In August 2014, the Alerian MLP Index hit an all-time high of 540, a near quadruple from the previous bear market bottom. Since then, the North American oil and gas midstream company average has dropped more than 75 percent.
This year, the Alerian touched a mid-March low of 62, almost 90 percent below the August 2014 high. And despite more than doubling since, it’s still roughly 25 percent below its 2008 nadir.
Along the way, the North American midstream sector has suffered literally hundreds of distribution cuts, as well as bankruptcies and liquidation sales. And the once ultra popular master limited partnership model of distributing maximum income has fallen into disrepute.
Midstream’s challenges have been myriad. Oil prices’ drop from over $100 a barrel in mid-2014 dispelled the myth the sector was immune from volatility in energy prices. That lesson has been rammed home again this year, as oil and gas producers have cut production and pressured midstream volumes.
This week brought yet another blow. After a series of rulings rejecting federal permits for new pipelines, the US District Court for D.C. actually threw out one for an already operating one. The result: An order to immediately shut down the $3.8 billion Dakota Access Pipeline, which transports oil from the Bakken shale of the upper Midwest.
Lead owner Energy Transfer LP (ET) is filing for a stay of the decision. And the Trump Administration is likely to join its appeal. But if those efforts are unsuccessful, the company will have no choice but to wait for the results of what’s likely to be a 13-month environmental review.
Shutdowns of malfunctioning infrastructure are commonplace. But this is the first time a court has ordered a relatively new pipeline to cease operations, on the grounds a permit was improperly issued. And that’s understandably causing many investors to reassess sector risks.
Oil first broke under $100 a barrel back in mid-2014. Since then, Energy and Income Advisor has advocated “high grading” energy portfolios. That is, focusing on the handful of companies most likely to weather a “lower for longer” energy price environment, and dumping everything else.
That’s still the most important advice we can give. And our EIA coverage universe of 200 or so companies recommends several times as many sells as buys.
But for those now tempted to abandon even the best in class, we advise taking a deep breath and standing pat, for the following reasons:
- The world hasn’t stopped using oil and natural gas, and pipelines are still the safest and most efficient way to get energy to businesses and consumers. Even with Covid-19 depressed demand, a cutback in associated gas from reduced oil output and an unprecedented build out of renewable energy, the US still produced 33 percent more natural gas in March 2020 than it did in January 2017. And by 2025, the U.S. Energy Information Administration’s middle case estimate is we’ll produce 8 percent more oil and 9 percent more gas.
- When midstream infrastructure is shut down and/or new construction abandoned, the value of capacity on existing pipelines rises, and so do asset prices. Warren Buffett may wish he’d waited a day or two for the DAPL decision before paying 10 times EBITDA for Dominion Energy’s (NYSE: D) pipeline assets. But the fact that Berkshire Hathaway (NYSE: BRK/B) offered that much is a pretty strong affirmation of the long-term worth of these assets.
- Even after six years of sector turmoil, there are still arguably far too many owners of energy midstream assets in the US. But the ranks of companies that matter have narrowed down to roughly 10 names. And these now face far less competition for both new projects and investor dollars, which means fatter returns in a recovery.
As we’ve said before, the key for investors isn’t the fate of one pipeline or another. It’s how positioned companies are to handle a setback at an asset they own or are building.
Last weekend, Dominion and Duke Energy (DUK) cancelled the Atlantic Coast Pipeline after years of regulatory delays and rising costs. The partners have warned they’ll be making hefty writeoffs against the Q2 earnings. But by and large, exiting the project will be relatively painless, as they redirect their CAPEX budgets into more profitable areas.
Energy Transfer has a weaker balance sheet. And the company faces revenue pressure elsewhere, including bankrupt Chesapeake Energy’s (CHKAQ) attempt to exit its capacity contract on the Tiger Pipeline.
This is also a test case for the Federal Energy Regulatory Commission’s authority to enforce energy contracts in Chapter 11 cases. That challenge was avoided in the PG&E Corp (PCG) bankruptcy, as the utility elected to honor its power purchase contracts despite the court’s claim of jurisdiction. But if Chesapeake challenges and FERC loses, pipeline companies will face new threats to contracts.
A long-term shutdown of DAPL would also have profound economic consequences for producers in the Bakken, as they’ll have to find enough space on more expensive railroads and trucks. It would be especially bad news for locally focused midstream companies like Oasis Midstream Partners (OMP), which is tied to nearly bankrupt Oasis Petroleum (OAS). And it would also create challenges for some larger players like ONEOK Inc (OKE).
On the other hand, closing DAPL will increase demand for space on Kinder Morgan’s (KMI) Double H pipeline. And less Bakken oil getting to market will increase demand for output from places like the Permian Basin, with a commensurate benefit for its midstream companies.
Bottom line: Where there’s great danger, there’s also immense opportunity. The pipeline wars continue. But as investors, we win by focusing on the handful of companies that are best positioned to emerge from this shakeout.
All of them are historically cheap and ripe for purchase by patient long-term investors. Look for more in the upcoming issue of Energy and Income Advisor.