West Texas Intermediate (WTI) crude oil slipped into backwardation last year, a situation where volumes for future delivery trade at a lower price than the prevailing rate.
A market in backwardation implies that traders expect the price of crude oil to decline in coming months, an outlook that corresponds with surging crude-oil production from US shale oil and gas plays and refineries’ limited capacity to process light-sweet crude oil.
This disconnect has prompted Plains All American Pipeline LP (NYSE: PAA), a master limited partnership (MLP) that owns an extensive network of crude-oil pipelines and related midstream infrastructure, to forecast that the US eventually could face an oversupply of light-sweet crude oil. (See Blue-Chip MLPs’ Outlook for North American Energy Markets.)
What are the investment implications of a crude-oil market in backwardation?
MLPs that produce oil and gas usually hedge their output to varying degrees, locking in future cash flow and ensuring a higher level of visibility and confidence in their distributions.
With WTI futures trading at a discount to the front-month price, upstream operators that haven’t already hedged their output a year or two into the future could face lower price realizations in coming years.
And in Vanguard Natural Resources LLC’s (NSDQ: VNR) fourth-quarter earnings call, management indicated that the publicly traded partnership expected to focus on acquiring natural-gas assets.
This strategic shift, which actually began last year, reflects intense competition for oil-bearing properties that have inflated asset prices, especially in the Permian Basin. Meanwhile, although crude-oil output usually entails higher profit margins, backwardation in this market means that producers must hedge their output at lower prices.
In contrast, larger oil and gas companies continue to monetize their mature natural-gas assets to fund drilling programs in unconventional plays, ensuring that upstream MLPs have ample opportunity to acquire these properties at favorable prices. Even better, producers can hedge future natural-gas output at higher prices, providing a highly visible stream of cash flow.
For these reasons, we recently dropped an oil-focused name from our MLP Portfolio in exchange for a partnership that generates the majority of its distributable cash flow from its natural-gas output and stands to benefit from a number of drop-down transactions from its general partner.
Elliott and Roger on Mar. 20, 2018
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