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RBN Energy on Midstreams in 2021FYI Look Into the Future - The 2021 Outlook for Key Midstream-Sector PlayersWednesday, 12/02/2020Published by: Housley Carr
There’s no question, the pressures on many U.S. midstream companies have been steadily increasing for some time now, and the past few months have really tested them. Like exploration and production companies, refiners, and others in the energy space, midstreamers have seen their well-considered plans for 2020 upended by demand destruction, commodity-price gyrations, and cutbacks in capex, drilling, and production. While it may be tempting to simply wait out the last few weeks of this crazy, unforgettable year and hope that 2021 will be better, there’s actually at least some good news out there for the midstream sector, and good reason to believe that midstreamers have been positioning themselves to financially weather whatever next year may have in store. Today, we discuss highlights from East Daley Capital’s newly issued 2021 Midstream Guidance Outlook, which focuses on key trends affecting midstream asset owners. Each holiday season for four years now, our friends at East Daley have delved into the trends and developments they see affecting the broader midstream sector in the months ahead. In a series of reports, they also assess how the ongoing evolution of the energy industry is likely to help or hurt a couple of dozen or so representative companies, as well as which midstreamers it believes will perform better or worse than consensus expectations. The first glimpse we get is their just-release 2021 Midstream Guidance Outlook – Fight or Flight: Taking Stock of the Midstream,” which lays out their view of the key market drivers impacting midstream companies as the energy world prepares to transition from the COVID era to (fingers crossed) a long-lasting post-pandemic period. Then, over the next few weeks, we’ll see the latest edition of East Daley’s annual Dirty Little Secrets report, with Part 1 providing an even-more-detailed analysis of midstream and market fundamentals and Part 2 featuring very granular, company-by-company reviews. Last year’s report (see What I Like About You), focused on themes ranging from anticipated crude oil pipeline overbuilds and Permian production to the need for more natural gas supply rationalization as supply at the time was outpacing demand. The collapse of global economic activity and commodity prices earlier this year due to the COVID-19 pandemic exacerbated some of these issues and completely reversed others. As we head into 2021 — finally! — significant headwinds remain because lower production estimates portend reduced capacity utilization of infrastructure in many basins. We will discuss the negative effects of this excess capacity on midstream companies in upcoming installations, but today we’ll start by looking at some positive trends for the midstream sector amid challenging industry conditions. There are three primary themes in the new report:
We’ll discuss these one by one. Gains in Gas-Focused Production The pandemic and economic downturn lowered the long-term demand outlook for crude oil, but caused what appears to be only a temporary setback in demand for U.S.-sourced natural gas. While a number of LNG cargoes were cancelled earlier this year, temporarily reducing gas demand in the process (see Sultans of Swing for more), the story for U.S. gas demand growth is still largely intact and supported by inelastic demand from residential, commercial, and industrial users, as well as growing pipeline exports to Mexico and renewed growth in waterborne exports of LNG — a topic we covered recently in Extreme Ways. There’s a gas-sourcing issue, though. With oil prices still well below where they stood pre-coronavirus, drilling-and-completion activity in crude-focused plays from the Bakken to the Eagle Ford is down considerably, and lower production of oil means less associated gas. To incentivize more production from gas-focused plays like the Marcellus/Utica in Appalachia and the Haynesville in northern Louisiana, gas prices may face upward pressure. With the potential for higher gas production in these plays, some midstream companies with assets there — including Williams, MPLX, Antero Resources, and Western Midstream — may see material gains in their revenue and earnings. The Permian Exception Sure, the Permian is likely to experience lower-than-previously-expected production growth in crude oil, and now has far more oil pipeline capacity than it will need for at least a few years. The good news for midstreamers is that West Texas production of associated gas is likely to continue growing. In both the Midland and Delaware portions of the Permian, wells typically see their gas production decline (dashed and solid red type curves in Figure 1) more slowly than crude production (dashed and solid green lines). Over time, this means that the average gas-to-oil ratio (GOR) increases. Figure 1. Permian Well Type Curve Decline Behavior. Source: East Daley’s 2021 Midstream Guidance Outlook Also, the 4 Bcf/d of new gas-pipeline capacity to the Gulf Coast that will be coming online over the next few months in the form of the Permian Highway Pipeline (PHP) and Whistler Pipeline will continue to ease takeaway constraints that have long depressed West Texas gas prices. We’ve discussed many times in the RBN blogosphere the pressure that Permian producers have had to deal with when confronted with limited takeaway options and resultant gas price discounts, including in Don’t Dream It’s Over. [And for a detailed analysis of how this capacity will affect gas basis relationships across Texas for the next several years, check out our recently released Some Beach report.] With pipeline capacity available to access key markets and reduced basis discounts, Permian producers also may be incented to refocus their capex on areas that would previously have been considered too gassy — with higher GORs — and also to gather and sell more of the gas that may have previously been flared. All that suggests that, despite lower crude production forecasts, associated gas growth in the Permian will continue at a healthy pace over the next couple of years — to the point that it may yet even outstrip the capacity of existing gas processing plants in the play and lead to the development of new processing capacity. Focus on Free Cash Flow To reposition themselves for much leaner times, and to help renew investor interest, most midstream companies are now striving to fund all of their capital spending and distributions from their cash flow, and still have cash left over in both 2021 and 2022. (We discussed a similar effort in the upstream sector in The Bare Necessities.) The ability to fund capital expenditures from cash flow is in sharp contrast to the past decade, when midstreamers distributed almost all operating cash flow to equity holders and issued debt and/or more stock to fund massive capital spending programs. As for the cash they expect to have left over in each of the next two years, it can be used to pay down debt, finance additional projects, or be distributed to equity holders via additional distributions or stock buybacks. Free cash flow (FCF) is the cash that is still in hand after a company pays for its operating expenses and capex. Figure 2 plots a selected group of midstream companies’ average FCF to equity yield as a percentage (y axis) against the companies’ current leverage (x axis). The FCF/share-to-equity relationship is seen as providing a good proxy for the cash flow per share that could be captured by equity holders after all other obligations are paid — things like interest, taxes, and capex. Plotting average FCF-to-equity-yield against current leverage provides some useful insights in assessing equity valuations in the midstream sector. Figure 2. Average Free Cash Flow to Equity Yield (2020-24) and Current Leverage for Selected Midstreamers. Source: East Daley (Note: the report’s version shows all 27 midstreamers.) Take Energy Transfer (ET), which has the highest FCF-to-equity yield of all of the 27 midstream companies that the report analyzes, and also is among the most levered. A recent distribution cut by the company implies that it will reallocate cash flow to lower leverage. Or consider TC Energy (TRP), which has one of the lowest FCF-to-equity yields but is also highly levered. This would appear to be a concerning combination, until you see that these are made much less ominous by the safety of TRP’s massive footprint of highly regulated assets that face little competition. One more … look at Shell Midstream (SHLX): high average FCF-to-equity yield and relatively low leverage, and — as shown in Figure 3 below — Shell has one more thing going for it. (More on this in a moment.) Given the hard times that midstreamers have been facing — what with big shifts in supply, demand, and commodity pricing, as well as regulatory risks and potential headwinds from renewable energy — living within cash flow would appear to make a lot of sense. There’s a possible downside to that strategy though, namely that if a midstream company pulls back on capex it may not generate enough new cash flow to offset declining cash streams from its legacy assets. To assess the relative exposure of midstreamers to future declines in cash flows from their older pipelines, storage and other assets — exposure that might be tied to contract roll-offs, marketing risks, tariff rate cases and/or production declines in less-productive basins — East Daley developed (and regularly updates) what it calls a “Treadmill Incline Intensity” (TII) index. As with the treadmill at your gym — or, this year, the Peloton bike in your home office or basement — the steeper the incline, the tougher the challenge. The midstream companies toward the right end of Figure 3 may be in for a real workout over the next few years, with expected EBITDA declines from legacy assets in the 2020-24 period equal to more than 10%, 20%, or even 30% of their total 2020 EBITDA. In contrast, the half-dozen midstreamers at the left end of Figure 3 with negative TII scores would be expected have a much easier time of it on that front. (A negative TII score indicates that a company’s legacy assets are expected to generate a higher EBITDA over the forecast period, possibly due to expected rate increases or higher utilization of its assets.) Which brings us back to the Shell example introduced above. In addition to the company’s high average FCF-to-equity yield and relatively low leverage (shown in Figure 2), it has a rare negative TII score, which suggests that earnings from the company’s legacy assets are expected to increase over the next four years. Figure 3. Treadmill Incline Intensity Percentage, 2020-24. Source: East Daley’s 2021 Midstream Guidance Outlook All in all, despite this train-wreck of a year that we all are happy to see end, there are at least some positive trends at play and some midstreamers that will be able to capitalize. Good news for some prospective midstream investors includes a likely increase in natural gas prices leading to production gains in gas-focused basins and the Permian, which raises the prospect of higher regional utilization, notably of processing plants and gas pipelines in the Permian. And one more thing: though over the past couple of years, we have noted that investors have generally shown little affection for energy companies (see I Can’t Make You Love Me) — and for the midstream sector in particular — most midstream companies have finally adopted a much more disciplined approach to spending, one that should put them in a strong position for dealing with whatever lies ahead. For more information about East Daley’s newly issued 2021 Midstream Guidance Outlook, click here. |
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