- Midstream 2Q results and outlooks were mixed overall, and growth capital spending plans for 2020 and beyond continued to be trimmed. The recovery in US oil production is underway as shut-in wells return, and natural gas liquids have been a bright spot.
- Operational outlooks were in focus as the macro recovery continues, but renewables and the election were also key topics.
- The shifting strategy of exploration and production companies away from growth in favor of returns could be a net positive for midstream, as oil prices have tended to drive sentiment and equity performance.
The macro challenges in the quarter, an upcoming election, a strategy shift from producers, and increased discussion of renewables made for an eventful 2Q earnings season across energy. Today’s note discusses some of the key takeaways from earnings season and particularly the implications for midstream.
Results for 2Q and outlooks were mixed; companies continue to tighten belts on growth spending.
Midstream results have been somewhat of a mixed bag relative to analysts’ expectations. Some companies reaffirmed financial guidance or narrowed their range of expectations, others cut guidance as initial outlooks proved overly optimistic, and some names even raised 2020 guidance outright or at the midpoint, including Plains All American (PAA), Hess Midstream (HESM), Equitrans Midstream (ETRN), Western Midstream (WES), and Targa Resources (TRGP). Stay tuned for an upcoming note with more detail on company outlooks and guidance adjustments. Shifting to spending, midstream growth capital budgets continued to come down. Energy Transfer (ET) announced a further $200 million reduction to 2020 spending resulting in an updated budget of $3.4 billion. ET guided to 2021 spending of $1.3 billion and $500-700 million in 2022 and 2023. PAA and Williams (WMB) both reduced their 2020 growth spending plans by $100 million. Enterprise Products Partners (EPD) lowered growth capital spending for 2021 and 2022 by a combined $700 million relative to guidance provided earlier this year.
Production recovering, and NGLs a bright spot.
US oil production fell to 10.0 million barrels per day (MMBpd) in May, which was down 2.7 MMBpd or 21.5% from March 2020 as producers shut in wells. Shut-ins likely peaked in May, though June could also be a weak month. Moving into the third quarter, shut-in volumes should largely be returning (read more), and EPD’s management noted the steepness of the V-shaped recovery in production. PAA raised its estimated 2020 exit rate for Permian oil production to 4.1 million barrels per day (MMBpd), which is an improvement of ~240,000 bpd at the midpoint given prior expectations for a 15-20% decline in exit rate. The new forecast of 4.1 MMBpd would imply a 12.4% decrease relative to December 2019 based on historical Permian production numbers from the Energy Information Administration.
NGL volumes seemed to be a bright spot, proving resilient for some in 2Q and recovering quickly for others as a few companies mentioned July volumes ahead of pre-COVID levels. ET noted record volumes on their Mariner East system in the Northeast and strong volumes for their NGL pipelines in Texas, resulting in record high transportation volumes for their NGL segment in 2Q. Current volumes for their Mariner East complex and Texas fractionation facilities were above the levels seen before COVID-19. EPD discussed record receipts of Y-Grade NGLs in June and July driven by strength from the Permian. ONEOK’s (OKE) July raw NGL volumes were above the level from 1Q thanks to greater ethane recovery in the Mid-Con and increased volumes of propane-plus from the Permian. OKE anticipates ethane recovery continuing on its system for the rest of this year given the economic incentive to extract ethane and healthy petrochemical demand.
What could the shifting model for E&Ps mean for midstream?
Exploration and production companies (E&Ps) are transitioning away from a growth strategy to one focused on cash returns, financial discipline, and free cash flow generation. A greater focus on returns and capital discipline have been talking points for years, but it feels like E&Ps are actually getting some religion. The model is shifting to more moderate production growth or even maintaining production to generate free cash flow for reducing debt and returning cash to shareholders through dividends, buybacks, and/or variable dividends. For example, Devon Energy (DVN) is targeting production growth of up to 5% each year, reinvestment of 70-80% of cash flow, low leverage, and free cash flow generation to support dividends and buybacks. DVN announced a special dividend earlier this month connected to an asset sale. Pioneer Natural Resources (PXD) has a similar plan to generate 10%+ total return comprised of 5%+ production growth, their regular dividend, and a variable dividend for 2021 payable in 2022. PXD’s slide below summarizes the new strategy taking hold in the E&P space.
Source: Pioneer Natural Resources 2Q Earnings Presentation
The strategy shift upstream has multifaceted implications for midstream. For one, more modest production growth could be supportive of the ongoing recovery in oil prices. Despite fee-based businesses and significant exposure to natural gas, midstream tends to trade more in line with oil prices than seems justified, and oil prices drive sentiment. A more stable oil price helped by producer discipline could be more conducive for midstream equities than higher volumes. Furthermore, improvements by E&Ps may bring more interest to energy in general, which has been largely overlooked as a sector given its 2.5% weighting in the S&P 500 as of July 31. That could potentially extend to greater investor interest in midstream as well. More moderate production growth or maintaining production may seem negative for midstream volumes, but prior to COVID-19 and the collapse in oil prices, US production growth was already expected to moderate. While US production is likely to respond to the price environment with some lag, large producers limiting growth likely helps avoid US production overshooting to the detriment of oil prices in a higher price environment.
What about the election?
The election was a common topic of questions on earnings calls across the energy sector. Several management teams pointed out a disconnect between campaign rhetoric and what can actually be achieved. A broad comment from an executive at Valero (VLO) was that the elected administration will be dealing with a COVID recovery economy, and energy will be needed to drive the economy. EPD management said tax rates look poised to increase for individuals and companies. That outlook and a focus on execution in a challenging environment has put an MLP vs. C-Corp analysis on the back burner, with management expressing contentment with their MLP structure. For E&Ps, commentary focused more on Vice President Biden’s opposition to new drilling permits for federal lands and waters and the ability to navigate changing regulations, including stockpiling federal permits now.
Renewables also discussed more frequently.
Even before BP’s (BP) significant strategic announcement on August 4 outlining its path towards net-zero emissions, renewables were a topic of Q&A on midstream calls. On its August 1 quarterly call, the management of WMB discussed investing $200-400 million in solar projects in the coming years. WMB also discussed sourcing renewable gas and eventual opportunities around hydrogen in addressing a question. TC Energy (TRP) similarly mentioned that hydrogen could be blended with methane flowing through its pipes and left commingled or extracted at the other end of the pipeline in response to a question. TRP is also working on two pumped storage projects. Enbridge (ENB), which has an existing renewables footprint (read more), talked about being well positioned if hydrogen becomes an energy solution decades from now. ENB also noted opportunities in US wind but cited challenges such as a less developed regulatory environment and supply chain. While most tend to focus on the threat of the upcoming energy transition (including Alerian), it is important to note that there are opportunities as well.
Earnings season was particularly eventful this quarter for midstream and broader energy. Operational outlooks were in focus as the macro recovery continues, but renewables and the election were also key topics. While the shift away from growth at any cost for oil and gas producers could seem negative on the surface for midstream, the potential for a more stable oil price helped by producer discipline and the possibility of attracting investors back to energy in general could result in a net positive for midstream.