Commentary: Energy MLP Strategy

• With better visibility on global demand impacts from rising interest rates, oil prices steadied and rose in July, August and September.
• Looking forward, the trajectory of oil prices over the next year or so will likely be dictated by demand factors — not supply.
• If global oil demand growth approaches oil economist estimates, we see upside in oil prices into 2024, continuing to drive visibility in U.S. oil production growth to the benefit of U.S. midstream companies.

Energy MLP stocks were a bright spot in a challenging third quarter for equity markets, with the Alerian MLP Index returning 9.89% as the S&P 500 Index declined 3.27%. Supply cuts from OPEC+ combined with lower U.S. inventories pushed oil prices higher, fueling further inflation and interest rate concerns — a headwind for broad equities, but a positive for energy stocks.

The dynamics affecting the MLP market remain unchanged. Global economies continue to face multiple headwinds, led by a combination of stubbornly high (though recently moderating) inflation, elevated geopolitical uncertainty and lingering supply chain and policy impacts from the COVID-19 pandemic. In the U.S., we have begun to see the dampening effects on the economy of tighter monetary conditions. During 2022, equity markets began pricing in a reasonable chance of recession, both in the U.S. and abroad. Thus far in 2023, global equity markets have recovered most of the losses incurred during 2022 and expectations are increasing that developed economies might avert a severe recession.

Crude oil prices fell from more than $120 per barrel in June 2022 to ~$70 per barrel to end June 2023. Recession fears left oil market traders fearful of global demand downdrafts for crude oil in 2023 much like those witnessed during the Global Financial Crisis (GFC). A stronger U.S. dollar and large-scale releases of crude oil from the U.S. Strategic Petroleum Reserve (SPR) further pressured oil prices. On the other hand, demand fear was partially offset by some optimism for a rebound in China consumption with the lifting of COVID-19 restrictions. The surprise OPEC+ supply cut of 1.1 million barrels per day at the end of March also likely puts a floor on oil prices over the near term. With better visibility on global demand impacts from rising interest rates, oil prices steadied and rose in July, August and September.

"What has been a meaningful source of supply in the crude oil markets will become a source of demand looking forward."

Essentially all of this oil demand growth is expected in developing nations, rather than OECD nations. We would argue that oil prices of roughly $70 per barrel at the end of June discounted that oil demand growth will not approach levels expected by oil economists in 2023 and 2024. Said differently, oil traders seem to expect a material contraction in global oil demand growth rates compared to oil economists. A final twist to oil demand analysis remains the timing of the U.S. refilling its vastly depleted SPR. After drawing down the SPR by roughly 275 million barrels (or ~45%) in the previous 18 months, the U.S. government announced in June initial plans to begin refilling the SPR beginning in September. Thus, what has been a meaningful source of supply in the crude oil markets will become a source of demand looking forward.

If global oil demand growth does approach roughly 2 million barrels per day in 2023 and another 1.0-1.5 million barrels per day in 2024, we see upside in oil prices over the balance of 2023 and into 2024. The supply side of the global oil market will meaningfully struggle to meet that kind of demand growth. We would also argue that the incremental barrel of oil supply in such a scenario will almost have to be a barrel of U.S. oil — continuing to drive visibility in U.S. oil production growth to the benefit of U.S. midstream companies.

Looking at natural gas, the short-term outlook is decidedly negative while the intermediate- to long-term outlook remains robust. An almost complete lack of typical weather last winter left natural gas storage levels 32% higher at the end of March 2023 than a year before. Higher storage levels entering the spring and summer also equates to lower natural gas demand to refill storage levels. As a result, U.S. natural gas prices fell from above $5 per mmbtu at the end of March 2022 to $2 per mmbtu at the end of March 2023. In our view, pricing for U.S. natural gas will not meaningfully recover until the beginning of winter (with an effective reset on storage levels).

With continued organic domestic demand growth and increasing demand for U.S. liquefied natural gas (LNG) in the international markets, the intermediate- to long-term outlook for U.S. natural gas prices and necessary production levels remains constructive for U.S. midstream companies.

Valuation for U.S. midstream companies remains well below the levels seen before the pandemic. Entering 2020, enterprise value to EBITDA (EV/EBITDA) multiples stood at roughly 10.5x. Despite the rebound the sector has experienced since the March 2020 lows, the sector today trades at 8.4x — despite what we view as a vastly better business model. Dividend/distribution coverage has moved from 1.1x to more than 2.0x. The sector has moved from being free cash flow negative to free cash flow positive (increasingly so in 2023) and balance sheet leverage (debt/EBITDA) has moved from more than 5.0x to below 3.5x. With no need for midstream companies to access capital markets for the foreseeable future, we increasingly expect excess cash flow (above and beyond capital spending and dividends/distributions) to be used for increasing share buybacks and further increasing dividends/distributions.

With improving financial metrics and continued low valuations, we still see solid upside potential for the U.S. midstream sector despite strong performance in 2022 and thus far in 2023.

The ClearBridge Energy MLP Strategy underperformed its Alerian MLP Index benchmark during the third quarter. In terms of absolute performance, all four subsectors in which the Strategy is invested made positive contributions, with the diversified energy infrastructure subsector contributing the most and the natural gas transportation & storage subsector the main laggard.

On a relative basis, the Strategy underperformed due primarily to stock selection effects. In particular, stock selection in the liquids transportation & storage and natural gas transportation & storage subsectors detracted.

In terms of individual holdings, Energy Transfer LP, Targa Resources, Plains All American Pipeline LP, Cheniere Energy Partners LP and Magellan Midstream Partners LP were the main contributors. The main individual detractors were Enbridge, TC Energy, Kinder Morgan, Hess Midstream LP and Equitrans Midstream.

During the quarter holding Magellan Midstream Partners LP was acquired by holding ONEOK.