- With the onset of the COVID-19 pandemic, U.S. midstream stocks experienced a precipitous fall followed by a tremendous rally through June 2021 and choppy trading since.
- The pathway to U.S. oil production approaching pre-pandemic levels is through increasing drilling activity, and with crude oil futures currently discounting roughly $65 per barrel over the next two years, we believe economic returns will be sufficient enough to expect a continued expansion of the number of rigs drilling.
- At the end of August, U.S. midstream stocks were down less than 10% on a total return basis from pre-pandemic levels; an improved yet underappreciated midstream business model coupled with increased drilling activity driving increasing U.S. production leaves the sector with a favorable risk/reward proposition today.
Entering 2020, expectations were high for U.S. midstream stocks. Private equity transactions of midstream assets in 2019 portended higher cash flow multiples for publicly traded midstream companies in 2020. U.S. production of crude oil, natural gas and natural gas liquids was expected to rise — driving cash flow growth for midstream companies.
Then COVID-19 hit. The Alerian MLP Index (AMZ) rose 5% during the first two weeks of 2020 — and, in a breathless collapse, fell almost 70% in the following eight weeks before making a bottom on March 18, 2020. Oil prices fell from roughly $60 per barrel to well below $15 per barrel. Natural gas prices fell from more than $2.00 per metric million British thermal unit (MMBtu) to below $1.50 per MMBtu. The number of rigs drilling for crude oil and natural gas collapsed from 805 at the end of 2019 to 244 by August 2020. This quickly led to U.S. oil production falling almost 20% in six months (with less severe declines for natural gas and natural gas liquids). Finally, almost half of the publicly traded midstream sector cut their dividend/distribution to investors by an average of 49%.
With the realization that the pandemic’s impacts on the midstream sector were severe rather than catastrophic, the sector rebounded off the March 2020 lows — gaining 148% on a total return basis by early June 2021. Yet, the sector was still down more than 20% off its pre-pandemic levels. For a fuller recovery to ensue, the sector needed more visibility on the trajectory of the global economic recovery (in other words, the recovery in global oil demand driving a rebound in global oil production). At this point, such visibility was not there.
Exhibit 1: U.S. Midstream Performance
The Evolved Midstream Business Model Is Still Underappreciated
Until four years ago, the midstream/MLP business model was to effectively pay out operating cash flows to investors in the form of dividends/distributions. Any growth projects — buying an existing asset or building one — required access to both the equity and debt capital markets. Cash flows from the acquired or newly built asset supported roughly 10% annual growth in dividends/distributions for the sector.
This business model worked until early 2016, when oil prices and midstream stocks collapsed. The decline in stock prices for midstream companies left them with effectively no access to the equity capital markets. To complete growth projects already in various stages of completion, many midstream companies were forced to finance them with only debt capital. As a result, midstream stocks became overleveraged. In an effort to improve balance sheet leverage ratios, many midstream companies reduced dividends/distributions.
This painful, but necessary, exercise moved most midstream management teams to limit dividend/distribution growth rates — allowing coverage ratios to rise. The flexibility afforded by excess cash flows after dividends/distributions reduced the need for midstream companies to issue equity to finance growth projects. Yet, midstream companies in aggregate still did not truly generate free cash flows (defined as operating cash flow minus capital expenditures minus dividends/distributions). The sector no longer needed access to equity capital markets but still required access to the debt capital markets to finance growth projects.
Following 2016, most midstream companies that were structured as MLPs announced transactions to eliminate incentive distribution rights (IDRs) paid to general partners. These transactions increased available cash flows to limited partners and reduced the cost of equity for these companies.
"The sector will be free cash flow positive after dividends and distributions in 2021 for the first time."
The COVID-19 pandemic has forced midstream companies to complete their business model transformation to generating free cash flow after dividends/distributions. Some midstream companies chose to reduce dividends/distributions. Others reduced capital spending. Others did both. Again, while painful like in 2016, this final transformation leaves midstream companies in unchartered waters. The sector will be free cash flow positive after dividends and distributions in 2021 for the first time. This true free cash flow yield will likely widen in 2022 and 2023. Midstream companies won’t need access to equity capital markets, nor to debt capital markets, to finance capital projects. They will also have excess cash flow after dividends and distributions. Midstream management teams will now be able to naturally deleverage balance sheets, buy back stock and increase dividends and distributions.
Admittedly, most midstream companies had this evolved business model forced upon them, first by the oil price collapse of 2015–16, and, second, by the COVID-19 pandemic. Nonetheless, this new business model is now entrenched in the sector and should lead to a more sound and less volatile environment for midstream companies going forward.
Significant Improvement in Midstream Financial Metrics
The evolved business model has driven meaningful improvements in relevant midstream financial metrics. Free cash flow yield (after capital spending and dividend/distributions) should approach 5% in 2023 after perpetually being negative in years past — driving increasing share buybacks, balance sheet deleveraging and dividend/distribution increases. Dividend/distribution coverage should be in excess of 2x going forward after consistently sitting in the 1.1x–1.2x range in the past. This should greatly insulate midstream companies from being forced to reduce payouts to investors in the event of an unexpected downturn in business fundamentals. Balance sheet improvements have also been notable with debt/EBITDA ratios expected to finish 2022 below 3.5x, after averaging nearly 5.0x before the business model evolution. One offset to this more stable and durable business model is slower dividend/distribution growth than in the past. The old business model drove dividend/distribution growth in excess of 10%. The new business model will likely lead to 2%–4% annualized dividend/distribution growth for the sector.
Crude Oil and Natural Gas Demand Trends
After reaching an all-time high of 100.9 million barrels per day during the fourth quarter of 2019, global oil demand plummeted with the onset of the COVID-19 pandemic. By the second quarter of 2020, global oil demand had fallen to 82.9 million barrels per day — an 18% decline from the
peak. This sudden decline in demand left the global oil market grossly oversupplied and oil prices fell from roughly $60 per barrel to below $20 per barrel in less than four months. With COVID-19 vaccine rollouts and the reopening of the global economy, global oil demand is expected to average roughly 96 million barrels per day in 2021 and approach previous peak demand in 2022.
U.S. natural gas demand also declined as the pandemic unfolded. However, it did not fall as precipitously as crude oil. Used less as a transportation fuel, U.S. natural gas demand fell roughly 2% in 2020 compared to 2019. Even so, U.S. natural gas prices still declined by roughly 25% from $2.00 per MMBtu to $1.50 per MMBtu in early 2020. As we look ahead, domestic natural gas consumption is expected to be down less than 1% in 2021 and roughly flat in 2022.
Drilling Rig Activity and Production Trends
Predictably, drilling rig activity collapsed with demand declines driving pricing declines for both crude oil and natural gas. The number of rigs drilling in the U.S. for crude oil fell by 75%, and natural gas directed rigs running fell by 45%. In total, the number of rigs drilling in the U.S. fell by 70% from peak to trough in 2020.
Drilling activity is typically a leading indicator of production trends and this instance proved no different. U.S. oil production fell from roughly 13 million barrels per day entering 2020 to 9.7 million
barrels per day in May 2020. Over the same period, U.S. natural gas production fell by roughly 10%. Importantly, the decline in U.S. energy production drove a decline in U.S. midstream cash flows (which ultimately accelerated the evolution of the midstream business model).
Since August 2020, U.S. drilling activity has increased meaningfully off the trough, but it still sits well below pre-pandemic levels. Total rigs running in the U.S. have more than doubled from 244 to 508 at the end of August 2021. This has driven a recovery in production that should continue into 2022. Over the past year, U.S. oil production has increased from 9.7 million barrels per day to 11.5 million barrels per day. Yet the 508 rigs drilling at the end of August is roughly 35% below pre-pandemic levels and U.S. oil production remains well off the 13 million barrel per day level seen before the pandemic.
Exhibit 2: U.S. Rig Count
The pathway to U.S. oil production approaching pre-pandemic levels is through increasing drilling activity. With crude oil futures currently discounting roughly $65 per barrel over the next two years, there should be sufficient economic returns to expect a continued increase in the number of rigs drilling. Yet, large publicly traded oil and gas producers have asserted they will not significantly increase drilling activity, even with crude oil and natural gas prices at current levels. Their stated modus operandi is to return free cash flow to investors rather than increase drilling activity. This is in direct contrast to previous cycles.
Perhaps contrarian, our view remains that if economic returns are there (and they are), capital will find its way to drilling more wells. Rig count acceleration may be slower than in prior cycles, but economic returns will drive capital toward increasing the number of wells drilled, in our view. This should result in a continued recovery in U.S. production volumes, which should drive growing cash flows for U.S. midstream companies in both 2022 and 2023. It is also important to note that a continued recovery in U.S. production volumes will come with little capital spending requirements on the part of midstream companies. The infrastructure systems are largely built out.
Exhibit 3: Total U.S. Energy Production Expected to Rebound in 2022
Recent U.S. Midstream Stock Performance
From the end of 2020 to mid-June, the Alerian MLP Index generated a total return of 57%. Over the ensuing two and a half months to the end of August, the Index was down 14%. In fairness, the Index was still up 35% year to date through August compared to the S&P 500 Index, up 22%, and the S&P 500 Energy Index, up 31%. Still, it is only natural to ask if the correction is a buying opportunity or a warning shot of worse to come. In our view, the answer to this question boils down to whether the Delta variant of COVID-19 briefly slows or stalls the global economic recovery from the pandemic.
"Perhaps contrarian, our view remains that if economic returns are there (and they are), capital will find its way to drilling more wells."
The recent correction in midstream stocks leaves the sector to the end of August trading roughly 7% below pre-pandemic levels on a total return basis. Interestingly, U.S. midstream debt trades at higher levels than before the pandemic with a midstream debt basket due in 2025 trading at 106 just before the pandemic and currently trading at 109. For reference, this midstream basket of bonds traded down to 78 in March 2020 before rebounding. From this perspective, it would appear the debt market has more confidence in the evolved midstream business model and fundamental outlook than the equity market.
Delta Variant: The Fly in the Ointment?
Our base case remains that global oil demand continues to recover to pre-pandemic levels during 2022 — driving the need for more oil supply on the global market. At present, oil prices continue to signal a need for continued increases in U.S. drilling activity to bring more oil onto the market. This, in turn, should increase throughputs across energy infrastructure systems in the U.S. — allowing growing cash flows to fully display the benefit of the evolved U.S. midstream business model.
Yet, the Delta variant certainly presents risks to the trajectory of the oil demand recovery not foreseen earlier in the summer. We continue to expect a full recovery in oil demand, but it remains possible the recovery does not fully occur in 2022 as we currently expect. If the Delta variant pauses or slows the demand recovery, the macro variables that have been tailwinds for midstream stocks will turn to headwinds.
Framing the Midstream Risk/Reward Proposition
The expected return of owning a midstream stock is a function of 1) cash flow multiple contraction or expansion; 2) current yield; 3) free cash flow yield after capital spending and dividends/distributions; and 4) the expected growth rate in dividends/distributions.
Let’s first look at the downside risk. If the Delta variant (or any other variant) stalls out the recovery in U.S. energy production (via lower demand driving lower prices and a stalled recovery in drilling activity), midstream cash flows would likely be flat in 2022 compared to 2021. This would drive negative revisions to expectations for EV/EBITDA multiples, expected free cash flow yields and expected dividend/distribution growth. We break down the components to understand the downside risk of owning midstream stocks in this negative scenario:
- EV/EBITDA multiple: Midstream stocks currently trade at an EV/EBITDA (cash flow) multiple of 8.5x. The sector traded at a 9.5x multiple prior to the pandemic and at a 6.5x multiple at the March 2020 trough. Even with a more stable and durable business model, we think it would be naïve to think the sector’s EV/EBITDA multiple would not contract in such an environment. With current dividends/distributions likely secure even in this negative scenario, and with improved balance sheet leverage compared to a year ago, we would not expect the sector to trade down to the 6.5x EV/EBITDA multiple it did in March 2020. Yet, a multiple contraction to 7.5x EV/EBITDA is certainly plausible in this negative scenario. This would drive downside in midstream stock prices of roughly -25% from end of August levels.
- Current yield: The midstream sectorcurrently trades at a current yield of roughly 8%.
- Free cash flow yield after capital spending and dividends/distributions: In this negative scenario, the sector would still generate excess cash flow. However, the free cash flow yield after capital spending and dividends/distributions would be 2% (as opposed to 3% in our base case).
- Dividend/distribution growth rate: With significant excess cash flow coverage beyond existing dividend/distribution levels, we would not expect reductions to dividends/distributions in this negative scenario. However, we would expect the growth rate in dividends/distributions to slow from 3% to 1%.
Downside risk: The -25% downside from multiple contraction would be partially offset by 8% current yield, 2% free cash yield and 1% dividend/distribution growth — presenting total downside risk of -14%.
The upside potential scenario sees a continued recovery in U.S. energy production driving a 7% increase in cash flows for midstream companies in 2022. This, in turn, will drive free cash flow expansion, balance sheet deleveraging, accelerating share buybacks and increases in
dividends/distributions. This remains our base case.
- EV/EBITDA multiple: With the improved midstream business model, we think it is certainly possible (if not conservative) to assume midstream stocks attain the same 9.5x EV/EBITDA multiple they traded at prior to the pandemic. If so, midstream stocks prices will appreciate by 22% to trade at a 9.5x multiple.
- Current yield: The midstream sector currently trades at a current yield of roughly 8%.
- Free cash flow yield after capital spending and dividends/distributions: After moving to positive for the first time ever in 2021, free cash flow yield after capital spending and dividends/distributions grows to 3% in 2022 and 5% in 2023.
- Dividend/distribution growth rate: In addition to share buybacks and balance sheet deleveraging, dividend/distribution growth rates should accelerate to roughly 3%.
Upside potential: The 22% upside from multiple expansion plus 8% current yield, plus 3% free cash yield, plus 3% dividend/distribution growth presents total upside potential from end of August levels of 36%.
In sum, we believe current conditions imply a -14%/+36% risk/reward proposition from present levels for the U.S. midstream sector, a proposition we find attractive.