The US Energy Renaissance has gone from “feel good” story to “mystery plot” in a short time. From an energy infrastructure investor’s perspective the outcome is puzzling as the narrative seems generally supportive for higher prices and yet positive money flows are scarce.
US energy production is increasing and it is projected to continue to grow at a moderate pace. The dislocation of 2015 has ushered in a new era of less friendly capital markets which forced domestic producers to refocus from pure production to profitability. The end game of this strategic change translates into rational productivity growth which should be supportive of less volatile commodity action.
Similar changes were also forced upon the midstream operators whose problem never was profitability but leverage and funding of growth. In a regime of less open capital markets, higher cash flow retention became a priority and more rationality in projects management also moved to the forefront. These dynamics had positive and negative effects; on the positive side, leverage has come down and more efficiency is seeping into the business model. On the negative side, distributions have suffered and in some cases growth rates were reduced or temporary outright cuts were implemented.
The resulting dynamic is a major shift in ownership of midstream assets where the traditional income investors are reducing their exposure and institutional buyers are taking their place. This is evident in large billion dollars direct pipeline purchases and midstream asset management deals recently done by Blackstone and Lovell Minnick. Unfortunately, the change of the guard is slower than anyone would like and midstream assets feel stranded in limbo. Yet a value proposition is clearly on the table: 7% yields growing generally at larger rates than inflation are hard to find and eventually will be arbitraged by the market.
Domestic production of oil, gas and related products is increasing, domestic demand is increasing and exports are increasing. This is not the picture of a disappearing industry; in fact, especially in relationship to natural gas (which represent 50% of midstream volumes) its symbiotic relationship with renewables (which we analyzed in earlier blogs) helps improving the chance that cleaner air targets are indeed met.
Value investing requires patience and this particular trade has certainly tested the patience of many investors; however, the fundamental picture has remained generally healthy. For example, in the case of some of the largest operators (EPD, MMP, KMI) operating cash flow and free cash flow per share is actually higher now that at the top of 2014. Not to mention that the last time Crude Oil traded at these levels, midstream assets were over 30% above current levels.