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April 15, 2018

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Week Thoughts: Big League Move for Energy, Midstream Follows

Midstream had a solid week, pulled higher by rallies in energy stocks and oil prices.  Tuesday was the best day for MLPs all year (+3%) and Wednesday saw follow through, but the other 3 days were negative.  Midstream performance was torn between improving sentiment for energy stocks and negative price action among income-oriented stocks like utilities and REITs, which under-performed on higher interest rates.

The XLE had its best week since December 2016 (+6.0%), on the back of oil price gains that sent oil to its highest price in 3.5 years.   Sentiment in energy has improved for a few weeks now to the point where the XLE is about on par with the S&P 500 YTD (as noted by Barron’s this week).
Oil prices have strengthened, energy stocks are trading better, and regional oil price differentials have widened.  This sets up well for midstream to post decent quarterly results and continue to see improved sentiment and better performance.  One final aspect of the setup (as noted a few weeks ago) is that April is one of the most consistently positive months for midstream stocks historically.
Major League Midstream
Because its baseball season, I figure it’s a good time to delve deep into a very specific and somewhat obscure baseball film analogy to frame the current state of the midstream sector.
In November 2015, I made a reference to the 1989 film Major League in a blog post (see here).
Looking back at that post was interesting, and not just because the grounds crew picture was still apt.  Even then questions were being raised as to the value of IDRs (this was the week TRGP bought in its MLP subsidiary) and the future of the structure.  Today, years later, midstream is still struggling with existential questions around IDRs and MLPs, along with other fun acronyms like ITAs and FERC.
Back to Major League, the film represents some of the best examples of “gallows humor” of all time.  Its success was followed by a few copycats like Necessary Roughness (1991) and Little Giants (1994).  The thread of downtrodden, hard-luck characters runs through all the characters associated with the fictional Cleveland Indians franchise: front office personnel, fans, broadcasters, players, and even the grounds crew.  Being associated with the MLP “sector” at this point has a similar feel.
Major League has a happy ending, but it takes the rest of the community a while to recognize the performance of the Indians on the field and hop on the bandwagon with the regular fans.  That part also feels about right for MLPs today.  Expectations in the market have been reset lower by the MLPs themselves, but also by lower stock prices, such that signs of life would first be met with dis-belief before any sort of bandwagon crowd emerges.

There are many parallels across the movie to the MLP sector.  I’ll run through a few of them now.
FERC: “Maybe the problem is, we’re coddling these guys too much.”
The owner of the Indians is disappointed the team isn’t losing more at one point, because she wants them to have extremely low attendance.  So, she decides to reduce expenses and they end up flying in a beat-up prop plane.  That move by the owner to make things even worse for the team feels like the FERC ruling a month ago.

Juuuuust a Bit Outside
Bob Uecker’s portrayal of Harry Doyle is classic.  His role for the Indians is somewhat like my role in the midstream space, except he doesn’t even try to mask his despair and cynicism.

Doyle: Just a reminder, fans, comin’ up is our “Die-hard night” here at the stadium.  Free admission to anyone who was actually alive the last time the Indians won the pennant.

Fewer and fewer investors were around when MLPs and midstream corporations were consistent outperformers.  Also, fewer people are paying attention now that fundamentals have turned and positive leverage and structural changes are washing over the troubled sector.

Doyle: One hit, that’s all we got, one goddamn hit?
Assistant: You can’t say “goddamn” on the air!
Doyle: Don’t worry, nobody’s listening anyway.

The Lineup: Characters as MLPs
Several characters in Major League have parallels in MLPs.  Let me explain.
Roger Dorn: The high paid veteran played by Corbin Bernsen who is unwilling to put his full effort into the games and risk his free agency potential.  At one point he brings out his contract and reads to Coach Brown the part where it says he doesn’t have to do calisthenics.  Coach Brown promptly drops the contract on the ground and urinates on it.
This is kind of how the market feels about IDR structures at this point.  The IDR construct may say you are entitled to a promoted distribution over time, and you may feel you deserve a premium multiple for that IDR cash flow (either in ongoing trading valuation or in a elimination transaction).  But that old school mentality is out the window at this point.  Humility is the order of the day.
Jake Taylor: The veteran back for one last run.  He knows what it takes to win, but he’s got creaky knees and is generally in a funk.  His character is like some of the larger, older MLPs like EPD and MMP that have continued to grow and don’t have IDRs but have fallen with the rest of the group.

He was an all-star in Boston, wasn’t he?
Yeah, wound up in the Mexican League.  Had problems with his knees.
Wish we had him a few years ago.
We did.

Pedro Cerrano: Voodoo worshiping power hitter who can’t hit a curve, but believes external forces (Jobu, his little hitting god) can help him.  In the end, Pedro gives up reliance on those external forces: “F#@k you Jobu, I do it myself.”
His character is like MLPs who continue to blame external forces for their demise, whether its oil prices or capital markets weakness. Even those struggling MLPs are seeing the MLP 1.0 model is not going to work today.
Rick Vaughn: The aggressive and wild pitcher who starts the film in prison.  At one point, Vaughn explains to a teammate how he ended up playing in the California Penal league: I stole a car.  There are MLPs that have been punished by investors, stuck in the penalty box (apologies for mixing metaphors), after cutting distributions and disappointing on operating results.

Vaughn shows up to the first practice without sleeves and a hat.  The coach says: “we wear caps and sleeves at this level, son.”  It’s the same for MLPs.  They need to improve corporate governance if they want respect from the institutional investor community.
“In case you haven’t noticed, and judging by the attendance you haven’t, the Indians have managed to win a few here and there, and are threatening to climb out of the cellar.”
As noted above, the film has a happy ending as the team rides a “nobody believes in us” attitude to a winning season culminating in a one-game playoff win against the Yankees.  Jake Taylor drives in the winning run with a bunt after calling his shot.  Taylor regains respect, the city celebrates and the owner gets her comeuppance (although she probably made a ton of money that season).

Could there be a happy ending for midstream investors this year?  Expectations are low if you go by stock price performance, but yes, it is possible.  It will take execution on ongoing reported results plus ongoing progress on leverage, simplification, and corporate governance.  KMI is batting leadoff for another earnings season this week.
Winners & Losers
Notable winners this week were compression MLPs APLP and USAC, beaten down SMLP and continued strength from TEP following its simplification announcement.  In a reversal from recent strength, the worst performers were small cap MLPs that aren’t represented in indices and don’t generally have large institutional followings.

Year to date, compression MLPs dominate the top 5, with 3 of the top 5.  PAA continued recent strength, with +17% returns so far this year.   Amid all the MLP strength, DM and TCP didn’t move much and remain at the bottom of the year to date leaderboard.  Expect them to stay there until some action is taken by sponsors or until there is more FERC-related clarity.

General Partners and Midstream Corporations
The GPs and corps were in line with MLPs overall this week.  Like the leaderboard for MLPs, compression (AROC) and Tallgrass (TEGP) traded well.  Despite the NGL price move, TRGP was among the worst performers, with its funding gap in focus since its latest capex boost.

On the YTD leaderboard, PAGP took over the top spot in the group from OKE this week, and both have produced 10%+ total return so far.   NSH dropped a few spots back to the bottom of the group after a flat week.  TEGP’s strong performance since the simplification announcement has pushed it up a few spots as well.

Canadian Midstream
Canadian oil price (WCS) has rallied 52% this year, and the differential to WTI narrowed this week despite elevated agita around TransMountain’s expansion leading to a full trade war.  KML was the worst performer, but the rest of the Canadian midstream group was positive, led by Pembina Pipeline.   Big cap names TRP and ENB continue to lag on FERC, leverage and structural uncertainties.

On the year to date leaderboard, KML maintained its lead, but Keyera is edging closer to the top spot.  KML remains the only positive performing stock in Canadian midstream this year.  It will be interesting to see if KML retains its lead amid all the TMEP noise and if KML can use its premium currency to participate in M&A before the TMEP premium fades.

News of the (Midstream) World
Another big midstream asset sale was announced away from the publicly-traded midstream group this week, which reduces potential funding burden on the publicly-traded midstream players, but adds more private capital into an already competitive commercial situation in the Permian Basin.
Outside of that, the big news was Kinder Morgan throwing down the gauntlet in Canada and setting a go/no go date of May 31st.  On the other end of the spectrum and on the other coast, the U.S. is exporting LNG from the East Coast with the official startup of Dominion’s Cove Point facility.  USA! USA!

Capital Markets

  • None.

Growth Projects / M&A

  • On Sunday night (4/11), Kinder Morgan Canada (KML) announced it will suspend non-essential spending on the Trans Mountain Expansion Project (TMEP) due to opposition by British Columbia, leading to several announcements during the week listed below (press release)
    • KML will consult with various stakeholders to reach agreements by May 31 that may allow the project to proceed, otherwise the project will be canceled
    • On Monday, Alberta and the federal government (Trudeau) indicated that they are considering potential financing strategies or other options that would enable KML to proceed with TMEP (Global Mail)
    • On Wednesday, Finance minister, Bill Morneau, pledged that the federal government would deliver a rescue plan by the 5/31 deadline that would give KML the confidence to move forward with TMEP construction (Global Mail)
    • Trudeau is expected to meet with Premiers of British Columbia and Alberta on Sunday (Vancouver Sun)
    • KML has already spent C$1.1bn on the C$7.4bn project
  • Private equity-backed Brazos Midstream announced sale of Delaware Basin midstream assets to Morgan Stanley Infrastructure for $1.75bn (press release)
    • Assets, located in Reeves, Ward and Pecos counties, include 350 miles of gas and oil gathering pipelines, 260 mmcf/d gas processing complex with an additional 200 mmcfd of capacity under construction, and 50,000 bbls of oil storage
    • Assets are underpinned by long-term dedications of 300,000 acres
    • Valuation details were not released, but this continues a recent trend of midstream companies being outbid by private equity players for midstream assets in premium locations
  • Private player, Outrigger Energy II, announced the development of a tri-stream midstream system in the DJ Basin which will include wellhead gas gathering and a 600 MMcf/d cryogenic processing plant (press release)
  • Williams Partners (WPZ) announced filing of a FERC application seeking approval for $405mm Southeastern Trail expansion project on its Transco Pipeline system (press release)
    • Project includes 7.7 miles of new pipeline, upgrades to equipment and horsepower additions, supported by long-term contracts with utility customers
  • Mountain Valley Pipeline, owned by EQT Midstream (EQM) and NextEra Energy (NEE), announced MVP Southgate project, a proposed interstate natural gas pipeline anchored by a firm capacity commitment from SCANA (SCG) (press release)
    • Binding open season for the project was also announced and the project is expected to be in-service by 4Q 2020
  • Energy Transfer (ETP) announced binding open season on a 30,000 bpd diesel fuel pipeline from the Gulf to Permian (press release)
  • Sempra’s (SRE) IEnova announced plans to develop a marine liquid fuels terminal in Baja California, Mexico (press release)
    • The $130mm project will have an initial storage capacity of 1mm barrels of gasoline and diesel, is expected to be in-service in 2H 2020, and has signed a long-term contract with Chevron for 50% of storage and capacity
  • TransCanada (TRP) announced open season for Marketlink for short-term agreements to transport crude oil from Cushing, OK to the Gulf (press release)
  • Dominion’s (D) Cove Point LNG has officially entered commercial service (press release)