do believe this transition may be much slower, more complex, expensive, and labored than may be commonly recognized.

Putting Today’s Valuations In Context

Given the push and pulls listed above it is obviously impossible to forecast hydrocarbon demand decades out. However, we do have confidence that however these competing influences unfold, the impact on hydrocarbon demand can evolve necessarily very slowly and over many decades.

Further, global oil and gas investment has fallen from approximately $750 billion per year pre-2016 to a range of $400 billion to $480 billion per year since and spending in 2020 and 2021 is likely headed even lower.(5) It is certainly possible that as decline rates in legacy global oil fields slowly overwhelms this muted level of investment, the call on efficient US shale production could actually increase even if aggregate global demand falters in the future.

Therefore, if energy transition anxiety is contributing to today’s depressed midstream equity valuations, we are hopeful that over time the market may begin to more rationally assess this risk. For example, Wells Fargo recently published a report on terminal value highlighting that “Based on our analysis, we do not see any realistic renewables scenarios that would materially impact oil and gas demand within the next 10 years. In contrast, investors are assuming free cash flow for these companies to fall to zero (and/or 100% goes towards servicing debt) starting in 2030.”

Wells Fargo analysts also estimate that for many MLPs, investors are ascribing zero or minimal terminal value after 10 years.  This analysis bears repeating, according to Wells Fargo’s analysis, today’s midstream equity values imply that investors are assuming there is no equity value in these companies after 10 years.

To use a specific example, consider Enterprise Products Partners (NYSE: EPD). EPD currently yields in excess of 10% and generates a free cash flow yield of greater than 15%.  Taking into account its free cash flow, Wells Fargo estimates there are 13 years of free cash flow discounted in the current EPD unit price.  In effect, investors are not paying for any free cash flow generated by EPD after 13 years.8 

Closing thoughts

We believe the extreme, relatively near-term impact to midstream operations implied by today’s valuations is outside even the most aggressive renewables or decarbonization projections we have reviewed; even those that give little notice to the significant real world challenges that such a transition will have to overcome  If midstream equities are trading with minimal terminal value after 2030 based on energy transition anxiety then we believe midstream equities may benefit as more rational analysis around this issue emerges.

Further, at whatever pace energy transition occurs, it is clear the investment required could be enormous reaching into the many trillions. Just as today’s oil and gas majors are amongst the globe’s largest investors in wind and solar, there is no reason US midstream operators would not invest in new logistics assets related to renewables over the coming decades as well.  In fact, it is almost impossible to envision that these companies with hard asset management expertise and growing free cash flows would sit idly by while trillions in attractive investment opportunities are pursued by others.  For instance, one of the most apparent opportunities is hydrogen transportation and storage which is very similar to natural gas transportation and storage that many MLPs are involved in today.

We believe that over time these miscalculations will become more and more apparent to market participants and, hopefully, allow the sector to return to more normal trading ranges.

1. Bernstein Desk Color: Energy: Oct. 19, 2020

2. Morgan Stanley, High Frequency Indicators: Oct. 23, 2020

3. Bloomberg Energy Net Daily Deliveries to US LNG Terminals

4. Bloomberg Energy U.S. Waterborne LPG and Ethane Exports

5. Wells Fargo, Midstream Monthly Outlook: October 2020.

6. Bloomberg as of 10/31/2020.

7. Cornerstone Macro: Battery Scalability Bottlenecks and Energy Density Shortcomings: November 25, 2019.

8. Wells Fargo, Midstream: Quantifying Terminal Value in An Energy Transition: October 26, 2020

Midstream operators and companies are engaged in the transportation, storage, processing, refining, marketing, exploration, and production of natural gas, natural gas liquids, crude oil, refined products or other hydrocarbons.

Important information

Blog header image: Dave Carr / Getty

As of 9/30/2020 Invesco SteelPath MLP Alpha Fund, Invesco SteelPath MLP Income Fund, Invesco SteelPath MLP Select 40 Fund and Invesco SteelPath MLP Alpha Plus Fund held 13.58%, 0.00%, 5.06% and 13.53%, respectively in Enterprise Products Partners LP. 

Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their advisors for a prospectus/summary prospectus or visit invesco.com.

The opinions referenced above are those of the author as of November 4, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

The mention of specific companies, industries, sectors or issuers does not constitute a recommendation by Invesco Distributors, Inc. Certain Invesco funds may hold the securities of the companies mentioned. A list of the top 10 holdings of each fund can be found by visiting invesco.com.

Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply-and-demand for energy resources. Short-term volatility in energy prices may cause share price fluctuations.

Energy infrastructure MLPs are subject to a variety of industry specific risk factors that may adversely affect their business or operations, including those due to commodity production, volumes, commodity prices, weather conditions, terrorist attacks, etc. They are also subject to significant federal, state and local government regulation.

Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. Diversification does not guarantee profit or protect against loss.

The opinions expressed are those of Invesco SteelPath are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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