Energy pipelines – until the end of the world
Pablo Kohen, senior investment analyst in the global listed infrastructure team at First State Investments, gives his view on US energy pipelines’ outlook.
After collapsing at the beginning of 2016 to a low of $33/bbl, oil prices have recovered to close to $50/bbl level, leading share prices higher across the energy pipeline space as well.
Lower oil prices at the start of the year, the reduction in capex plans by oil and natural gas exploration and production companies (E&Ps) and the tightening of capital markets, drove the energy pipeline space to a state of turmoil.
These factors proved problematic for an industry which had previously relied on bullish capex plans (resulting in excess infrastructure capacity), and the promise of what turned out to be unsustainable distribution growth, to justify high valuation multiples.
The lower oil price environment led to a reduction in capex programs, the funding of distributions using internal cash flow generation, and less dependence on third party capital (either debt or equity).
Distribution cuts were implemented in order to increase coverage ratios (the most infamous one being Kinder Morgan’s 75% dividend cut in December 2015). Balance sheet repair took centre stage.
While crude oil volumes have started to trend downwards due to cuts in capex and rigs, we expect further volume weakness in the short term before the oil market rebalances.
E&Ps would like to see a “sustainable” oil price above $50/bbl before they add rigs, complete ‘Drilled But Uncompleted’ wells, and increase production levels again.
Production basins have experienced an overbuild of pipeline infrastructure capacity in recent years, driven by the fracking boom. As a result, many crude oil pipelines remain under-utilised and it is likely to take time before these achieve better returns or a need arises for additional capacity.
This environment also poses some risk for the operators of long haul pipelines that are fully contracted today, but may not get re-contracted if the subdued volume environment persists.
More positively, infrastructure overbuild is not yet evident in the natural gas space. Additional capacity is needed to bring volumes to end markets, especially from the huge and prolific Marcellus / Utica basin in the North Eastern US.
Natural gas demand growth is being driven by power generators which are replacing coal-fired power plants with gas; energy distribution companies that need to meet additional demand; exports to “gas hungry” Mexico; and upcoming LNG liquefaction facilities being developed in the US.
Another interesting theme discussed during my trip was the expected recovery in ethane volumes. The substantial increase in wet gas production has driven ethane volumes higher, depressing its price.
Eventually it became cheaper to leave the ethane within the natural gas stream (a process known as ethane rejection) than to isolate it and sell it separately. Interestingly, pipeline companies have started to indicate lower rejection levels, due to an expectation that export terminals and petrochemical facilities now being developed in the US Gulf Coast area will trigger a recovery in ethane demand.
However, we remain cautious on this potential upside, as pipeline companies have yet to sign long term, take-or-pay contracts with credible counterparties.
We have preferred natural gas-focused pipeline companies that have strong distribution coverage, healthy balance sheets and expansion plans that rely on end-customers (demand-pull) rather than on producers (supply-push) such as Spectra Energy, TransCanada and Columbia Pipelines Group.
We are developing a strategy at the moment to get exposure to the ethane recovery theme, without adding commodity risk to the portfolio.