Midstream/MLPs: Cutting Through the Noise

07/20/21 | Mauricio Samaniego

Summary

  • Fee-based businesses and contract protections equip the midstream space to better withstand commodity price volatility relative to its energy peers while delivering attractive income and greater cash flow stability.
  • Resilient natural gas prices and steady demand benefit midstream and help alleviate effects from the uncertainty permeating the oil market.
  • Oil and natural gas production forecasts were revised higher for 2021 and 2022, with both crude oil and natural gas production expected to grow in 2022, which fares well for midstream’ s volume driven, fee-based business model.

Following nine consecutive months of positive equity performance, midstream stocks experienced some turbulence last week, finishing lower as short-term selling pressures shook oil prices and broader equity markets over concerns surrounding the COVID-19 variant and its effect on the economic recovery and oil demand. With the news headlines and short-term price movements likely raising some level of concern for midstream investors, this piece takes a deeper look to decipher the noise and highlight midstream’ s unique ability to endure commodity price headwinds.

Midstream has the upper hand relative to energy peers.
After posting highs not seen since 2018 during the first half of June, oil prices trended lower last week amidst dampening optimism, extending their selloff on Monday as concerns over demand disruptions were met with shifting supply dynamics following OPEC’s announcement it had reached a formal agreement to gradually raise production—aiming to unwind production curbs by September 2022. While uncertainties over renewed lockdowns and its effect on oil demand are still premature—and have not led to downward revisions in economic growth forecasts—midstream stands out amongst the energy space for its fee-based business model and contract protections that support cash flow stability and help insulate the space from a volatile crude oil environment. From a quantitative standpoint, although cross-asset correlations and correlations with WTI prices tend to increase during drastic price declines, the historical correlation between midstream MLPs and WTI crude has been the lowest relative to broader energy represented by the Energy Select Sector Index (IXE) and the energy subsectors shown below.

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Resilient natural gas prices and higher production fare well for midstream
Despite volatility inflicted upon the crude oil market, the midstream space continues to benefit from resilient natural gas demand as the summer heat wave, rising liquified natural gas (LNG) exports, and tighter supply have kept natural gas prices hovering around a two-and-half-year high. As of the end of June, the weighted exposure to natural gas gathering, processing, transportation, or liquefaction for the Alerian MLP Infrastructure Index (AMZI) and the Alerian Midstream Energy Select Index (AMEI) stood at 61% and 65%, respectively.

Admittedly, midstream stock prices are not fully immune from the implications of the decline in commodity prices, particularly from a sentiment standpoint, but they do benefit from steady production growth given the volume driven, fee-based nature of the business. As production picks up across the globe following OPEC+’s announcement, expectations that US shale producers will gradually raise production are also intact—with production estimates being revised higher this month as the effects of the reopening economy continue to show up in the data. In its July Short-Term Energy Outlook, the US Energy information Administration (EIA) raised its forecasts for both US crude and natural gas production. For 2021, the updated projections incorporate upward revisions of 0.02 million barrels per day (MMBpd) for crude and 0.37 billion cubic feet per day (Bcf/d) for natural gas, while projections for 2022 were raised by 0.06 (MMBpd) for crude and 0.76 (Bcf/d) for natural gas.

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Bottom Line:

While longer term implications to global oil demand and a potential derailment of the economic recovery would fare negatively for midstream and energy broadly, fee-based business and contract protections equip the midstream space to better withstand commodity price volatility while delivering attractive income and greater cash flow stability relative to its energy peers. In addition, vast exposure to natural gas help alleviate the effects of oil price fluctuations amid resilient natural gas prices and steady demand. On the supply side, although higher oil and natural gas production can inflict downward pressure on commodity prices, midstream benefits from more supply coming online due to its volume driven, fee-based business.

AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (AMUB). AMEI is the underlying index for the Alerian Energy Infrastructure ETF (ENFR).

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