North American energy producers are fighting back and winning, the war against OPEC. The pressure on OPEC countries continued to build until the point they ultimately decided to cut production by 1.2m barrels. The result of this capitulation by OPEC was oil prices soaring and maintaining a level in the mid $50s. As oil prices moved up, North American E&P companies have added over 400 drilling rigs, with more being added each week. This rebirth of the North American Shale Boom is releasing a wave of new production that flows th rough MLP pipelines on the way to end-users. Not only are the producers getting back to work, but a wave of new projects are being developed by MLPs to support further production growth. MLPs remain an attractive investment for many reasons including; improving underlying energy fundamentals, valuation metrics towards historical lows, cash flow that is rising, and volume growth in the coming years. MLPs with assets in the low-cost basins such as the Permian and Marcellus will benefit from rapid volume, and cash flow growth as producers focus on those locations. Another tailwind for MLPs is the expected completion of up to seven world-class petrochemical facilities that will significantly boost demand for ethane and propane. After a tough two and a half years in the energy markets, it is certainly a welcome development to have tailwinds at the back of MLPs once again.
MLP Q1 Update
MLPs continue to bounce back as underlying energy fundamentals improve. The Alerian MLP Index returned 4.8% in the first quarter. At several MLP conferences we have attended this year, sentiment was quite optimistic versus a year ago. MLP management teams have been encouraged by recent energy stability, recent sector financings at low discounts and several large projects have received go-ahead. MLPs continue to trade at significant discounts to historical valuations. Midstream MLPs now yield 7.3% (median) and trade at an estimated 2018 Price/DCF and EV/EBITDA multiples of 11.0x and 11.6x. This compares to 5yr averages of 6.5%, 13.5x, and 13.4 x, respectively. Not only are MLPs trading at cheap valuations, but they are re-entering a phase of distribution growth. These discounts offer a compelling investment opportunity for the long-term investor.
The U.S. continues to transform into a major energy export player in world markets as excess products are sold into world markets. MLPs invested tens of billions to support the export effort. Companies with marine dock facilities or pipelines leading to export facilities are positioned well as we expect exports to continue to grow rapidly. Mexico continues to pipe in an increasing amount of gas exports from the U.S for power generation and industrial use. I have been told that all the pipelines going into Mexico will be deep enough to avoid any potential border wall. U.S gas exports to Mexico are critical because Mexico has no domestic gas storage, and their domestic production has been declining for years. This production decline creates a large and growing demand for U.S gas.
Speaking of Mexico, the Trump Administrations goal of energy independence and the efforts to cut certain regulations will be beneficial to MLPs as energy infrastructure demand grows. Trump’s support of energy infrastructure was highlighted on his second day in office when he signed an executive order expediting the Dakota Access and Keystone XL pipelines. Members of OPEC stayed true to crude oil production cuts and will likely extend the cuts for another six months as global oil inventories rebalance. The production cuts have pushed oil prices into the mid-$50s which have led to a significant increase in the drilling rig count. The increase in rig count is a leading indicator for future volume growth in pipelines. One theme that continues to strengthen is identifying opportunities in low-cost shale basins.
“People just don’t seem to realize how big the Permian is. It will eventually pass the Ghawar field in Saudi Arabia, and that is the biggest in the world”. – Scott Sheffield, founder of Pioneer Resources
Production of crude oil in the Permian Basin continues to defy expectations. It was the only shale basin that continued to grow production during the oil price crash. The Permian currently produces a little over 2 million barrels per day of crude oil (Mb/d). Analysts are confident that the Permian will double production to over 4 Mb/d by 2020. Many analysts project production will double again by 2025. Much of this production is possible due to efficiency gains due to technological developments in drilling techniques. According to the Energy Information Agency, in March 2012, the typical Permian well was producing approximately 102 barrels of crude per day. In March 2017, that number increased to 660 bbl/d or an increase of nearly 550%. M&A is extremely active in the Permian with nearly $20B worth of deals completed in 2016. Several MLPs participated in the Permian deals. Sunoco Logistics, Targa Resources, and Plains All American all acquired private companies with core Permian assets. The companies paid a premium as they project the new assets being synergistic with their existing Permian assets and expect the price paid ultimately to look cheap in the coming years.
All this new production creates a significant need for new infrastructure investment. Figure 1 illustrates the need for pipeline takeaway capacity in the coming years. When producing crude oil, you typically produce byproducts such as natural gas and natural gas liquids. The significant production of all three hydrocarbons has created substantial investment opportunities for MLPs that operate in the basin. One surprise of the Permian has been the amount of natural gas it produces. The Permian produces approximately 8 billion cubic feet per day (Bcf/d) which compares to the Marcellus at 19 Bcf/d. Several MLPs are developing projects to provide additional takeaway capacity from the basin. In fact today, April 10th, Enterprise Products announced a massive project that will carry as much as 600,000 barrels per day of natural gas liquids from the Permian to the Gulf Coast. As recently as eight months ago, analysts and even MLP management teams were worried about potential overbuild of pipelines in the Permian. New analysis suggests that the Permian could be experiencing a shortfall in takeaway capacity as soon as the end of 2018.
Figure 2 illustrates how many barrels per day existing pipelines can move out of the region, which totals roughly 2.2mb/d. With the expansions underway, takeaway capacity will be nearly 3mb/d by year end. Some other regions we are focused on are the SCOOP/STACK formation in Oklahoma. It’s early in the development of the SCOOP/STACK play, but initial production rates have been comparable to some areas of the Permian. The Marcellus Shale in Pennsylvania continues to grow. The only thing that is currently slowing Marcellus growth is the lack of pipeline takeaway capacity. There are several pipeline projects currently being developed or proposed to solve the problem, but many are facing delays. It’s much easier to build a pipeline in Texas than the Northeast. As pipelines are completed in the Northeast, we expect the Marcellus to see a step-up in production to fill up the new pipelines.
Almost all the question marks that have weighed on MLPs over the past twenty-four months have been answered. Fundamentals have improved markedly and suggest growth is coming. Volumes are increasing, crude and gas prices are steady, and new projects are coming online. For the first time in at least eight years, politics are not a headwind. Abundant, cheap natural gas supplies in the Marcellus shale have attracted opportunistic manufacturers to move within our borders as new petrochemical plants come online. We have seen OPEC comply with their production cut, and in some cases, members even cut more than they agreed to. Investors do not often come across a sector with solid current and future fundamentals that is significantly undervalued to historical averages. MLPs, though, are exactly that. While of course not without risk, it seems there are currently far more reasons to invest than not to invest in MLPs.
David DeWitt Bob Milnes