Midstream energy catalysts

Energy 2/10/2020
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In 2019, we introduced three key catalysts for the midstream energy sector. In this piece, we will provide an update on those catalysts and provide our catalysts for 2020. Midstream energy has faced a number of challenges over the past five years, but has persevered and maintained strong fundamentals. Additionally, valuations have remained attractive. The three catalysts, beyond fundamentals and valuations, that we think will drive performance in 2020 are: transparency, return of capital to shareholders and reduced volatility.

Update on 2019 catalysts

Our catalysts for 2019 were: structure, return of capital to shareholders and flows. Below is a scorecard on how those catalysts played out. With great strides on most topics, overall, the catalysts played out as expected. One area of disappointment was flows as we did not see retail investors reentering the space as we had hoped.

2020 Midstream energy catalysts

Transparency

As a team we advocate for midstream energy companies to improve transparency in a variety of ways. Two of the large initiatives are improved corporate governance and highlighting ESG efforts. Other areas are better disclosures, less reliance on industry jargon to make communications more understandable for investors and more GAAP-based financial reporting metrics.

We have extensively discussed the improvement needed in corporate governance between MLPs and c-corps, which is illustrated in the following chart. We think it is no coincidence that at least part of the reason that c-corps have outperformed MLPs over the past few years is the superior corporate governance. In 2019, companies with metrics closely aligned with good corporate governance practices outperformed those with poor corporate governance metrics by an average of 18.5%. We see this as an opportunity and are pushing MLP management teams to improve their corporate governance.

Source: company filings and U.S. Capital Advisors as of 12/31/2019

Another aspect of transparency that we find highly important is highlighting ESG efforts. Surprising to some, midstream energy has made quite a bit of progress on ESG initiatives, but they are not doing a good job highlighting their efforts. The chart below on the left shows that the majority of midstream energy companies have CO2 emission reduction programs. The right side of the chart shows the percentage of midstream energy companies that provide a sustainability report. At more than half for MLPs and nearly all c-corps, this is an impressive feat, especially considering that number was close to zero only five years ago. Many energy companies have even hired sustainability officers.

Source: company filings and U.S. Capital Advisors as of 12/31/2019

Return of capital to shareholders

The second catalyst is return of capital to shareholders, which is a repeat from 2019. The chart below on the left shows both historical and forecasted free cash flow and highlights the substantial disruption midstream energy companies underwent in 2016-2019. You can see the direction and inflection both working in favor of investors. The chart on the right further illustrates the significant transformation with substantially all midstream energy companies expected to generate free cash flow in 2020.

Source: company estimates and Tortoise as of 12/31/2019
Note: Free cash flow adjusted for historical asset sales. The projections above are based on industry estimates and are no guarantee of future outcomes.

Next, we show the potential upside to total return through the reduction of leverage and share buybacks. The chart on the left below shows how leverage is expected to make progress toward the shaded target range for midstream companies of approximately 3.5x-4.0x debt/EBITDA. The right side of the chart shows an analysis of stock buyback potential. For illustrative purposes, we assumed target leverage metrics of lower than 4.0x were met prior to allowing for any buybacks and assumed capex funding of 50% debt, with the clear potential for the sector to engage in buybacks.

Source: company estimates and Tortoise as of 12/31/2019
The projections above are based on industry estimates and are no guarantee of future outcomes.

Reduced volatility

One of the key reasons cited by investors for leaving or not entering the sector is heightened volatility. The graph below shows the relative volatility between the Alerian MLP Index and the S&P 500 Index. Clearly, volatility spiked in the MLP sector, starting in 2013 and culminated in 2016 when the market was down as much as 30% before ending the year 20% in positive territory.

AMZ/S&P 500 volatility

Source: Barclays and Bloomberg as of 12/31/2019.
Past performance is no guarantee of future results. It is not possible to invest directly in an index.

The table below shows significant operational characteristics of midstream energy companies that tend to affect volatility and how they have evolved over the past several years. With improvement in these key areas, we believe that volatility should return to more normalized levels in the near future.

Distribution reductions, as seen in the chart below, have been a key factor in the sector’s volatility over the past several years. As midstream companies persevered through the energy downturn and company structure evolved, so too came distribution cuts. 2019 showed a sharp reduction in cuts and during the fourth quarter, Alerian-linked products experienced a 3.5% growth in income, which we believe is a strong catalyst for the sector in terms of income sustainability. We expect to see income stability return to the sector in 2020. In addition, there was a shift in flows of index-linked products in 2019. After outflows of approximately $400 million during the first nine months of the year, during the fourth quarter there were inflows of $620 million, which showed quite a turnaround in investor sentiment.

Historic income reductions

Source: Bloomberg, company filings and U.S. Capital Advisors as of 12/31/2019. The projections above are based on industry estimates and are no guarantee of future outcomes.

Summary

We believe transparency, return of capital to shareholders and lower volatility will play a key role as catalysts for the midstream energy sector in 2020. As impact investing and ESG efforts continue to gain traction with investors, transparency will be an important consideration and seemingly an indicator of potential positive performance. The significant increase in midstream companies’ abilities to generate positive free cash flow should benefit investors. After several years of tumultuous energy markets, reduced volatility would be a welcome change for investors. If these catalysts play out as we hope they do, we expect a strong 2020 full of opportunities for midstream energy investors.

Disclosures

This commentary is provided for discussion and informational purposes only to provide background information with respect to the market generally, and is not an offer to sell or the solicitation of an offer to buy an interest in any current or future vehicles or funds controlled by Tortoise, and you acknowledge that you are not relying on the information contained in this presentation as the basis for any such investment decision you may make in the future. Prospective investors should not construe this overview or any other communication as legal, accounting, tax, investment or other advice, and each prospective investor should consult with their own counsel and advisers as to all legal, tax, regulatory, financial and related matters concerning an investment.

This commentary contains certain forward-looking statements. These forward-looking statements include all statements
regarding the intent, belief or current expectations regarding matters covered and all statements which are not statements of historical fact. The forward-looking statements involve known and unknown risk, uncertainties, contingencies and other factors, many of which are beyond our control. Since these factors can cause results, performance and achievements to differ materially from those discussed in the presentation, you are cautioned not to place undue reliance on the forward-looking statements.

Master limited partnerships (MLPs) are subject to many risks, including those that differ from the risks involved in an investment in the common stock of a corporation. Holders of MLP units have limited control and voting rights on matters affecting the partnership. Holders of units issued by an MLP are exposed to a remote possibility of liability for all of the obligations of that MLP in the event that a court determines that the rights of the holders of MLP units to vote to remove or replace the general partner of that MLP, to approve amendments to that MLP’s partnership agreement, or to take other action under the partnership agreement of that MLP would constitute “control” of the business of that MLP, or a court or governmental agency determines that the MLP is conducting business in a state without complying with the partnership statute of that state. Holders of MLP units are also exposed to the risk that they will be required to repay amounts to the MLP that are wrongfully distributed to them. In addition, the value of the funds’ investment in an MLP will depend largely on the MLP’s treatment as a partnership for U.S. federal income tax purposes. If an MLP does not meet current legal requirements to maintain partnership status, or if it is unable to do so because of tax law changes, it would be treated as a corporation for U.S. federal income tax purposes. In that case, the MLP would be obligated to pay income tax at the entity level and distributions received by the funds generally would be taxed as dividend income. As a result, there could be a material reduction in the funds’ cash flow and there could be a material decrease in its net asset value. Furthermore, MLP interests may not be as liquid as other more commonly traded equity securities.

The Alerian MLP Index is the leading gauge of energy infrastructure MLPs. The capped, float-adjusted, capitalization-weighted index, whose constituents earn the majority of their cash flow from midstream activities involving energy commodities, is disseminated real-time on a price-return basis (AMZ) and on a total-return basis (AMZX).

The S&P 500® Index is an unmanaged market-value weighted index of stocks, which is widely regarded as the standard for
measuring large-cap U.S. stock market performance.

MLPs = Tortoise MLP Index®, a float-adjusted, capitalization-weighted index of energy MLPs. To be eligible for inclusion in the Tortoise MLP Index®, a company must be publicly traded, organized as a limited partnership or a limited liability company, and be classified as an “energy MLP” by the Master Limited Partnership Association (MLPA). Tortoise MLP Index® is the exclusive property of Tortoise Index Solutions, LLC, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Indices. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omission in calculating the Indices. “Calculated by S&P Dow Jones Indices” and its related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Tortoise Index Solutions, LLC and its affiliates. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). It is not possible to invest directly in an index. Index returns and yields shown are presented before management fees and other expenses of Tortoise advisory products and services. Clients or investors in Tortoise products and services will experience returns and yields reduced by advisory fees and other product expenses.

Past performance is no guarantee of future results.