The recent selloff in midstream equities has spurred the pursuit for answers. After bottoming in August, strengthening equity prices in September seemed to indicate the group was headed to higher levels. Tightening global supply and demand fundamentals provided further reason for optimism particularly given the sector’s strong correlation to crude oil pricing during the month. Going into October, however, a confluence of midstream company events, some anticipated and some not, triggered a dramatic move lower, leaving many investors hard-pressed to identify a single root cause. Now in its 4th week, the pullback, while moderating, continues to reflect a noteworthy shift in investor sentiment.
As the dust settles and the market finds its footing, our primary concern is ensuring that our investors have a proper understanding of recent events and their relevance for midstream equities. To that end, we share our view of current events and estimate what these events mean for the sector going forward. In this blog entry we address several key issues: I) identify recent events responsible for the weakness in midstream equity prices, II) offer our take on EPD’s announcement and what it means for other midstream companies and valuations, and III) revisit the importance of our investment approach which we believe mitigates the impact of the type of volatility we are seeing today.
I. Key recent events responsible for the weakness in midstream equity prices.
1. Making room for a relatively large IPO weighs on the market: During mid-October, BP Midstream Partners, LP (BPMP) began the marketing effort to support its October 26th initial public offering (IPO), intending to raise nearly $900 million. For investors participating in the IPO, sourcing the cash to purchase the newly created BPMP shares meant either deploying existing cash balances or liquidating other midstream holdings.
Those who view the BPMP IPO as a source of selling pressure may point to the August 15th secondary offering by Energy Transfer Partners, LP (ETP), in which ETP sold $1 billion worth of equity into market in an overnight deal. In the day following the ETP issuance, the midstream sector tracked by the Alerian MLP index declined by roughly 2%. In our view the impact of BPMP’s IPO likely added some degree of pressure to midstream equity prices but by itself was not fully responsible for the market’s decline, simply because the magnitude of the decline in market value terms vastly exceeded the value of BPMP’s equity raise. Nevertheless, the weight of the offering has likely contributed to some degree to sector weakness.
2. Concern over midstream project returns [Consequences of a “food fight”]: In recent meetings with midstream management teams we have discerned a tone of unease associated with a heightened level of intra-industry competition. While upstream volume growth remains intact across key basins, the number of companies vying against one another to win new business (build-out of greenfield projects with anchor shippers) in those basins has introduced an elevated level of risk to transport rates. Here’s how. Most midstream project proposals include a price per volume of barrel of oil or mcf (thousand cubic feet) of gas transported. With most companies competing against one another on the basis of price, competitive pressures imply that the lowest-priced project proposal generally stands a better chance of winning a project award.
Unfortunately, a lower price or tariff likely implies a lower project return, all else equal. More importantly, the willingness by a midstream company to deploy capital with a less favorable return profile, vis-à-vis existing portfolio returns, suggests an erosion of capital discipline. While difficult to quantify given the long-term nature of project development and ultimate return generation, market concern regarding competition and the implied departure from capital discipline has compounded the perceived risk of many midstream equities.
Outside of competitive new-build markets, we’ve also seen evidence that changes in regional pricing differentials may impact the re-contracting of assets in some key basins. On October 2nd, Boardwalk Pipeline Partners, LP (BWP) announced the renegotiation of its Fayetteville and Greenville lateral pipeline contract with Southwestern Energy (SWN) at a rate well below its previously contracted price. Although volumes were contracted at a term which resulted in a neutral impact to the contract’s NPV, the fact that weakness in current pricing had manifested itself in a longer-term contract was again indicative of project re-contracting rate risk which, in our opinion, has contributed to investor perception of overall sector risk.
In our view, midstream competition and the evidence of softening transportation prices or tariffs (in some areas) are meaningful risk factors potentially affecting midstream company portfolio returns. From an investor’s perspective, the need to be compensated with a premium for these risks implies that share prices adjust to entice investors to accept these risks. We believe that recognition of these risks has contributed to weakness across the sector.
3. Distribution cuts and distribution growth moderation: The October 12th announcements from Genesis Energy Partners, LP (GEL) and Enterprise Products Partners, LP (EPD) that distribution payouts rates would be lowered (GEL’s current distribution and EPD’s future distribution) brought renewed anxiety to the sector still stinging from Plains All American (PAA/PAGP) cut back in August.
The GEL announcement was preceded by an extended period of unit price underperformance, a sign that investors anticipated the cut. In fact, in prior months, several sell-side analysts suggested underlying business fundamentals at GEL placed the distribution at a heightened level of risk. The EPD decision to decelerate its distribution growth rate, however, came abruptly without warning. To complicate matters, the EPD decision was justified with a proposition for investors who were asked to accept a tradeoff between the distribution growth rate reduction today, in return for a more accretive return to the unit holder in the future.
II. Different audiences and the battle of valuation method. In our view, EPD’s distribution growth deceleration announcement, while logical, was explained with a complicated rationale which left investors uncertain as to its implication for peer companies and sector valuation.
EPD distribution growth moderation and investor psychology: In our view the EPD announcement was significant in that it came from what many perceive to be the highest quality midstream company in the industry. It was also significant because EPD management decisions are widely viewed as an industry. By announcing the future cut, EPD provided precedent for others to cite in the event these companies find that they must alter their distribution policy. This ‘follow-the-leader’ mentality is pervasive across Wall Street and we believe it may suggest more widespread ‘moderation activity’ by other midstream companies. Given the difficulty in timing and quantifying other future ‘moderation activities’, we believe that equity holders have chosen to sell now, preferring to wait for market stabilization before meaningfully returning to the group.
EPD distribution growth moderation and the valuation discussion: EPD’s announcement that it would shift the return profile to investors from one of near-term dividend growth to one of total return on equity appreciation has created a dilemma for investors trying to quantify what those shifting cash flows might mean for valuation. The most frequently used valuation conventions are seemingly at odds with one another, thus the dilemma.
Historically, midstream equities have been valued using two primary methods of estimating prices: 1) the dividend discount model (DDM), and 2) Enterprise Value to Earnings Before Interest Taxes Depreciation and Amortization multiples (EV to EBITDA).
For DDM users, distribution growth deceleration is effectively a future distribution cut, which implies that the present value of future distributions will be lower, assuming all other valuation assumptions are unchanged. A reduced present value would make the current market price appear more expensive, which could in turn prompt investors to sell. On the other hand, those utilizing an EV to EBITDA methodology would see the retention of cash as a positive, as net debt is reduced more quickly over time and the impact of future equity dilution is minimized. In this scenario, investors would see, all else equal, the distribution retention as a positive since future EV to EBITDA multiples would be lower, making the equity look less expensive.
The broader discussion regarding valuation is no doubt complex and is further complicated when considering the choice of valuation method varies depending on what component of return is most important to a particular investor. For retail investors, the distribution is probably sacred and remains the primary reason for investing in midstream companies and MLPs, which suggests the DDM method will remain important for that group. For institutions, which represent an increasing component of midstream equity ownership, current income is likely of much less importance, which implies that EV to EBITDA will remain important. We believe this crosscurrent regarding valuation methodology has no doubt added to investor anxiety and added to sector pressure.
III. Know your customers from whom the revenue is generated. We believe that our approach to midstream investing positions our portfolio to weather the volatility during times of uncertainty like we are seeing in today’s market.
As we have stated, our investment approach emphasizes a preference for assets that sit closer to the end user along the midstream value chain. In practical terms, volume throughput on these demand centric assets is influenced more by incremental consumption trends or ‘demand-pull’ and less by upstream producer volume or ‘supply-push’, which can be heavily impacted by commodity price volatility.
Benefiting from stable throughput, demand-pull oriented assets generally enjoy more consistent operating performance which tends to translate into greater stability in financial results, ultimately providing investors with the potential for a more reliable stream of cash distributions.
In our view, stability of cash generation is a key differentiating factor across midstream companies, and importantly distinguishes those assets capable of preserving equity or unit value in the face of heightened volatility.
- In the case of equity issuance, we believe an entity demonstrating cash flow stability will likely experience less volatility than other less stable entities or members of the MLP group given a generally higher investor confidence level in such assets.
- Entities demonstrating more stable cash flow generation typically adhere to a higher degree of capital discipline in their capital allocation process. These companies generally benefit from enviable project portfolios capable of generating consistent returns throughout the cycle, which further insulates them from risk to project returns, new-build or otherwise.
- From a valuation perspective, a more stable cash flow profile has, by definition, less variability and therefore a comparatively lower degree of risk. As a result, this type of cash flow profile should be more highly valued regardless of the methodology used to estimate a price target.
While the market pullback has shown some signs of moderation, the uncertainty surrounding these recent events is still evident in elevated sector volatility levels. As a result, we would not find it surprising to see the remainder of the year prove to be bumpy for midstream equities. Nevertheless, we have confidence that our emphasis toward demand centric assets will prove beneficial, providing stability and resiliency.
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