After a gut-wrenching 2020 in which bankruptcies, write-downs and historic losses consumed the oil and natural gas industry, the U.S. midstream sector is poised for a stable path to recovery in the year ahead, according to experts.
Several key themes this year could shape the return to normal, including the pace of economic reopenings/demand recovery amid the Covid-19 pandemic, the incoming Biden administration and the trajectory of commodity prices, analysts said.
The Permian Basin, where production has made a surprisingly swift turnaround despite ongoing uncertainties related to the virus, is viewed as the place to be for midstreamers. However, other producing areas could also fare well for some companies.
“Midstream cash flows, and especially volume exposures, have the reputation of being a ‘black box’ given the players’ large portfolios of discrete, diverse and infrequently disclosed contracts and counterparties,” said analysts with Raymond James & Associates Inc.
Head In Sand?
The Raymond James research team, led by J.R. Weston and Justin Jenkins, said there was “real concern” among investors exiting the 3Q2020 earnings season that the industry was taking the “ostrich position” of pointing to completions expected to take place in the fourth quarter of 2020 and in 2021. The real issue, they said, is a perceived inventory depletion headwind looming in 2022 unless drilling activity picks up in every basin other than the Permian.
“Since then, West Texas Intermediate prices have moved up essentially $10/bbl, and we’ve seen steady rig additions, albeit mostly in the Permian,” the Raymond James team said.
Associated gas production from the Permian has made a remarkable comeback from summertime lows. RBN Energy LLC data point to output of 11.5-12.0 Bcf/d, which is on par with year-ago levels. Looking at 2020 overall, associated gas from the Permian, which is responsible for almost half of all the associated gas from the Lower 48, did not decline over the year and actually grew by a fraction of 1%.That occurred even as Permian crude production declined by 11%, RBN said.
Other producing regions have seen more modest improvements. The Midcontinent, Rockies and Bakken Shale saw substantial rig declines in 2020. Still, some midstream companies in the Denver-Julesburg Basin have seen rigs return over the last few months, according to Raymond James.
Analysts said the Bakken “drives the most debate among investors, though activity has stabilized over the past month. “Winter weather is a real factor, and we would not be surprised to see rigs come off soon.”
Meanwhile, Northeast gas declines were “relatively modest,” and some midstream companies have reported increased rig activity in recent months.
Nevertheless, production growth projections have tempered over the past year. For example, RBN expects Permian gas production to exit 2021 at around 12.5 Bcf/d and to grow to around 13.0 Bcf/d in 2022.
“The rig count is less than half of what it was,” said RBN analyst Jason Ferguson. “Producers are not outspending, and the historical relationship of how many wells will be drilled at this price has changed.”
Long before the pandemic decimated energy demand, production outlooks across several U.S. basins were much rosier. This prompted a “pipeline building frenzy” in oil, natural gas and natural gas liquids and “fierce competition for throughput commitments,” according to RBN. With many projects now online, and a few more wrapping up construction over the next few months, “there just aren’t enough barrels (or cubic feet) to go around.
“The market impact in these situations is always the same: a dog fight between new pipes and legacy pipes to fill throughput space,” RBN CEO Rusty Braziel said. “Prices on the receipt end get bid up, prices on the delivery end get pushed down so the price differential from receipt to delivery gets crushed, often to a level less than the pipeline’s transportation fees.”
Ferguson said pipelines in the Midcontinent already have seen an impact from the in-service of Kinder Morgan Inc.’s Gulf Coast Express and Permian Highway Pipeline systems, which each move gas from the Permian to Gulf Coast markets.
Flows moving from West Texas north have declined to under 1 Bcf/d, from around 1.8 Bcf/d, and could fall further. Once the Targa Resources Corp.-backed Whistler Pipeline Project, another Permian system, comes into service as expected this summer, there could be a price signal that pipelines in the Midcontinent should reverse.
“Whistler just adds to the competition among pipelines,” Ferguson said.
Pipelines with minimum volume commitments (MVC) can hold on to throughput, according to RBN, since shippers have to pay for the space whether they use it or not. Pipes without sufficient MVCs, however, are faced with declining volumes, “or the need to radically reduce their rates to retain volumes on their systems.”
Covid-19 is still running rampant in the United States and around the world, which causes uncertainty, according to a Morgan Stanley Research team led by equity analysts Stephen Byrd and Devin McDermott. The rate of recovery in the energy industry remains “tightly intertwined” with restrictive measures in response to the virus, the progress of vaccine distribution and additional stimulus legislation by the incoming Biden administration in the interim.
Several U.S. states are considering new limits on activity as the number of people infected with the virus continues to grow. California, North Carolina and Ohio are under some sort of stay-at-home order or curfew, and overseas, some European countries also have reimposed lockdown restrictions.
Meanwhile, vaccinations in the United States have occurred slowly, far short of the 20 million people who were expected to have gotten the shot by the end of 2020.
Rystad Energy expects that vaccine campaigns may fuel a rapid recovery going forward. The research firm expects monthly supply deficits to begin as early as May.
As for additional stimulus, a $2.3 trillion omnibus spending and coronavirus relief package that included a $600 stimulus check passed by the House and Senate was signed into law by President Trump last month.
FCF In Focus
The Morgan Stanley analysts view the transition to positive free cash flow (FCF) as a “critically important pivot” for the midstream sector.
However, some investors believe capital discipline to be “ephemeral” as either improvement in fundamentals creates new opportunities for capital deployment or earnings degradation “challenges the resolve to hold the line on new spending.”
Still, the midstream industry as a whole can still find a path forward, the Morgan Stanley team said, through a more direct focus on carbon intensity reduction and disciplined FCF-focused strategies.
“Considerable” debate exists around the timeline and extent to which the global energy economy might transition away from hydrocarbons to renewable sources. However, Morgan Stanley researchers said “the burden of proof effectively now resides with the companies themselves” and other industry participants to establish the longevity of hydrocarbon demand.
“Incorporating renewable alternatives with existing midstream assets (and an expected time frame for viability and scale) could help to extend investors’ useful life assumptions for midstream assets,” the Morgan Stanley analysts said. However, the midstream sector should adopt “a more patient approach” to capital deployment.
PwC’s research team said the oil and gas industry needs to find ways to “consistently” generate FCF, “and do so at $30/bbl, the most-recent low point in the cycle.” This would enable oil and gas companies to deliver the type of results analysts believe are required to attract value investors.
Alerian analysts agreed that FCF generation could help further strengthen balance sheets or lead to more buybacks, which in turn could drive capital appreciation. The independent index provider also said above-average yields backed up by “stable, fee-based cash flows present an opportunity for income-seeking investors with treasury still near all-time lows.”
Third quarter announcements saw five new buyback authorizations in the midstream space, bringing the total to 14, according to the firm.
Alerian also noted that in the wake of macro headwinds and elevated yields, dividend growth has already been widely suspended in the midstream sector, with only a few notable exceptions. For companies generating meaningful FCF with “comfortable” leverage positions, the firm indicated that buybacks would likely represent a more compelling way to return cash to shareholders until equity values improve and yields return closer to historical averages.
“For midstream investors, the proliferation of buyback programs is a welcome development and provides tangible benefits of the anticipated FCF inflection in the space,” Alerian Director of Research Stacey Morris said. “Buybacks represent a significant reversal from the old master limited partnership model of issuing equity. Importantly, buybacks can help support midstream equity prices into a macro recovery, which is self-help that was not available coming out of past energy downturns.”
Meanwhile, sweeping legislative changes under the incoming Biden administration may be in the cards after the Senate runoff elections in Georgia. Democrats are taking control of the Senate and have gained control of Congress and the White House for the first time since 2011.
President-Elect Biden has vowed to stop awarding new drilling permits on federal property. ClearView Energy Partners LLC analysts said new projects would likely face broader environmental reviews under a Biden administration that would explicitly consider upstream and downstream greenhouse gas emissions. Other hurdles also could be added, but the ClearView team said although longer environmental reviews represent regulatory risk on the front end, “approvals that survive a more robust process may have lower risk of reversal on judicial review (the back end).”
Meanwhile, the Federal Energy Regulatory Commission has a good track record when it comes to legal challenges under the Natural Gas Act and the National Environmental Policy Act (NEPA). Work stoppages on natural gas and liquids lines construction have occurred when the courts vacated permits issued by other federal agencies, ClearView analysts said.
However, the new administration could use pending legal challenges to rescind and revise the NEPA reform package that went into effect in September. The Trump administration published the final reforms to the Nationwide Permit (NWP) program in the Federal Register on Wednesday, but they may not last, according to ClearView.
“Either way, we think the Biden administration would have an opportunity to revisit the reforms,” ClearView analysts said, but a new rule in effect might slow down the issuance of new permits.
Morgan Stanley analysts expect “an even more onerous approval process” for new interstate pipelines and export terminals under the new Biden administration. Such a backdrop could limit new growth projects for midstream companies. Assuming U.S. production resumes growth, this could result in infrastructure constraints over time, “although significant excess pipeline capacity exists in most key oil basins today.”
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