Midstream energy companies bounced back in the second quarter and are poised to have a strong finish to the year. Strong earnings, a robust growth outlook, and strong energy fundamentals are supportive of further gains in the midstream sector. After years of underinvestment, new concerns about having enough oil to supply growing demand has pushed oil prices into the $70-$80 range. Pipelines are beginning to fill up throughout the country, and new investment in infrastructure will be needed to support further U.S shale growth. The Permian Basin in West Texas has seen production increase by nearly 50% to 3.5 million barrels/day in the last 12 months. All this growth is positive for energy infrastructure companies as all the product needs to be processed, transported and stored. The growth has positioned the United States to be one of the major energy exporters in the world. Despite a strong quarter, MLPs remain undervalued versus historical metrics. The MLP sector continues to evolve as companies continue to pursue the elimination of incentive distribution rights, simplified structures, a move to a self-funding model and a slow down in distribution growth. All these changes are creating a stronger sector for the long run.
What Happened in 2Q18?
Midstream energy companies reported strong earnings during the second quarter with many companies surpassing analyst estimates. The results were driven by increasing volumes, improving commodity prices and new projects coming on-line. The strong results and positive outlook resulted in
positive fund flows and strong returns for midstream infrastructure. The MLP landscape continues to change. Simplifications were all the rage this quarter as companies continue to clean up their structure to address investor concerns surrounding complexity, potential conflicts of interest and weak corporate governance. On May 17th, C-Corporations Williams Companies, Enbridge Inc and Cheniere Energy announced roll-ups of their underlying MLPs which ultimately will reduce the MLP count by 5 names. We expect future roll-ups to continue as companies address their complicated business structures. Midstream C-Corps historically trade at a slight premium to their MLP brethren, and for the most part, C-Corp conversions have traded positively after announcing the transaction.
During the quarter, crude oil prices increased by over 14% to $74. This increase in prices was driven by global supply disruptions, a recognition that oil markets are rapidly tightening, and infrastructure constraints in U.S Shale that will keep a cap on near-term growth. Natural gas and natural gas liquids (NGLs) pricing remained strong with demand from exports continuing to increase. Demand for NGLs is driven primarily by the petrochemical industry which has invested billions for new plants that take advantage of the low-cost feedstock. Pipeline companies that process NGLs continue to benefit from increased NGL pricing and increased volumes.
Additional Infrastructure Needed
Production growth in shale basins throughout the country is driving new demand for pipelines and associated infrastructure. During the quarter, The Interstate Natural Gas Association (INGAA) updated their 2016 report on energy infrastructure needs. The update shows a significant increase in the expected midstream infrastructure
investment required through 2035. The new study indicates that $791B of midstream investment is needed through 2035, versus $546B from the 2016 study. Increased spending estimates underpin longer-term growth opportunities for the sector. With domestic production levels of oil, natural gas and NGLs at all-time highs, it appears we are in an era of long-term growth. The chart below illustrates where the infrastructure investment is expected to take place. The majority of the investment will be in natural gas. On the oil side, much of the near-term investment is being done in the Permian Basin. A key area of investment will be to grow our export capacity across all hydrocarbon markets. Historically, natural gas has been a commodity that mostly traded in regional markets. However, Liquified Natural Gas (LNG) markets are rapidly developing and giving natural gas the ability to be a globally traded commodity akin to crude oil. This global shift in natural gas trading is sending demand to new highs as countries around the world are focused on clean-energy initiatives of which gas a major part. India and China are two markets that are seeing the most investment as they have prioritized reducing pollution.
MLP valuations are discounted relative to history, other energy subsectors, and other yield-oriented securities. Of the three most widely cited metrics, MLPs are between 20% and 35% undervalued, and this is occurring during a period where fundamentals are as strong as they have been in years. Why are we here? There is no
doubt that many factors outside of the fundamentals continue to weigh on sentiment. These include corporate governance issues, high leverage, and fears that there is less distribution growth ahead. The issues are being addressed, and there is a gorwing list of MLPs known as the “reformers” which have acted to better align the interests of the various stakeholders. The simplification transactions that occurred during the quarter are moving more companies in the “reformer” direction. As we continue through this period of consolidation and restructurings, we think it is an ideal time to be allocating to the sector as fundamentals and outlook remain robust. Fund flows into energy infrastructure were positive over the quarter, and we think this trend will continue.
We believe now is an ideal time to be allocating to midstream energy. The sector has rarely been more attractive. With strong underlying fundamentals and growing earnings, the sector is poised for further gains. At a time when we hear about global trade wars in the daily news, domestic energy infrastructure is an ideal, defensive sector to invest in. After several years of pain for the sector, we are once again on the growth path. Investors do not often come across a sector with strong current and future fundamentals that is materially undervalued versus historical metrics. The robust performance in Q2 was encouraging, and we expect the strength to continue.