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Since we began investing in and covering the MLP and midstream investment universe in 2020, we’ve remained bullish in anticipation of a structural oil supply shortage, as well as a continued infrastructure buildout necessary to facilitate the transition to renewables. Things have worked out well, with the Alerian MLP index up more than 50% over that timeframe.
We remain bullish long-term. We assume that global oil supply will be incapable of producing enough oil to satisfy demand at low prices and that U.S. shale will be called on to supply the marginal barrel. We therefore expect gathering and processing (G&P) companies to benefit, while also using a higher sustained “mid-cycle” oil price to value other energy equities. As for the natural gas infrastructure buildout, it would appear that legislative and regulatory roadblocks to natural gas infrastructure would limit growth opportunities for many midstream operators. However, we believe it is only a matter of time before more projects get the green light to forestall the economic devastation that would ensue in an energy-starved economy.
Still, unrestrained bullishness amid an asymptotic rise in oil prices is misplaced. We’re responsible for managing funds with an emphasis on income safety . To that end, we advise conservative investors who depend on income derived from midstream investments to exercise caution in today’s environment of spiking energy prices. Reducing Midstream Equity Risk
We constructed our HFI Research MLPs portfolio in a “barbell” fashion, split into two halves. We invested the first half in North American midstream stalwarts. These companies occupy central positions in North American midstream. We expect these companies to sustain high throughput and favorable financial results in any but the most adverse economic conditions.
We invested the other half of our portfolio in G&Ps with assets concentrated in the Permian. We believed that over the coming years, oil production outside the U.S. will be constrained and that the Permian will be the go-to for marginal supply. If so, G&Ps will be among the leading beneficiaries. Our G&P thesis has played out nicely, and we think our G&P holdings have a long runway for growth in free cash flow and distributions.
Recent events should give every energy investor pause. Energy investing involves the almost unimaginably complex marriage of countless macro factors with company-specific fundamentals. The latter are dependent on the former, so gauging the prospects for an individual equity requires an understanding of how it is situated in the global energy ecosystem.
Among midstream equities, G&Ps are the most heavily exposed to shifts in macro energy-market fundamentals. These companies will require a continued supportive macro backdrop to sustain cash flow growth.
The only scenario we see in which that backdrop is destroyed is a global recession. A global recession could precipitate an oil oversupply that prompts a pullback in Permian production. While we think the world remains some ways off from a global recession, there can be little doubt that its likelihood has increased with Russia’s invasion of Ukraine.
While we’re not ready to consider a recession as probable unless energy and food prices increase significantly from here or if global economic stress rolls on for months, here are some bearish factors that have our attention: Recessions tend to follow oil price spikes. In terms of an oil price “spike,” we’re currently dealing with small potatoes compared with 2008, but the accelerated rate of price increases is concerning. Generally, a sharp acceleration in the rate of change is what impairs demand instead of high prices in and of themselves. A gradual ascent to a higher price plateau allows consumers to recalibrate their finances and, if necessary, adapt their lifestyles to the new regime. But a sharp spike has a sudden psychological and financial impact that causes end-user behavior to change quickly. The risk at the moment is that such a spike is underway and that it sends prices to levels that destroy demand. If it does, its impact will be felt globally, but most acutely in nations like India, which are seeing a particularly steep increase in energy costs as priced in their local currencies.
By all appearances, Russia will be the victor in this conflict. This isn’t the outcome we prefer, but for our investments, what we prefer is irrelevant. If Russia does win, we doubt it can successfully subdue 40 million Ukrainians indefinitely. Without knowing precisely what “victory” for Putin looks like, we can be sure tensions will remain high. Does that […]
source A Word Of Caution For Conservative Midstream Investors
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