For the quarter ended December 31, oil lost 37.9% of its value and energy equities followed.  The XOP, a measure of oil and gas producer price performance, lost 39.1%. The AMZ, a measure of midstream MLP performance, lost a much less severe but still unsettling 17.0%.

Midstream MLPs: What Just Happened?

Past performance does not guarantee future results

However, we believe the fundamental backdrop for the energy sector and midstream MLPs is much less scary than the price collapse just experienced. In our opinion, over the fourth quarter of 2018, energy and midstream equities succumbed to a painful combination of de-risking, tax-loss selling, and apathy for still out-of-favor subsectors, leaving midstream MLP valuations at historic lows.

Historical Context

The Financial Crisis

The fourth quarter of 2018 held some resemblance to the fourth quarter of 2008 when crude oil collapsed by 55.7%. Specifically, the broader market, as measured by the S&P 500 (SPY), also experienced a severe correction. For the quarter, the SPY lost 18.0%, which is near the 21.6% loss experienced over the fourth quarter of 2008. 

Though, consider that over the fourth quarter of 2008, U.S. GDP fell by a whopping 8.2% as all facets of the economy appeared impacted by the seeming perils of the financial crisis. As a result, global oil demand experienced a dramatic reversal shifting from a 1.5% pace of growth to a -0.7% decline in 2008 and a -1.1% decline in 2009.

In contrast, for the third quarter of 2018, U.S. GDP grew at a 3.4% pace. While global economic activity does appear to be slowing, the prospects of a 2008-like global economic crisis appear remote. Further, oil demand growth for 2018 appears set to approximate 1.4 million barrels per day (mm bpd), or 1.4%. The “agencies” (IEA, EIA, OPEC) are forecasting similar demand growth in 2019.

2014 Cyclical Break

While the oil price collapse of 2008 was demand driven, the cyclical break in oil prices that began in the fourth quarter of 2014 was supply fueled. In late 2014, the oil markets awoke to the productive potential of U.S. shale. In the face of this new source of supply, OPEC nations flooded oil into the market in hopes of drowning out nascent shale drillers with a low price. This market share battle ended when U.S. shale, through aggressive efficiency and productivity improvements, proved it was here to stay and OPEC finally cut supply in late 2016 to support pricing. In contrast, at the most recent OPEC meeting on December 6, 2018, OPEC members agreed to lower their production targets in order to maintain a healthier price.

More importantly, global oil and gas investment leading up to 2014 was robust but global oil and gas investment since has been tepid. Today, U.S. shale nearly stands alone in receiving enough investment to grow supply to meet future demand or to offset declines elsewhere. In fact, the International Energy Agency (IEA) has voiced concern that without a significant increase in energy investment elsewhere, the call on U.S. shale may be more than what is possible.  As a result, the specter of a 2014-like supply shock appears remote. (Note: In the near future we will provide an additional blog with greater oil macro data).

Conclusion

When considering the fundamental backdrop discussed above, we feel comfortable suggesting today’s oil price level, and the resultant equity price turmoil, are unlikely to sustain. Nonetheless, midstream MLP multiples now sit at 7.3x versus a historical 10-year average of 11.0x.

U.S. midstream volume growth appears relatively sheltered from price volatility as the primary threat to crude pricing is the low break-even economics of U.S. shale. In other words, despite near-term crude oil price volatility, U.S. volumes appear set to grow meaningfully. As a result, we expect midstream MLP volumes, the primary driver of midstream cash flows, to remain healthy.

All current and historical data sourced from Bloomberg as of 1/3/19.