Market Dynamics and the US Energy Revolution

The role of master limited partnerships

Originally published in the January 2015 issue

Parker Global Strategy specialises in providing liquid US energy infrastructure investment strategy to non-US investors. The firm was originally founded in 1995. It now manages over $3 billion in assets with a strongly theme-oriented approach, leading to the formation of a multi-manager customised portfolio of various energy strategies and then to direct investing, with a very specific expertise in master limited partnerships. Parker is based in Stanford, Connecticut, with offices in Denver, Colorado, and a client service representative in Tokyo.

We’ve lost 50% of the price of crude oil over the last six months. It’s primarily due to concerns over oversupply. The oversupply is being driven by the US shale revolution. In addition to the concerns of oversupply from shale, we certainly had some influx of production coming from Libya, the Gulf of Mexico, and Brazil, which then was also exacerbated by some demand forecast cuts, specifically from the International Energy Agency, which then made the market look at OPEC as a possible solution for propping up prices. Saudi Arabia did not. OPEC has basically gone silent; it’s asleep, leaving the market to its own devices.

So, as you see, the price of oil just kept creeping down, searching for a floor. We had moments of thinking, in December, that there may be a chance that it might start stabilising in the mid-50s, but that was short-lived, especially when we started to understand, and the market started to realise, how much oil was being stored, and the glut was as big as it could be.

In the oil supply, as the Gulf was reducing, shale was just starting to pick up, and it’s been year-on-year up a million barrels for over three years. So it’s really ramping up, and could continue. Then, in 2014, the Gulf came back and Brazil showed up – Brazil was expected to increase production for some time, but it always got delayed. And then Libya also added to production in 2014, adding to the glut. We’re going to have to rebalance oil, and it’s going to take a couple of years before supply and demand can rebalance. There’s going to be a slowdown in exploration and production (E&P) capital expenditure, for sure, and the market is looking for a metric to find this, and without OPEC and Saudi Arabia balancing out the supply.

Markets have to look at what the cost of production is, which would lead us all to believe that oil has further to go down before it stabilises. McKinsey – who study oil and gas a lot – did a global study basically saying that, at $50, 190,000 barrels are under water; in other words, it’s costing more to get it out ofthe ground than what they’re receiving.
And, this is just the cost; it’s not talking about the cost of putting in wells; it’s just the production getting out of the ground. At $45, another 400,000 barrels are in play. If it gets to $40 a barrel, another million and a half get into play. I’m not saying they’re all going to disappear, because every region, every producer has their reasons on why they’re producing, but it’s a factor that could play a role in balancing out the supply versus demand.

If we get to this, the other thing that we need to think about is the decline rates. It has been estimated that a million and a half barrels a day need to be created every year, to stay even with oil volumes. Before the price decline I and others were estimating that crude oil production could grow 1-1.5 million barrels a day. Now we assume that that’s going to be adjusted downward, given what’s happened to price. In addition to that, you have the idea that shale oil, as it is, does deplete faster, so you’ve got to have a situation where, if you’re going to keep the shale oil going, you’re going to have to keep drilling – that also will play a role.

So, you take the capital expenditure coming down; you take some of the ongoing production being reduced, plus this whole area of depletion, and we’re thinking, and looking at the data, there is a good chance that we could actually see a shortage of crude oil by, maybe, the end of 2016, but really probably more by the end of 2017. It’s going to be low; it’s going to take a while; but there’s data out there that would tell me that oil prices can come back.

Now, are they going to come back all the way to 100, 110? Probably not, but it’s going to bounce, and there’s going to be an equilibrium somewhere along the way. An interesting statistic: five times the price of WTI has dropped more than 50%, and five times the price increase in the following 12 months has been up an average of 52%. So oil is volatile, and there is opportunity both ways.

With regards to the US, they’ve already announced about 20% overall capital expenditure (capex) reductions. When I say capex reductions, I’m really talking about for 2015. We still assume that this is a postponement: it’s not going to be eliminated going forward. We also think that the service companies, the Halliburtons of the world, that are servicing the oil rigs are going to have pressure put on them by the producers to reduce their costs.

In US natural gas, three of the largest natural gas producers in the Marcellus shale formation in Pennsylvania have already announced increases year on year on capex, and it has to do with how cheap the natural gas really is in the US. The other thing for the US and for shale (which is going to create more volume) is that there is approximately a six-month backlog of wells that have been drilled that need to be completed. So, they’re in a stage of completion, and they’re going to complete them because they’ve spent the money to drill; they’ve spent the money for fracking, and now it’s time to hook them up, but it takes about a six-month lag, so you’ll have some increased production there.

You have to be quite granular when it comes to production costs. In North Dakota, for instance, they’ve got lots of oil, shale oil: the Bakken shale. What’s interesting is, the highest cost counties have also very low production. So, you have a county like McKenzie in North Dakota with cost bases of under 350, doing 350,000 barrels a day. So, at $50 oil, they’re estimating that only 10% of the Bakken is below break-even. That’s just a fact that you really need to understand, because if you look at the Bakken generally, people say, ‘Oh, well, break-even cost there is $65’. Well, not really.

For the energy revolution in the US, we have the influx or the peak in 1971, and then a nice steady line going downward. Well, technology came to the rescue. It’s really wild-cattish from Texas and Oklahoma, who didn’t have the wherewithal or the money to go to the Gulf or go to South America or go to Africa; these guys had to figure it out at home, and they just experimented. They figured out, if fracking could work in shale, it could be producing wells that could make money. Then they coupled that with horizontal drilling, and off they went.

There’s a lot of oil that was coming into the US that’s having to find other homes. Again, the technology is really what has driven this revolution – fracking and horizontal drilling. It’s also about land rights, legal systems in the US, that allow for private lands to be drilled, and I think that’s the beauty of it.

To give you an idea of the timeframe on the infrastructure: the Marcellus, we’re talking about 100 years of work. Utika is associated with Marcellus. Permian is going to be huge. So, this gives you an idea; this is not just a short-term play. I’m not looking at an infrastructure play that’s going to be great for 15 and then sell it. This is a long-term play, and what’s going to drive it is these efficiencies.

When it comes to natural gas, we’ve been growing demand within the United States, which is much to the benefit of the US. Of note: first one, power generation. We had a lot of utility plants that are fired by coal, and they’ve been changing over to natural gas, one, because it was cheaper – though, coal keeps coming down, so that’s not as true – but regulation is forcing them to do it because the greenhouse gas emissions from coal are so much worse than natural gas, and the government, the EPA, has been putting on standards that are coming true. That’s a real boost to demand for natural gas.

The industrial chemicals, the liquids coming off of natural gas liquids, are the feedstock for plastics. Not only are the plants in the US growing, but it’s attracting plants from outside the US, coming to the US because it’s so cheap.

So, what’s the impact? The impact is investment opportunities in infrastructure, for sure: plants and equipment, new technologies, service technologies to help make the oil and gas flow faster and cheaper. It has been great for the US economy, and again, one of the cheapest hydrocarbons in the world.

When we talk about infrastructure, what we like to invest in is midstream energy. These are the pipelines, storage tanks, processing units, the logistics of energy that are required to get the energy out from the ground to where it’s needed. Most of what we do is through our MLPs that basically are not subject to commodity risk; there are a lot of “reservation contracts”, 10 years, 15 years, where they actually reserve the pipe for a producer for a flat rate. And, if they use it, great; if they don’t use it, they still have to pay.

MLPs were started in 1986; they were from a tax act, and it was the governments that really wanted the private sector to build this infrastructure. At that time, it was about rebuilding old infrastructure. It was a boring business; it was boring, but great. It had a nice yield; it traded like a high-yield bond, but with the advent of the revolution, all of a sudden, we have this huge growth piece to it. So, you have good yield, and good growth of yield, and that’s really the play.

They get a tax advantage in that the taxes flow through, and that helps their cost of capital. That’s really the key; their cost of capital is less, which puts them in the front row of getting those jobs to build the infrastructure.

All we trade is publicly traded MLPs – that way, we can have the kind of liquidity that you would want, i.e., daily. It’s worth something, and the capitalisation goes up, somewhat, with the infrastructure need. We expect that to continue; we expect more IPOs.

MLPs have performed extremely well, relative to other asset classes. The primary driver of MLPs is stability of distributions, and in order to have stability of distributions, you’ve got to have good cash flow coverage.

MLPs, historically, have basically distributed their free cash flow, and so when they’re doing new projects, they go to the capital markets, equity and debt. Their balance sheets are about 50/50 debt to equity, and they’ve been big players in that market. But that’s the key driver; you want to have the guys with the least leverage that you can with regards to the cash flows.

Most MLPs are limited partners, so when you buy an MLP, you own the assets. Then there’s the thing called a general partner, which actually manages the assets. The general partner (GP) is incentivised to grow those distributions for the limited partners, and to incentivise them to do that, they’re given rights based on the volume growth. So, if they start out, a new GP might start out with 5% incentive distribution rate (IDR); they could grow that to 40% or even 50% over time as they grow the MLP.

So, as the old adage goes from us, if you like the MLP, you should love the GP, because the GP is really a leveraged play on the assets and the footprint of that MLP. There are 11 sectors that we look at – the large cap diversified ($20 billion plus type market caps). They’re highly diversified, and they’ve got very strong balance sheets. They tend to do well in times of stress, so clearly, we like them now.

So, what we like, we like the general partners; we like the drop-down story. And we really do like the MLPs that are involved in the whole export LNG area, and ethane.

We see real value in very large integrated oil companies, like a Marathon, let’s say. Marathon has MLP-eligible assets; that is, they have pipelines, they have storage. They could be an MLP if they chose to, but it’s not; it’s in Marathon. So, what they did, they created a general partner internally; they created an MLP, of which they kept 60%, and IPOed 40%, so they control the whole thing.

Then, they take those assets in the C Corporation; they get a higher valuation, because in the MLP structure, there’s no corporate tax. So, they drop them down, they get cash to do other things, and while they’re doing that, they’re going to the market, to investors, and saying, “We’re going to grow this MLP at 15% to 20% a year for the next three years.” We know they have the assets; we know that if they put the assets down, their IDRs and their GP will go up. So, there’s a terrific synergy. In three years there may not be, but we’ll probably be long gone. These ones yield pretty low – they’re yielding closer to 3% – but you’re looking at 20% growth of that distribution pretty much in the bag, regardless of what happens to oil prices at the moment. This is one of the reasons why we like this so much.

To give you an idea of that GP, how valuable they can be, Plains All American had a GP that they IPOed – Plains is a huge midstream large cap diversified MLP that was worth about $20-25 billion. When they IPOed, they sold the GP; it sold for $20 billion. We look at these carefully, and we like to participate in these.

Ethane as an export: ethane is a by-product of natural gas liquids. Enterprise Partners, one of our names, just started exporting it, so they did 5 million barrels a day, and looking at this, I think there’s a huge growth opportunity.

In a long-term view of performance of MLPs by the proxy of the Alerian index, it has performed through bull markets, bear markets, and the financial crisis. Lehman Brothers had $3 billion of MLPs and their administrator sold them in around four days, and that was back when the daily market value was $300 million. So, you can imaginewhat that did to our market: it created some interesting buying opportunities, and it has gone up.

They trade daily, so they have volatility. We have had corrections every year, and it keeps recovering. We’re obviously in the midst of one right now, because they have been selling off in sympathy for oil, primarily because people are looking at the capex cuts and saying, “Well, wait a minute, how’s that going to affect them?” Frankly, the good ones are being sold with the bad ones; we’ve seen indiscriminate selling. This is a highly retailed product in the US, so there’s a lot of emotional selling and buying. We’ve seen some pretty indiscriminate selling lately, which obviously gets us pretty excited for the future.

Correlations are relatively low, through most things (although clearly, in times of stress, these things change). Yields are currently about 6%. Our fund is more like 4%, because we like the growth names, and the growth names have a little less yield. But it compares very nicely to other high-yielding assets. So with a compounding return of almost 16%, outperforming equities, that’s a good alternative to other high-yielding securities. It’s a high-yielding product with a lot of growth, and that’s what makes it so interesting.

On the outlook, we’re defensively postured right now; we have a lot in the large cap, large diversified. We want to wait and see what happens, when oil bottoms. When oil bottoms, then we’ll have a better sense for which MLPs we feel are best positioned, and we’ll get an opportunity to not only do those, but really go into opportunistic types of scenarios that we like to do, so we’re defensively postured.

But, going forward, the Alerian is cap-weighted, and that’s what most of the ETF-type products are like. We don’t think the large cap is really where all the growth is going to be. It doesn’t include those IPOs that we like, but we think the fastest-growing MLPs are going to probably be the smaller ones, but it’s a dangerous time to be playing a lot in there. So, we think there’s value there.

The indexes don’t even take general partners in. That’s not part of their purview and we think that general partners are going to continue to be a very strong and important part of the programme.

There are risks, yes: price, price of oil. There are MLPs that have exposure to oil; we have actually stayed away from them consistently, like the E&P names, but obviously, with capex coming down, that’s going to affect it. So we’re going to see some volatility with price, but ultimately, value finds value.

As far as volume goes, I think that some of the shales, like mid-continent, are vulnerable. It’s a higher costing shale, but not the Permian, Eagle Ford, Marcellus. The US shale revolution isn’t over, and frankly, wherever oil ends up, this market is going to balance, and it’s going to be competitive, and it’s going to be there, which is all I care about because I just want to see that infrastructure built. And I think it’s going to happen.

Obviously we care a lot about balance sheets: that’s why we don’t like the E&P companies. There are a lot of little E&P companies, and some of them are MLPs that are levered. They are going to be hard pressed to survive two years. In fact, as oil prices bottom, you’re going to see the strong companies start buying them up. They’re going to pick them up on the cheap, because there’s a lot of value there, but there were some guys that were a little bit too much the West Texas cowboy – they were going for it a little bit.

Lastly, Morgan Stanley did an investor survey in December. It gives you an idea of where the investors in the US are looking at MLPs, and the expected total returns are looking for, for 2015. Obviously, we think MLPs have been oversold, and we think there’s going to be a nice balance.

Michael Parker serves as President of Parker Global Strategies. He guides the firm’s strategic direction and manages the day-to-day business operations of the firm. Parker chairs the Executive Committee and is an ex-officio member of the Investment Committee. Prior to joining PGS in 2007, Parker held a number of senior management positions at Willis Re Inc. over a 17-year tenure. In 1993, he established Willis Re’s Stamford, CT office. Parker earned his B.A. with honors in US History at Middlebury College. He is a 2012 graduate of Harvard Business School’s OPM programme.

This article was extracted from a presentation at the Notz Stucki Investment Conference held in Geneva on 13 January 2015.