Recently, financial-crisis-like volatility has gripped the midstream energy sector. As a result, investor anxiety has peaked and inflammatory, fact-light articles are gaining more attention in the blogosphere than normal. To help our investors discern fact from fiction, we have attempted to provide our perspective for consideration through several recent commentaries (Kinder Morgan Spikes MLP Investor Fears, Kinder Morgan and Oil Prices vs. Fundamentals, Debunking the Blogosphere’s Comments on the MLP Market, Boring Can Be Good). Below, we highlight and update some of the more important points made in our recent commentaries for ease of reference.
Kinder Morgan’s (NYSE: KMI) decision last week to cure its over-leveraged balance sheet by cutting its dividend rate sparked fears that many others would follow suit. Ironically, Kinder’s shares actually traded higher after cutting its dividend, suggesting even this surprising corporate action was already overly discounted in its trading price.
This week, the Teekay entities chose a similar course of action (NYSE: TK, NYSE: TGP, NYSE: TOO), though this decision did not appear to be driven by any near-term credit or capital concerns, but rather a defensive shift in the wake of continued market turmoil. These distribution policy shifts, representing only a handful of the 100+ names that make up the subsector, have caused market anxiety to spike even further.
However, energy commodity and equity market conditions are extreme today. We recognize that until market conditions begin to normalize, some midstream companies with otherwise resilient operating cash flows but with substantial capital spending plans may choose to cut their payout ratios to help fund these projects. Midstream companies that have plenty of capacity under their credit facilities will elect to use them, while others will seek alternative financing such as preferred issues, private equity JV financing, or seek to delay or slow down capital spending. Though, similar to the financial crisis period, we believe distribution payout adjustment will remain the exception rather than the rule, and that most of those who choose this option are likely to return to their previous policies as soon as practical.
Also, in the wake of these decisions, many midstream operators have taken the opportunity to communicate to the market that they have no intent or need to mimic this action. Additionally, approximately $3 billion of share buyback programs have been announced in recent quarters, a rare choice for this capital investment intense industry. In addition, insider buying has been spiking with recent Energy Transfer Equity (NYSE: ETE) purchases leading the pack.
While these reassurances have yet to help buoy the trading prices for the asset class, we believe they help to highlight how starkly market perception has deviated from underlying fundamentals, the outlooks of the manager’s that run these businesses, and the operational trends reported in recent quarters.
For example, volumes for natural gas, natural gas liquids, and refined products have all continued to grow throughout this period of turmoil for the commodity and energy financial markets. Further, while crude oil volumes have begun to show some decline, this decline has been relatively modest. Even more importantly, the operating performance for most midstream companies in recent quarters has remained stable as their majority fee or fee-like margins have remained stable.
Despite fears of mass midstream contract violations or restructurings, there remains little recent or historic precedence to suggest this is a reasonable fear. Rather, recent history provides examples supporting the strength of midstream contracts. For example, though Williams Partners (NYSE: WPZ) recently renegotiated some of its gathering agreements, the result was fairly neutral to the company; while Oneok Partners (NYSE: OKS) was actually able to increase the fee-based component of their margin through recent contract adjustments.
Kinder Morgan’s recent credit rating troubles also seemed to spark fears that midstream companies might not be able to access the fixed income markets. However, the credit markets have actually been quite resilient.
Since June 2015, when crude oil prices began to exhibit this latest round of weakness, the credit spread for investment-grade midstream companies has widened by 183 basis points, to a 378 basis-point spread,1 versus a 39 basis-point widening for the broader investment-grade universe.2 Though the widening of the midstream credit spread appears to reflect some energy market anxiety, on an absolute basis, borrowing rates remain very attractive and accommodative to capital funding. Further, only a handful of midstream operators have a material level of issues maturing over the next couple of years which, in total, represents just 9.0% of outstanding midstream investment-grade debt with Kinder Morgan issues representing over one-third of this total.
Perhaps also impacting midstream sector sentiment has been a more dramatic deterioration in the high yield market. From June 2015, the high yield spread for midstream companies has widened by 325 basis points, to a 623 basis-point spread on the 10-year Treasury,3 relative to a 278 basis-point widening for the broader high yield universe.4 A significant proportion of this relative spread weakness occurred over the last week as energy pricing took an additional leg down and news of liquidity concerns at a relatively small investment house caused market anxiety to spike.
Even so, spreads are well below those experienced over the financial crisis period and few midstream operators sit in a position that would require near-term access to the high yield market. Only a handful of high yield midstream issuers have material maturities over the next few years with the first maturities not until late 2016. In total, high yield maturities represent just 7.4% of midstream high yield debt and NGPL Pipeline Company (NGLPL) issues represent over one-third of this total. Notably, it was Kinder’s acquisition of additional NGPL ownership that appeared to spur Moody’s review of Kinder’s rating.
It appears the sector’s negative technical and momentum pressures stem from the crude oil price environment. Therefore, a firming or leveling of the crude oil price environment may be needed to improve midstream sentiment.
We also admit distribution policy shifts remain a potential for a limited number of companies. We routinely stress test the potential impact to company operating performance of underlying commodity market conditions to understand the risks inherent in the businesses in which we may seek to invest. However, stress testing management decision making is inherently much less precise. In times of capital market distress, we attempt to recognize those names that could choose to alter their distribution policy and determine the best course of action in light of this possibility. Notably, though the decision has often been to liquidate such a position, we do not believe this is always the best course of action. However, again, we believe the list of those who may make this shift remains very limited.
As we noted in Kinder Morgan and Oil Pricing vs. Fundamentals, though we believe near-term price changes are impossible to predict, the current level of oversupply is actually much more modest than what is commonly believed. We also remind investors that at the bottom of every market cycle ever, sentiment was at its lowest, the sell side the bleakest, and helpful catalysts completely out of sight. It also appears that short interest in the sector has surged in recent weeks suggesting even a modest improvement in sector sentiment could result in healthy short covering which, in itself, could aid the sentiment recovery cycle.
In the meantime, we rest confident in our understanding of the fundamentals underlying our midstream investments. We feel encouraged that sector valuations rest near historic lows providing an opportunity for significant gains over time. We also remain steadfast in our belief that a recovery in energy and sector sentiment is only a matter of time.
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1 Based on the change in the yield difference between the Barclays Midstream Index and the Treasury benchmark between June 1, 2015 and December 11, 2015.↩
2 Based on the change in the yield difference between the Barclays U.S. Credit Index and the Treasury benchmark between June 1, 2015 and December 11, 2015.↩
3 Based on the change in the yield difference between the Barclays High Yield Midstream Index and the Treasury benchmark between June 1, 2015 and December 11, 2015.↩
4 Based on the change in the yield difference between the Barclays U.S. Corporate High Yield Index and the Treasury benchmark between June 1, 2015 and December 11, 2015.↩
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.
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