Rebalancing Supply and Demand
Earlier this year we penned a paper titled, MLP’s: What the Market May Be Missing. At the time, midstream energy infrastructure MLPs were radically out of favor. Oil prices were still mired in a protracted correction that began in late 2014 when it became apparent the surprising pace of U.S. shale production growth had pushed the crude markets into a state of oversupply. The result was an oil glut that led to plummeting prices. We argued that there was a significant disconnect between market perception of midstream MLPs and the volume of energy that drives their revenues. Furthermore, while the recent MLP price decline is more extreme than 2008, the duration of peak to trough appears to be similar.
The market bottomed a mere 10 days following the release of the report and the asset class has subsequently rallied more than 55%. Today the market has begun to regain its footing as the global energy markets are in the process of rebalancing supply and demand. The collapse in price has now led to modest U.S. crude oil production declines which, in association with overseas conflicts and Canadian wildfires, have helped alleviate the oversupply and incentivized demand growth. In fact, the U.S. Energy Information Agency projects that supply and demand will reach a balance during the second half of 2016.1
We believe the North American basin will play a critical role in meeting incremental global demand going forward and will provide for a sustained period of rising U.S. production that could equal or exceed the production growth achieved over the past five years. Since the beginning of the energy renaissance, North American producers have meaningfully improved their drilling technology and economics. The resumption of U.S.-sourced production will enable midstream business and distribution growth prospects to regain greater visibility as midstream assets are a “must-run” link in the energy chain. While we certainly cannot guarantee any outcome, we believe a return to historic yields and multiples is a possibility as growth reemerges.
Midstream Fundamentals and Contracts Prove Resilient
First-quarter operating performance was, on average, modestly better than expectations. 32 companies announced distribution increases, 44 left distributions unchanged from the fourth quarter, and five announced distribution reductions. Although the sanctity of midstream contracts has been questioned over this correction, there have been very few instances where contract violation or restructuring has significantly impacted a midstream provider.
Capital Markets Show Signs of Normalization
Many sector participants encountered limitations accessing the traditional equity and debt capital markets during this downcycle. Because of this, some management teams chose to lower their distribution payouts to meet capital expenditure requirements or to simply relieve balance sheet stress. However, most have chosen alternative means to address their capital needs. In recent weeks, we have seen many signs that the traditional equity capital markets have begun to reopen.
The Terrain Ahead
We believe we have seen the worst of this energy market downcycle. The rate of midstream growth will likely moderate from peak levels, but average distributions are still likely to grow. Midstream operators also stand to benefit as they make more efficient use of their existing assets. The potential for business growth going forward is not reflected in current market valuations. For this reason, we believe MLPs continue to offer attractive total return potential based on the potential for price appreciation and stable or growing distribution streams.
For a deeper dive into our views, read Assessing the Terrain Ahead for Midstream and MLPs and review our suite of MLP products.
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1Source: International Energy Agency, Oil Market Report, June 14, 2016.
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.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
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.