Summary
- Oil prices have likely recovered more quickly than anticipated thanks to the disciplined cooperation of OPEC+.
- While midstream is unique from other energy sectors given its more defensive, fee-based business model, midstream MLPs and C-Corps have participated in energy’s rally.
- Midstream’s free cash flow and buyback potential, discounted valuations, and leverage to an ongoing macro recovery with potential tailwinds for the space could all contribute to continued positive momentum.
After years of underperformance relative to the broader market, the energy sector is finally enjoying a strong rally. The Energy Select Sector Index (IXE) is up 38.3% year-to-date through Friday, March 5, as West Texas Intermediate (WTI) oil prices have gained 36.2% YTD and closed north of $66 per barrel (bbl) last week. Despite its defensive, fee-based nature, midstream has participated in the broad improvement across energy. Today’s note discusses the improvement in oil prices, midstream’s participation in energy’s rally, and discusses the reasons that midstream and MLPs could continue to see gains.
How did oil get to the mid-$60s per barrel?
Oil prices have likely recovered more quickly than anticipated thanks to the disciplined cooperation of OPEC+ since April 2020 that resulted in significant production cuts starting in May. After briefly going negative in April, WTI oil prices recovered through May and spent most of the summer of 2020 trading in a range of approximately $36 to $43/bbl. Prices began to climb more noticeably in November, gaining 26.7% for the month, following positive vaccine announcements that provided optimism for a demand recovery largely anticipated in 2H21. WTI ended 2020 at $48.52/bbl. Supply restraints driven by producer discipline have largely boosted oil prices in 2021, with temporary interruptions to US production in February due to cold weather also helping. On January 5, Saudi Arabia announced an incremental cut of 1 million barrels per day (MMBpd) for February and March, bringing total OPEC+ cuts to approximately 8 MMBpd. Last week, OPEC+ largely reaffirmed the cuts with Saudi Arabia maintaining its incremental 1 MMBpd reduction. The news pushed oil prices to highs not seen since 2019 and drove a strong rally in energy.
Midstream has participated in energy’s rally.
Coinciding with the improvement in oil prices, energy stocks have rallied since November. Through March 5, the Energy Select Sector Index (IXE) has gained 83.1% since the end of October 2020 with WTI oil prices gaining 84.7% over that period. Aside from the improvement in oil, a rotation into value stocks and the reflation trade have helped boost energy. While midstream is unique from other energy sectors given its more defensive, fee-based business model, midstream MLPs and C-Corps have participated in energy’s rally. The broad Alerian Midstream Energy Index (AMNA) and the Alerian MLP Infrastructure Index (AMZI) have gained 41.1% and 54.6%, respectively, since the end of October on a price-return basis. In the first week of March alone, the AMZI was up over 11%, even outpacing the 10.0% gain in the IXE as oil prices hit new relative highs. Alerian’s MLP indexes, such as the AMZI, would be expected to have more upside to an oil price recovery for a few reasons – 1) MLPs were harder hit in 2020, 2) MLP indexes tend to have more exposure to companies focused on pipeline transportation of petroleum and less exposure to long-haul natural gas pipelines, and 3) MLP indexes tend to have smaller gathering and processing names that have greater indirect and sometimes direct exposure to commodity prices. That said, AMZI’s outperformance relative to broader energy (IXE) last week was somewhat surprising.
Why can midstream/MLPs continue to gain?
While the gains since the end of October have been impressive, midstream and MLPs could continue to see positive performance due to potential macro tailwinds that have yet to materialize and company-level improvements.
Macro recovery still underway. Even though oil prices are back above pre-COVID-19 levels, many macro tailwinds have yet to materialize. The vaccine-driven demand recovery remains more of a summer 2020 or 2H20 story. Improving demand would benefit midstream companies with refined product assets. In terms of US production, oil prices have not been high enough for long enough to garner a production response. If oil markets can stabilize at these levels or even move higher, production is likely to respond, albeit at a more measured pace given a focus on capital discipline for US producers. Improvements in production would benefit midstream volumes. With 8 MMBpd of oil production currently curbed by OPEC+, a careful unwind of those cuts over time as demand improves will likely be key to keeping oil markets stable.
Free cash flow and buybacks represent company-level tailwinds. Independent of the commodity price environment, many midstream companies are positioned to generate meaningful free cash flow this year. While energy companies are broadly pursuing free cash flow, midstream is differentiated in its ability to generate free cash flow after robust dividends and its visibility to free cash flow regardless of the commodity price environment. Many midstream companies have buyback authorizations in place which could be an added tailwind in this recovery. As shown in the table below, constituents with buyback authorizations represent about half of Alerian’s broader midstream indexes (MLPs and C-Corps) and upwards of 60% of the MLP index, AMZI.
Valuations remain discounted. Although oil prices are above pre-COVID levels, energy stocks remain well below where they started 2020 on a price-return basis. The IXE is down 12.1% relative to the first trading day of 2020, while AMNA and AMZI are down 16.0% and 24.4%, respectively. Furthermore, valuations for midstream remain discounted relative to history. Looking at forward EV/EBITDA multiples, the AMZI was trading about a turn below its three-year average and 1.5 turns below its five-year average as of February 26. The Alerian Midstream Energy Select Index (AMEI), an index with 25% MLPs and 75% US and Canadian C-Corps, was trading one turn below its three-year average and nearly two turns below its five-year average.
Bottom line
Setting aside the potential continuation of the reflation trade or value remaining in favor, midstream could continue to build on existing gains. Midstream’s free cash flow and buyback potential, discounted valuations, and leverage to an ongoing macro recovery with potential tailwinds for the space could all contribute to continued positive momentum for midstream.
AMNA is the underlying index for the ETRACS Alerian Midstream Energy Index ETN (AMNA). AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB). AMEI is the underlying index for the Alerian Energy Infrastructure ETF (ENFR). AEDW is the underlying index for the Alerian Midstream Energy Dividend UCITS ETF (MMLP), and the ETRACS Alerian Midstream Energy High Dividend Index ETN (AMND).
