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  • Roger S. Conrad

Issues

2018 Macro Outlook

At the outset of each year, the Energy & Income Advisor team reviews its big-picture calls from the previous 12 months and digests the lessons from our successes and failures. This self-reflection on what went wrong and what went right helps us to hone our investment strategy.

We also highlight our outlook for the coming year to set a basic framework that informs our positioning and helps to remove some of the emotion from the investment process. As always, none of our forecasts are set in stone; rather, these views necessarily will evolve as economic and market conditions change over time. In a dynamic market, what’s right at the outset of the year might no longer hold at the midway point.

Recent issues of Energy & Income Advisor have highlighted our outlook for energy stocks, master limited partnerships (MLP), and our International Portfolio. This time around, we’ll delve into four macro topics: the economy, the US equity market, crude-oil prices and natural-gas prices.

 

The Case for Energy Stocks

A year ago, we reasoned that energy stocks could outperform the broader stock market despite our projections for weak oil prices in the first half of the year. Our thesis hinged on our view that oil prices would average about $50 per barrel in 2017 and that many US shale players, especially early entrants in the Permian Basin and central Oklahoma’s STACK play, could earn strong returns on capital in this environment.

Although we were consistently negative on some large-cap master limited partnerships (MLP) last year—including Energy Transfer Partners LP (NYSE: ETP) and Plains All-American Pipeline LP (NYSE: PAA)—we expected select midstream operators to fare well in 2017. Our preferred names offered exposure to the Permian Basin and other areas where temporary dips in oil prices wouldn’t affect activity levels.

This bullish outlook proved to be our biggest miss a year ago: Energy was the second worst-performing sector in the S&P 500, and the Alerian MLP Index gave up 6.5 percent of its value. Few energy stocks avoided the carnage that engulfed the sector over the first eight months of 2017. Even high-quality upstream and midstream names like Concho Resources (NYSE: CXO), EOG Resources (NYSE: EOG) and Enterprise Products Partners LP (NYSE: EPD) found themselves caught up in the bloodbath.

However, it’s always darkest just before the dawn. We thought that this indiscriminate selloff resembled the classic, panic-driven plunges that tend to occur toward the end of the bear market and positioned the Focus List accordingly. Energy stocks have outperformed in the new year, but we remain bullish on the sector for four reasons.

Selectively Bullish on Master Limited Partnerships

Fundamentals for midstream MLPs generally appear bullish in 2018. Third-quarter earnings season underscored the extent to which the group has followed Enterprise Products Partners’ lead and sought to limit equity issuance to focus on self-funding growth opportunities.

At the same time, many MLPs have taken their medicine, slashing distributions and shoring up their balance sheets by monetizing noncore assets. This process hasn’t entirely run its course, with Energy Transfer Partners LP (NYSE: ETP) and others still leaning against the winds of change. Contract expirations and dilutive conversions of preferred units will also present challenges for some names in coming years. However, many partnerships have taken the necessary measures to put themselves on a sustainable path.

Besides the prospect of outsized production growth in the Permian Basin and STACK plays, our favorites should also benefit from supportive crude-oil prices and the highest gas-processing margins in years.

This issue of Energy & Income Advisor reviews the headwinds buffeting MLPs, the promise of the new year, trends in mergers and acquisitions, our top picks, pockets of underapprecated risk, and some under-the-radar opportunities. We’ve also updated most of the comments in our MLP Ratings table.

Positioning for the New Year after a Topsy-Turvy 2017

We maintain our bullish outlook for oil prices and cyclical energy stocks as 2017 winds down. Although we won’t hesitate to modify our views and positioning in response to incoming data points and developments, we expect 2018 to be less tumultuous for the energy sector, making the stocks easier to own and requiring less trading to deliver differentiated returns. Energy stocks could also benefit from the ongoing rotation into value-oriented sectors.

Second Time’s a Charm? The Case for Selective Exposure to Oil-Field Services

Heading into 2018, we like the setup for US-levered oil-field service stocks, though investors will need to remain selective and avoid the problem spots and value traps that lurk in this industry.

What’s changed over the intervening months?

Our outlook for oil prices is certainly more bullish than in late 2016 and early 2017, when we warned that the US production response would surprise to the upside and offset OPEC’s production cuts.

Although oil prices have rallied on several occasions over the past three years, we (rightly) regarded these upswings as ephemeral because the oil market remained in contango—that is, longer-dated futures commanded a premium to near-term contracts. This environment encourages market participants to store oil for future delivery and makes it easier for producers to hedge expected output.

In addition to improving investors sentiment, the recent strength in crude-oil prices should support solid capital spending among US exploration and production companies, many of which have taken advantage of the rally in WTI to lock higher prices on expected production.

Nevertheless, sentiment toward the industry remains cool, with investors erring on the side of caution and viewing the group as a show-me story—one of the big reasons oil-field service stocks hadn’t participated in the rally in crude-oil prices until recently. At these levels, the downside risk in many oil-field service names appears limited in the event that our investment thesis doesn’t work out.

 

Today, crude oil is in the early innings of a cyclical recovery. The market for Brent oil (an international benchmark) entered backwardation earlier this year, with front-month futures trading at a premium of $2.89 per barrel to volumes slated for delivery 12 months later. This structure discourages market participants from paying to store oil and indicates a tightening supply-demand balance.

 

Why Canadian Midstream Stocks Have Outperformed Master Limited Partnerships

In US dollar terms, the Solactive Canadian Midstream Oil & Gas Index has outperformed the Alerian MLP Index by more than 15 percentage points so far in 2017 and almost 25 percentage points since the energy down-cycle began in mid-2014.

Nine of the 10 Canadian midstream companies in our International Coverage Universe have increased their dividends at least twice since oil prices peaked in 2015. The lone exception, Kinder Morgan Canada (TSX: KML), completed its initial public offering on May 30, 2017.

Equally important, none of these names have cut their payouts since energy prices started to break down in mid-2014—a remarkable feat when you consider the pain that Canadian oil-field service companies and producers have suffered relative to their US peers.

Cross-border transportation constraints, coupled with surging US energy production, have ensured that Canadian upstream operators’ price realizations on crude oil, natural gas and natural gas liquids come at a significant discount to prominent benchmarks.

The group’s outperformance and steadily growing dividends stand in marked contrast to the turmoil afflicting US midstream master limited partnerships (MLP), where many prominent names such as Energy Transfer Partners LP (NYSE: ETP), Plains All-American Pipeline LP (NYSE: PAA) and Williams Partners LP (NYSE: WPZ) have slashed their distributions at least once.

All told, the 25 companies in the Alerian MLP Infrastructure Index have reduced their aggregate quarterly distribution by 14.5 percent from year-ago levels and almost one-third since early 2016. These payout cuts have reduced investors’ income streams and resulted in sharp selloffs in their stock holdings. Even Enterprise Products Partners LP (NYSE: EPD) and other higher-quality names have underperformed, suffering for the sins of their profligate counterparts.

We explore why Canadian midstream stocks have outperformed the Alerian MLP Index and the aspects of their business model that could provide a model for their counterparts south of the border.

 

MLPs: The Quest for Sustainability

With investor confidence in master limited partnerships (MLP) at low ebb, inflows to the group have slowed significantly, reducing the market’s capacity to absorb equity issuance. Many debt-constrained MLPs with higher yields have responded to this challenge by pursuing private placements of preferred units to finance growth projects or asset drop-downs.

A strong balance sheet and excess distribution coverage enabled Enterprise Products Partners LP (NYSE: EPD) to take a slightly different tack: reducing its rate of quarterly distribution increases to retain more cash flow.

With Enterprise Products Partners not getting credit for its consistent growth, management indicated that reducing the rate of distribution increases would put the MLP closer to being able to self-fund the equity portion of its growth capital in 2019—a major point of differentiation. Management asserted that any excess cash flow eventually could be used to buy back stock, depending on the valuation and how this option stacks up relative to other uses of capital.

This announcement from an industry bellwether raised questions about whether the traditional model of pushing the envelope on distribution growth while relying primarily on equity issuance to finance expansion opportunities still makes sense.

Given the pain of the past several years, a focus on building distribution coverage and improving leverage metrics should help to shore up confidence in the group. And any MLP that can grow its per-unit cash flow without leaning heavily on the equity market will have a distinct advantage as competition for volumes intensifies.

Enterprise Products Partners wasn’t necessarily the first MLP to go down this path—Magellan Midstream Partners LP (NYSE: MMP) hasn’t issued equity since 2010—but this announcement has changed the conversation this earnings season, with many partnerships tapping the breaks on distribution growth to build coverage and reduce the need to issue equity.

Thus far, third-quarter results suggest that most of our MLP Portfolio holdings will be able to make this transition with relative ease, though two names with tighter distribution coverage could face more of a slog.

International Energy Outperforms

We’ve completed our quarterly update to the ratings and comments in our International Coverage Universe. Key takeaways from this exercise include ongoing cost-cutting, deleveraging and consolidation in Canada. Meanwhile, natural-gas prices in Australia have soared, as the upsurge in exports has limited the supply available to the domestic market.

Against this backdrop, the names in our International Portfolio reported solid second-quarter results and affirmed or increased their guidance. All these stocks benefited from the US dollar’s weakness this summer.

The latter tailwind has made it a good year for our International Portfolio, with the conservative sleeve delivering an average total return of 12.6 percent and the aggressive sleeve up 0.5 percent. Over this period, the S&P 500 Energy Index gave up 8.8 percent of its value.

But solid fundamentals also contributed to these returns; all our conservative holdings increased their dividends at least once this year.

Power Plays

Recent improvements in global oil inventories and stronger-than-expected demand growth have bolstered oil prices—especially outside the US—and prompted value-focused investors to return to cyclical segments of the energy sector.

Meanwhile, the Energy Information Administration’s downward revisions to its outlook for US oil output and the decline in the oil-directed rig count have provided early indications that drilling and completion activity may obey the speed limits imposed by commodity prices.

Although these trends have lifted upstream-related energy stocks in recent weeks, the break-neck volatility of the past few years and the likelihood of shorter cycles in the energy sector argue for diversification into secular growth stories that depend less on commodity prices and timing your entry and exit points.

This approach has served us well over the years, with our exposure to that own renewable-energy capacity delivering particularly strong returns relative to the S&P 500 Energy Index over our extended holding periods.

To varying degrees, all the stocks that we highlighted in December 2014 that stood to benefit from lower oil prices also outperformed in a challenging tape. (See The Demand Side Beckons.)

We cashed out of Portfolio holdings Delta Air Lines (NYSE: DAL) and Royal Caribbean Cruises (Oslo: RCL, NYSE: RCL) for solid gains in November 2015, while anyone who followed our lead on Casey’s General Stores (NSDQ: CASY), Alimentation Couch-Tard (TSX: ATD/B, OTC: AQUNF) and Berry Global (NYSE: BERY) also fared well. (See Trimming Some of Our Hedges.)

With oil prices likely to range between $40 and $60 per barrel over the next few years, our playbook for late 2014 and early 2015 no longer holds the same appeal. At the same time, many of the renewable-energy companies in our Portfolios have rallied above our buy targets.

Fortunately, the ever-shifting energy landscape isn’t bereft of secular growth stories, including the specialized engineering and construction company and precision-power specialist highlighted in this issue.

Strategy Update

To say that 2017 has proved a challenging year for energy stocks would be an understatement.

The ebullience that reigned in the aftermath of OPEC’s November 2016 agreement with Russia and other major oil-producing countries has dissipated, thanks in part to the rapid recovery in US onshore drilling activity and output, persistently elevated inventories and oil prices that have slipped below $50 per barrel.

Upstream-related subsectors have borne the brunt of this pain, with the Bloomberg North American Independent E&P Index giving up almost 36 percent of its value this year and the Philadelphia Oil Service Sector Index plummeting 35 percent.

With WTI hovering around $45 per barrel, the market doesn’t appear to price in much risk that lower prices could lead to a moderation in onshore activity levels and production growth. As expected, the handful of upstream spending cuts announced during second-quarter earnings season primarily came from operators focused on marginal areas or burdened with strained balance sheets.

Meanwhile, the US oil-directed rig count also appears to have peaked and has started to trend lower, suggesting that upstream operators have responded to the decline in WTI and creating the potential for supply growth to moderate down the line.

Against this backdrop, we continue to favor midstream master limited partnerships (MLP) for their above-average yields and exposure to what we regard as a multiyear volumetric growth story where short-cycle US oil and gas production takes market share. In particular, basins that contain multiple hydrocarbon-bearing formations appear best-positioned for the long haul because of their superior economics.

Although our outlook for oil prices and the US energy patch favors an overweight position in core midstream holdings, nimble investors can generate alpha in upstream names by buying when oil prices retreat to the low end of their range and taking some profits off the table when they recover. Timing and stock selection—easier said than done with shorter cycle times—will be critical to producing differentiated returns.

We also continue to explore investment ideas related to energy efficiency, renewable energy and demand-side related opportunities, a process that we began with our recent issue on the petrochemical complex. Expect more in coming issues.

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    Elliott and Roger on Mar. 25, 2021

  • Portfolios & Ratings

    • Model Portfolios

      Balanced portfolios of energy stocks for aggressive and conservative investors.

    • Producers and Drillers

      Our take on more than 50 energy-related equities, from upstream to downstream and everything in between.

    • MLPs and Midstream

      Our assessment of every energy-related master limited partnership.

    • International Coverage

      Roger Conrad’s coverage of more than 70 dividend-paying energy names.

    Experts

    • Elliott H. Gue

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor

    • Roger S. Conrad

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor