August 15, 2017
- Falling oil prices have made headlines this year
- Crude oil production in the U.S. is growing
- Energy infrastructure companies may present investor opportunities
Identifying investment opportunity involves a variety of factors. A viewpoint that seems particularly relevant in today’s fast-changing energy industry comes from longtime investor, Seth Klarman, in his book Margin of Safety. Klarman states, “Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level, investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.”
That seems to reflect the environment today for energy infrastructure companies (many of which are structured as Master Limited Partnerships or MLPs). Falling oil prices have had a dramatic impact on their performance. For example, at the end of June, Spot West Texas Intermediate (WTI) crude oil stood at $46.04 per barrel, down 4.7% for June and 4.7% lower than a year earlier. As WTI prices have fallen, so have MLPs with the Alerian MLP Index (AMZ) declining 5.3% on a price basis, resulting in a -2.7% total return after distributions are considered through June this year.
Energy markets are still growing
Despite recent challenges, the underlying business values of energy infrastructure companies are improving. First quarter 2017 earnings before interest, tax, depreciation and amortization (EBITDA) growth were up 10.2% year-over-year1.
Energy infrastructure businesses are exposed to volumetric risk (the impact of changes in supply and demand of specific energy products). Focusing on oil and natural gas production volumes is a logical and appropriate practice.
Since 2016, even as oil prices have generally remained in the range of $50/barrel or less, U.S. production trends continue to increase. This is contrary to much speculation in the market that such low prices wouldn’t justify the cost of higher production. In fact, crude oil production in the lower 48 states is poised to surpass 2015 highs, and production growth expectations going forward have improved as well. Keep in mind that rising U.S. production should not have meaningful impact on global supplies as U.S. crude oil stockpiles (excluding the Strategic Petroleum Reserve, SPR) represent only about 10% of global inventory.
A potential boon for energy infrastructure companies
This production trajectory should be healthy for energy infrastructure since it is much more common that these midstream assets earn a set fee, or fee-like margin, for the volume of oil and gas transported or handled. In response to rising U.S. production, MLPs are positioned to potentially benefit as new projects come online over the next few quarters. Examples of announced infrastructure projects include:
- Energy Transfer Partners (ETP): Rover (natural gas pipeline), Mariner East 2 (natural gas liquids pipeline)
- Enterprise Products Partners (EPD): Midland-to-Sealy pipeline (crude pipeline)
- Targa Resources Corp (TRGP): Four processing plants (natural gas)
- MPLX (MPLX): Ozark pipeline & expansion (crude pipeline)
- Magellan Midstream Partners (MMP): Corpus Christi condensate splitter (light crude processing)
The investment opportunity
Midstream MLPs appear to offer attractive value in the current environment. They are currently priced at 10.7x price-to-distributable cash flow (or DCF – similar to a price/earnings ratio for stocks), based on projected 2018 DCF. This is comfortably below the five-year average of 12.9x, indicating that MLPs offer attractive value.
Despite the improving outlook for volume and distribution growth, energy infrastructure stocks are priced at historically attractive levels.
Any negative momentum pressures in the sector appear to stem from oil price trends. We may need to see a firming or leveling of the crude oil price environment to improve sentiment about MLPs. While near-term energy market volatility is sure to be driven by the unpredictable ebbs and flows in sentiment stirred by the most recent headlines, it is important to separate current unit prices from the underlying business value of energy infrastructure companies. Sentiment will eventually turn, and investors are likely to find the resiliency of midstream MLPs operating cash flows compelling once again.
Talk to your advisor to help determine if investing in energy infrastructure may make sense for your overall portfolio and goals.