An Energy Value Chain Overview and Outlook
As we closed out the first quarter of 2016, a production freeze proposed by the Organization of the Petroleum Exporting Countries (OPEC) created some optimism about achieving balance in the global oil markets, although an agreement was not ultimately reached. This, along with strong global demand and a decrease in U.S. production drove an uptick in oil prices. Although the broad energy sector, including pipeline corporations, saw some stabilization throughout the first quarter, MLPs continued to face significant headwinds. These included concerns about capital market access, credit ratings, capital expenditure reductions and counterparty risk. Despite these MLP equity market challenges, fundamentals in the midstream segment of the energy value chain remained intact. The majority of companies maintained solid balance sheets, stable cash flows and growing distributions, underscoring our conviction in the space.
Slowing U.S. crude oil production and strong demand strengthened oil prices, leading to improving general sentiment around energy, which lifted sector performance. Oil and gas producers were further helped by earlier efforts undertaken to reduce costs and improve efficiencies, as shown by the improvement in performance of the Tortoise North American Oil and Gas Producers IndexSM, which returned 7.5% for the quarter. Conversely, MLPs endured yet another tough quarter as negative market sentiment regarding the structure seemed to override solid company fundamentals. The Tortoise MLP Index® returned -6.1%, significantly underperforming utilities and REITs for the quarter, as reflected by the S&P Utilities Select Sector Index and the FTSE NAREIT All Equity REIT Index. The average MLP yield for the quarter was 10.3%. Midstream MLPs underperformed their upstream counterparts during the quarter. This was a reversal from their outperformance in previous quarters as upstream MLPs saw a greater recovery during the quarter as oil prices increased. North American pipeline companies also experienced a dramatic rebound, as reflected by the Tortoise North American Pipeline Index’sSM 9.4% return for the quarter.
Value chain overview
Upstream
Conditions improved for upstream oil and natural gas producers. They have become more disciplined with respect to capital expenditure, cutting their budgets for the second consecutive year, issuing equity and resetting their balance sheets to maintain their credit ratings. However, bankruptcy concerns have been an ongoing headwind for producers.
Crude oil
Global production has started to decline, though at a slower pace than had been expected. The rig count continued to drop, but production remained fairly strong as producers completed previously drilled wells and applied advanced technologies to get more oil out of existing wells. The Energy Information Administration estimates that U.S. crude oil production in March 2016 was 90,000 fewer barrels per day than was produced in February. U.S. production is projected to average 8.6 million barrels per day (MMbbl/d) in 2016 (down from an estimated 9.4 MMbbl/d in 2015) and 8.0 MMbbl/d in 2017.
Natural gas
A relatively warm winter caused a decline in natural gas demand for heating and drove natural gas prices even lower during the quarter. This demand decrease contributed to the already-high inventories, which are at the highest levels of the last five years. However, demand for natural gas is expected to increase in the coming summer months, as prices this low are attractive to electric utilities, making natural gas an economic choice over coal.
Natural gas production growth is expected to slow to 0.9% in 2016 from 5.4% in 2015. However, in 2016, electricity generation from natural gas is expected to outpace electricity generation from coal for the first time on an annual average basis.2Midstream
Among pipeline companies, performance varied depending on the type of product transported. Crude oil MLP and pipeline companies, as well as natural gas MLP and pipeline companies, improved significantly from last quarter, providing the best performance among pipeline companies. Refined product MLP and other pipeline companies continued to post positive performance during the quarter, thanks to continued strong demand for refined products in the low-price environment. Gathering and processing companies were restrained by concerns about counterparty risk and contract renegotiations.
Other issues included Kinder Morgan Inc.’s steep dividend cut in December 2015, which drove speculation that more distribution cuts would follow, the viability of Energy Transfer Equity, L.P.'s proposed merger with The Williams Companies, Inc., as well as actual and potential credit rating downgrades. It is noteworthy that many midstream MLPs maintained or increased distributions year over year, and there have been no bankruptcies in the midstream space.
While the possibility of lower volumes and the potential effect on pipeline companies’ profits persist, so does the need for pipeline infrastructure buildout. We believe that companies with pipelines in strategic locations will attract quality producers with products to transport. Our projection for capital investments in MLP, pipeline and related organic projects for 2016-2018 is approximately $120 billion.
Downstream
Many energy companies in the downstream segment of the energy value chain, including power utilities, have benefitted from lower oil prices. Refiners are included in this group, as low input costs have driven healthy demand. U.S. drivers paid less for gasoline in the first three months of 2016 than they did during any time in the previous 12 years, with the national average price for a gallon of gasoline at $1.86 at the end of the quarter.1 The number of miles Americans have driven also hit a record high in 2015.3 Although still attractive, refiner margins narrowed during the quarter due to lower gasoline prices as inventories have stockpiled. Like refiners, petrochemical companies continued to benefit from low input costs, though margins tightened due to falling ethylene prices for those companies that do not have integrated facilities to upgrade ethylene to polyethylene, which has been more price resilient.
Thus far, 2016 is proving to be a momentous year for U.S. energy exports, with many milestones accomplished in the first quarter alone. In January, for the first time in 40 years, U.S. crude oil was exported and the first liquefied natural gas (LNG) export departed U.S. shores in February. Even though exporting certain natural gas liquids (NGLs) is not new for the U.S., ethane, widely used in manufacturing and enjoying rising global and domestic demand, was exported for the first time in March. All of this positions the U.S. to become a relevant supplier of low-cost energy to the rest of the world.
Capital markets
Capital markets have been challenged for the midstream segment of the energy value chain. MLP and pipeline companies raised nearly $12 billion during the quarter, with approximately $9 billion in equity and $3 billion in debt. Because capital markets have become less accommodative for midstream companies during this period of market volatility, some midstream MLPs are seeking alternate forms of funding, such as preferred equity private placements. There were no IPOs in the energy sector during the quarter. Capital markets have been more accommodative for exploration and production companies, which raised more than $19 billion in total capital during the quarter, with a fairly equal split between equity and debt.
Merger and acquisition activity
Merger and acquisition activity among MLP and pipeline companies was steady during the quarter, with announced transactions totaling more than $17 billion. The largest of these was TransCanada Corp’s proposed acquisition of Columbia Pipeline Group Inc., a deal valued at approximately $12 billion. If approved, the deal would make TransCanada one of North America’s largest natural gas transmission businesses. This, along with news that Berkshire Hathaway purchased 26.5 million shares of Kinder Morgan, Inc., underscored the long-term appeal of pipeline assets.
Concluding thoughts
Market sentiment started to improve midway through the first quarter. We saw this as a potential inflection point and anticipate that the crude oil supply/demand equation will continue to find balance in 2016 and 2017. We also believe the U.S. could become the swing producer to meet increasing global demand in the near future. In our view, midstream MLP and pipeline company fundamentals remain solid and technical pressures are beginning to ease. Despite some headwinds still facing the energy sector, we are optimistic that these scenarios will create opportunities across the energy value chain.
¹ Energy Information Administration, April 2016
² Energy Information Administration, March 2016
³ Department of Transportation, Feb 5, 2016
Disclaimer
This commentary contains certain statements that may include “forward-looking statements.” All statements, other than statements of historical fact, included herein are “forward-looking statements.” Although Tortoise Capital Advisors believes that the expectations reflected in these forward-looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect, Actual events could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this publication. Tortoise Capital Advisors does not assume a duty to update these forward-looking statements. The views and opinions in this commentary are as of the date of publication and are subject to change. This material should not be relied upon as investment or tax advice and is not intended to predict or depict performance of any investment. This publication is provided for information only and shall not constitute an offer to sell or a solicitation of an offer to buy any securities.
The Tortoise MLP Index® is a float-adjusted, capitalization-weighted index of energy MLPs. The Tortoise Midstream MLP Sub Index is comprised of all constituents included in the following sub sector indices: Crude Oil Pipelines, Gathering & Processing, Natural Gas Pipelines, and Refined Products Pipelines. The Tortoise North American Pipeline IndexSM is a float-adjusted, capitalization-weighted index of pipeline companies (MLPs, corporations, LLCs) domiciled in the U.S. or Canada.
The Tortoise North American Oil and Gas Producers IndexSM is a float adjusted, capitalization-weighted index of North American companies engaged primarily in the production of crude oil, condensate, natural gas or NGLs. The S&P 500® Index is a market-value weighted index of equity securities. The S&P Energy Select Sector® Index is a modified market capitalization-based index of S&P 500 companies in the energy sector involved in the development or production of energy products.
The FTSE NAREIT All Equity REITs Index is an unmanaged, capitalization-weighted index of all U.S. equity real estate investment trusts. The S&P Utilities Select Sector Index is a modified market-cap weighted index composed of constituents of the S&P 500® Index in the utilities sector.
The Barclays US Aggregate Bond Index is an unmanaged index comprised of government securities, mortgage-backed securities, asset-backed securities and corporate securities to simulate the universe of bonds in the market. The maturities of the bonds in the index are over one year.
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