The basic energy infrastructure investment thesis generally runs as follows: North America is an energy hungry place. We drive cars, heat our homes, air condition our office buildings, and expect Amazon to deliver practically anything to our front door within 48 hours of deciding we want it. All of that takes energy, and an investment in energy infrastructure has a stable foundation in the base level of energy demand.
Bonuses to the investment thesis may include things like the tax efficiency of the MLP structure, the need to build out infrastructure to support the shale revolution (now in decline), or the need to supply LNG export facilities (which are now too abundant).
In a Demand-Pull World, Who Wins and Who Loses
The super-charged growth driven by the energy renaissance has disappeared over the past two years. This supply-push infrastructure need rises and falls with the production levels in the US. Should commodity prices recover and shale production again becomes wildly profitable, MLPs linked to those businesses may again flourish.
For instance, Saddlehorn and Grand Mesa decided to combine their pipeline projects that each would provide takeaway capacity from the DJ Basin (in Colorado) to the storage facilities in Cushing, Oklahoma. The supply-push need for infrastructure now only supports one pipeline instead of two. As a combined project, construction costs are decreased on both sides, pipeline capacity aligns with production expectations (no overbuilding), and future expansion is still possible. Saddlehorn is owned by three companies: 40% by Magellan Midstream Partners (MMP), 40% by Plains All American Pipeline (PAA), and 20% by Anadarko Petroleum (APC). Grand Mesa is entirely owned by NGL Energy Partners (NGL). Even though less new capacity is needed, I feel compelled to mention that less growth is not zero growth.
However, those MLPs which move, process, and store energy that serves the demand needs of North America have intact business fundamentals despite the unit price contagion from falling oil prices. Natural gas is not only used for heat and cooking, but natural-gas-powered electricity generation facilities are replacing coal-powered ones. Power plants still need natural gas delivered via pipelines. Airplanes need jet fuel, which requires refined product pipelines and storage. Equally, gas stations still need their storage tanks to be refilled so the Amazon driver can deliver your pantry box. You probably need to fill up your car, too.
While the subsectors listed in Alerian’s EMCS distinguish between product (Pipeline Transportation of Natural Gas vs Pipeline Transportation of Petroleum), they do not further distinguish between natural gas pipelines serving producing basins versus those delivering natural gas to power generation facilities. This is primarily due to the fact that few MLPs are entirely on the demand-pull or supply-push side of the energy business.
To illustrate both the need for more demand-pull infrastructure as well as the point above, we need look no further than the multiyear Transco pipeline expansion (owned by the Williams Companies (WMB) and Williams Partners (WPZ)). Current updates in plain language are available on their website, indicating just how many projects are designed to supply electricity generation facilities spanning the eastern seaboard. During their analyst day last May, Williams broke out which of their expansion projects are supply or demand driven.
A Base Level for Valuation
If the US population remains stable, there is some base level of hydrocarbon demand in the US. That demand will support a base level valuation for MLPs with demand-pull assets. While we can’t say exactly what that base level for valuation is, as an exercise, we’ve considered a couple of factors.
In order to visualize a demand-pull only energy environment, turn back the clock to a time when peak oil was one of the largest risks to the space. Following peak oil, the existing energy infrastructure would need only be maintained, as less and less oil would be produced every year. A 2005 report from the Department of Energy indicated that while dramatically improved fuel efficiency would be necessary, it would not be sufficient as substitute liquid fuels would also be required. Ten years ago, investors and MLP management teams discussed the possibilities around repurposing existing pipelines to carry these substitute fuels.
Today, with supply constrained (due to pricing, not because of availability), we’ve returned—in a way—to an outlook reminiscent of peak oil: existing pipelines still carry hydrocarbon-based energy, but the demand for new infrastructure will be limited to shifts in demand areas due to the urbanization of the US population or shifts in geographic locations of energy-intensive industries.
If we take 2005 as the date of peak concern about peak oil, the Alerian MLP Index (AMZ) ended that year at 237.4, just slightly below March 31, 2016 value of 270.9. However, there are any number of counterarguments for why the space should be valued differently than it was ten years ago. In 2005, the MLP space was exceptionally small as few investors had heard of it, which allowed inefficiencies to persist. There were no exchange-traded products to make an MLP investment accessible to those unwilling to file dozens of K-1s. Large energy corporations had yet to use the MLP tax structure to monetize their infrastructure assets. Along the same lines, MLPs have been very competitive in the acquisition of third party assets due to their structure.
In 2005, energy demand in the US had grown by roughly 1% per year since the petroleum shortages in the 1970s. In 2016, the EIA predicts that total energy use will grow by around 7% over the next 25 years (or only 0.3% annually). To break that out:
- Residential energy consumption is expected to remain flat over the period as energy efficiency standards offset population growth. We plug in more devices than ever before, but energy efficiency appliances are also now commonplace
- Commercial and industrial energy demand will grow modestly.
- Domestic transportation demand will fall.
While this two-thirds reduction in expectations for energy demand growth must be taken into account when considering a base level of valuations, it’s also important to look at the changing composition of our energy consumption and who stands to benefit. The majority of US electricity generation now comes from natural gas, not coal—a positive for MLPs operating natural gas infrastructure assets. However, wind and solar electricity generation is increasingly common. Likewise, the use of ethanol and biodiesel may reduce the need for hydrocarbon-based transportation fuels.
If energy infrastructure companies return to a level of valuation based solely on demand-pull needs, investors will return to thinking of them as a true yield play (rather than the yield + growth total return investment we’ve seen the past decade). One could say this is very bad luck, but then, if no new assets need to be built, MLPs will not need to access the capital markets, dissolving investor concerns about credit ratings and removing that pressure on equity prices.
A breakthrough in solar battery technology could send energy infrastructure MLPs lower, but a breakthrough in liquid hydrogen as a fuel could once again skyrocket the need for new (or retrofitted) pipelines across America. The multi-decade future of energy could take MLPs and energy infrastructure companies anywhere.