As discussed in our previous commentary, we believe technical trading factors have dominated price performance within the midstream sector recently. Furthermore, we believe crude oil price weakness has been the primary driver of poor sector sentiment and, in recent days, this sentiment was exacerbated by Kinder Morgan’s troubles. Regardless, this poor sector sentiment has created an environment ripe for technical trading influences. Ultimately, technical factors fade and fundamentals persist. Therefore, let’s consider the fundamentals.
First, recall that the midstream sector consists of many different asset types. While crude oil gathering and transportation is an important subsector, natural gas, natural gas liquids, and refined products, such as gasoline and diesel, also all flow through midstream assets.
The latest monthly data from the Energy Information Administration (EIA) is for September, and through September, lower 48 oil production volume had declined 2.0% since June 2015 but was still, resiliently, up 2.5% from the year-ago period. But natural gas and natural gas liquids (NGL) volumes, in aggregate, are up 2.6% and 2.9%, respectively, from June 2015, and 4.6% and 6.0%, respectively, from the year-ago period.
In addition, third-quarter earnings were just reported and the vast majority of midstream operators reported results that reflected continued resilient margins. For the third quarter, market-capitalization-weighted EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, averaged 2.6% higher than consensus expectations, and 7.8% higher than the second quarter of 2015.
Of course, what matters is what happens going forward. Over the next year, most prognosticators appear to expect more of the same: modest, slow crude oil volume declines for most U.S. basins until pricing firms. In fact, the stubbornness of U.S. production appears to be one of the primary drivers behind the continued weakness in crude oil prices. Natural gas and NGL volumes are expected to continue to grow. But when determining the value of an equity, it’s the mid- to long-term trends that matter most and the outlook for oil seems to be the most confusing. Therefore, we need to also consider some macro oil supply and demand figures to better understand where the “call” on North American oil production is likely headed.
Depending on whose analysis you choose, estimates for the current global oversupply of crude oil stand at between 700 thousand barrels per day (kbbls/d) and 1.9 million barrels per day (mmbbls/d), or from 0.7% to 2.0% of demand. Furthermore, global demand for 2015 is expected to be approximately 1.9 mmbbls/d higher than 2014 and global demand for 2016 is forecasted to be 1.0 mmbbls/d to 1.5 mmbbls/d higher than 2015. Similarly, over the next five years, total additional demand is expected to approximate 5 mmbbls/d to 7 mmbbls/d.
OPEC appears to have little spare capacity, and even if Iran is able to pursue its production goals, it is apparent that the majority of this additional supply must come from somewhere else. Also, every oil well ever drilled experiences natural declines in production (the global decline rate is approximately 5%) but international capital spending plans have been slashed at the greatest pace in history. For example, TPH Energy Research estimates that over 150 oil and gas projects have now been delayed or cancelled and estimates this action has removed approximately 13 mmboe/d (60% liquids) of future run rate production.
While the financial damage inflicted on North American oil and gas producers as well as oil field services providers has been extreme over the past year, one result has been a significant improvement in drilling and completion efficiencies. Therefore, we believe North American producers stand as the most likely incremental source of supply over the next five years and beyond. Further, we believe this “call” on North American production will benefit the midstream assets through which it flows. As a result, SteelPath feels very comfortable with the long-term fundamentals of the asset class.
But what of near-term sentiment and technical trading? The randomness of short-term commodity price changes means that, in our opinion, placing any bet on short-term expectations for commodity prices is a very low probability bet. So, once again, we will not attempt to predict when crude oil prices will turn.
However, there is little debate that pricing will have to be materially higher to incentivize enough supply to meet demand over time. Furthermore, based on the discussion above, we know global supply and demand appear likely to balance at some point over the next 6 to 18 months, depending on whose numbers you choose to believe. We also note that markets are unlikely to need real-time supply and demand balance prior to a crude oil price reaction as pricing is, by its nature, forward looking; so as market balance clarity improves, pricing should recover. However, the timing of this clarity is also unpredictable.
Clearly Kinder Morgan’s issues have further roiled market sentiment but we simply remind investors that Kinder Morgan’s issues are Kinder Morgan’s. Even so, Kinder’s decision to cut its dividend was not the result of cash flow degradation; in fact, the company maintained its distributable cash flow guidance. Rather, Kinder’s very high leverage created a near-term need to address its balance sheet, and cutting its dividend was its management team’s choice to satisfy this need.
While it is impossible to predict management decision making, we feel confident that most midstream operators haven’t experienced a sudden deterioration in their operating performance and we don’t believe many midstream operators face a Kinder-like decision. We also feel confident in the long-term outlook for North American oil and gas production and the midstream assets that will be needed to accommodate these volumes.
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Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.