The structure of pipeline companies should help differentiate investments as lower oil prices are likely to prevail for some time.
A lot of the downward pressure on oil has emanated from COVID-19 concerns and how its global spread could affect growth around the world. With slower growth, demand for oil has slowed. Saudi Arabia, the core of OPEC, called for a meeting to talk about constraining supply in support of prices. However, Russia declined to participate. Saudi Arabia responded by increasing its own output targeting market share and resulting in lower prices and the squeezing of higher cost producers. The US shale industry has been eating into market share over time and lower oil prices will damage the industry and reduce its production in the medium term.
Shakeout and the Game of Chicken
Look for a prolonged period with oil under $40 a barrel that will attempt to shake out some of the higher cost shale players and increase the market share for the likes of Russia and the Saudis. Continued supply increases and resulting lower oil prices could also be designed to pressure Russia back to the table to agree on some new supply constraints. It looks like a question about who blinks first.
Impact on pipelines and infrastructure
When one looks at the US market, the midstream or the pipeline sector is really made up of two groups of companies. Corporatized entities (C-corps) and Master Limited Partnerships (MLPs). MLPs are particular to the U.S. and many carry direct commodity exposure. RARE invests in C-Corps only and does not invest in MLPs. Within the C-Corp opportunities, RARE screens out companies with direct commodity exposure; however there is a little bit of indirect oil price exposure that flows through into the companies over time. While both C-Corps and MLPs have been sold off more than the broader equity market, the MLPs are down a lot further. A lot of investors, particularly in the MLP space, are leveraged funds and so, a sell down like this unwinds the existing leverage and that adds to the selling.
C-corps vs. MLPs
C-corps run large pipeline complexes, a combination of liquids, oil, and what they call NGLs (non-gaseous liquids) and, separately, gas pipelines. They generally cross state borders, and so they are either regulated and or contracted under long term agreements often on a take-or-pay basis. These companies will have agreements in place with many underlying shippers and so the creditworthiness of these shippers must be considered in any analysis of revenue.
For the MLPs, a number of them take more direct commodity exposure via plants that process gas that comes out of the ground -- separating it into dry natural gas (sent down the pipelines), leaving NGLs that are sold separately and priced relative to the price of oil. Hence, as oil prices go down, the value of non-gaseous liquids goes down,. That's a core part of revenue for a lot of MLPs, which is why they fall a whole lot further than the C-corps.
So you can be relatively comfortable at the C-corps because you've got essential infrastructure, you've got 15 to 20 year contracts or regulation that underpin your revenues, and you've generally got high credit worthy counterparties against those revenue streams.
Indirect impact of Oil prices on C-corps
C-corps and MLPs all sit in the energy category of the market. However, for C-corps, the indirect impacts of a lower oil price are twofold; firstly, a concern around counterparty risk should some of the shippers (who are sometimes oil producers) experience financial difficulty and look to renegotiate contracts. RARE believes this risk to their C-corp holdings is not material. Secondly, future capex may be curtailed should North American producers reduce drilling activity and output in a prolonged lower oil price environment.
But for several MLPs, 20% to 50% of their business could be with lower credit quality counterparties. So, you're are at risk of having a significant portion of earnings get tied up in either bankruptcy protection or restructuring. In addition to the credit stress, a low oil price and a market that's out of balance may see some risk of stranded assets in the gathering networks should producers put new projects on hold.
Earnings and Multiples
When investors think about the valuation implications from direct and indirect exposure to oil prices, they can generally quantify the risk on the earnings, but it is more difficult to quantify the risk on the multiple other investors are willing to pay for those earnings. The price to earnings multiple is sensitive to earnings growth over time and as earnings growth reduces (and uncertainty increases), these companies and investors are seeing a hit from both sides, the earnings and the multiple.
What's interesting in all of this is the C-corps become very good value as they sell off, because they don't have the same earnings risk. In addition, if they are not investing capital in growth projects, there is more cash in the businesses to return to shareholders. Therefore, it is possible we see buybacks start to increase, particularly for the gas businesses in the US.
Indiscriminate selling, patience and opportunity
Broad picture, we do not see direct oil price or commodity price exposure to the revenues of the C-corps. However, we do see implications from investor sentiment, possible reduction of long-term growth projects and potential credit stress.
The market is going to put this sector in the penalty box for a period and therefore we’ll be very careful about where and when we increase exposure. We need to see some of this credit stress come through, and then we'll be able to add a bit of exposure to the portfolio where we feel the sell-off has been unwarranted.
A C corporation (or C-corp) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation.
Capital expenditures (Capex) , also called capital spending, is an amount spent by a company to acquire or upgrade productive assets (such as buildings, machinery and equipment, vehicles) in order to increase the capacity or efficiency of a company for more than one accounting period.
COVID-19 is the World Health Organization's official designation of the current coronavirus.
Credit stress refers, in this instance, to the impact of bankruptcy or restricting on the revenue-generating assets of the MLP.
Master limited partnership (MLP) is a limited partnership that is publicly traded on a securities exchange. It combines the tax benefits of a limited partnership with the liquidity of publicly traded securities in certain businesses; mostly pertaining to the use of natural resources, such as petroleum and natural gas extraction, transportation and some real estate enterprises (e.g. real estate investment trust). In practice, MLPs pay their investors through quarterly required distributions. Failure to pay the quarterly required distributions may constitute an event of default.
The Organization of the Petroleum Exporting Countries (OPEC) is a permanent intergovernmental organization of 12 oil-exporting developing nations that coordinates and unifies the petroleum policies of its member countries.
The price-to-earnings (P/E) ratio, also referred to as the earnings multiple, is a stock's (or index’s) price divided by its earnings per share (or index earnings).
Shale oil is an unconventional oil produced from oil shale rock fragments by pyrolysis, hydrogenation, or thermal dissolution.