Strong earnings, a robust growth outlook and improved energy fundamentals pushed midstream companies higher in the third quarter. We believe the strength should continue as there are significant tailwinds at play in the sector. One strong tailwind is the continued growth in oil and gas production in the United States. In early September, the Energy Information Agency announced that the U.S is now the largest oil producer in the world. With further production gains expected, midstream energy companies are in prime position to capture additional volumes and cash flows. The U.S is also emerging as a global power in the export of Liquified Natural Gas (LNG). These positive energy trends will continue to drive midstream earnings higher for the foreseeable future. Despite a strong quarter, MLPs remain significantly undervalued versus historical metrics. After a difficult four years for energy markets, it is a welcome development to have multiple tailwinds at the back of MLPs once again.
What Happened in 3Q18?
Midstream energy companies reported exceptional earnings during the third quarter with most companies surpassing analyst estimates. The results were driven by increasing volumes, improving commodity prices and new projects coming on-line. Oil prices continue to rebound and are now approximately $75/barrel; the highest in 4 years. A long-awaited merger between Energy Transfer Partners and Energy Transfer Equity was announced during the quarter. The deal is expected to close by year end and it will eliminate incentive distribution rights. We view the merger as bullish for the sector as improved corporate governance has been a major focus for the sector. The Permian Basin continues to be a growth driver for midstream companies. Crude production in the Permian is moving towards 4 million barrels/day but has slowed significantly as there are not enough pipelines to move the oil. New pipelines are being developed and we expect pipeline takeaway capacity to be sufficient by the second half of 2019. Some other shale basins that will be facing infrastructure shortages are the Bakken in North Dakota and the Marcellus in the Northeast.
A petrochemical boom is driving strong demand growth for natural gas liquids (NGLs), specifically ethane. Ethane is used as a building block for plastics. Demand for ethane is expected to increase by nearly 700,000 barrels/day in the next three years. This demand is driven by seven new world-class ethane steam crackers coming online in the coming years. This petrochemical boom is driven by lowcost feedstock that U.S shales produce. They are now competitive or superior to Middle East petrochemical facilities. MLPs that operate infrastructure that processes these liquids are benefiting from significant volume growth and high processing margins.
LNG: A Global Game-Changer
One of the most impactful shifts in global energy in decades is the rapid growth in the LNG trade. Technological advancements have allowed natural gas to be liquified and traded globally just like the crude oil. Countries around the world are attracted to LNG as they move away from dirty coal and oilbased electricity generation. Demand from India and China has been surging as they try to lower pollution in their major cities. Europe is also a major source for LNG demand. The Trump administration is pushing the Europeans to buy more U.S gas as an alternative to Russian gas. The U.S is in a prime position to dominate LNG exports as natural gas prices in the U.S are $3/MMBtu versus over $10/MMBtu in Asia. Several new export facilities are under construction, and MLPs are building out pipelines to feed gas to the facilities.
Two companies that we have been actively allocating to in the LNG sector are Golar LNG (GLNG) and Teekay LNG Partners (TGP). Both companies are involved in shipping LNG around the world. LNG shipping rates have surged from lows last year of $40,000/day to around $100,000/day currently. Rates are expected to remain high as vessel supply is limited. Teekay LNG is one of the largest LNG shipping businesses in the world. They essentially operate as a floating pipeline with long-term fixed rate contracts. In 2015, Teekay slashed their dividend to fund the construction of several new ships. Fast forward to today and those ships are being delivered and placed into service. We expect Teekay to announce a return to distribution growth in November which should drive the stock price significantly higher as it trades at a significant discount to peers. Golar LNG is one of the most exciting companies in the energy sector. They operate a large fleet of ships and have developed technology for Floating Liquefied Natural Gas (FLNG). The FLNG technology is a massive ship that produces natural gas from offshore fields, liquefies the gas, and then offloads it to LNG carriers that carry it to end destinations. Earlier in the year Golar put their first FLNG asset into service. The economics are very good for Golar and each FLNG asset provides sizeable earnings growth for the company. We expect Golar to announce a new FLNG asset by year end.
MLP valuations continue to be discounted relative to history, other energy subsectors and other yieldoriented securities. Of the three most widely cited metrics, MLPs are between 15% and 35% undervalued, and this is occurring during a period where fundamentals are as strong as they have been in year. 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. Another issue impacting the midstream is a lack of fund flows as many investors are heavily invested in technology stocks. We believe we are entering a period where we will see a rotation into value stocks which should benefit MLPs.
We are very optimistic for a strong finish to 2018. Midstream companies are primed to benefit from improving operational economics, growing volumes and stable commodity prices. Several major projects will be coming online in the coming months that will enhance cash flows and drive earnings growth. The United States is an energy superpower and the buildout of infrastructure is critical to its success. With a dividend yield of 7.9%, and valuations at significant discounts to historical metrics, we view the asset class as one of the few great values in the market. It’s been a tumultuous road for MLPs since 2014, but the future remains bright as we return to growth in the energy sector.