Tortoise Talk 3Q2019

Energy 10/22/2019
Energy demand is at an all-time high and a global energy transition is taking place reducing global carbon emissions while meeting that demand. We are witnessing the next phase of U.S. energy independence emerge as the U.S. becomes a net exporter of low-cost energy to the rest of the world.
Tortoise Talk

The broader energy sector, as represented by the S&P Energy Select Sector® Index, fell during the third quarter, returning -6.2%, bringing year-to-date performance to 6.1%. Energy demand is at an all-time high and a global energy transition is taking place reducing global carbon emissions while meeting that demand. We are witnessing the next phase of U.S. energy independence emerge as the U.S. becomes a net exporter of low-cost energy to the rest of the world. Against that backdrop, approximately $15 trillion1 of investment in global energy infrastructure is required to support this energy transition, making it a compelling opportunity for midstream energy investors.

Third quarter 2019 total returns (%)

As of 9/30/2019. Source: Bloomberg. It is not possible to invest directly in an index. Please see index definitions on disclaimer page. Past performance is no guarantee of future results.

Upstream

The Tortoise North American Oil and Gas Producers IndexSM returned -12.0% in the third quarter, bringing year to date performance to -3.2% as the oil market continued its myopic focus on the trade war driving pressure on demand growth. Escalating tensions in the Middle East, mounting worldwide supply outages and positive news out of both the G20 Summit and OPEC+ meeting all proved insufficient to stimulate a sustained crude oil price response. As such, crude oil prices, represented by West Texas Intermediate (WTI), began the quarter at $59.09 per barrel, troughed at $51.09 on Aug. 7, 2019, peaked at $62.90 on Sept. 16, 2019 following the attacks on Saudi oil infrastructure before quickly trading back down to end the quarter at $54.07.

We continue to expect 2019 U.S. crude oil production to increase as numerous Permian pipeline projects in the Gulf Coast come online at the end of the year. U.S. crude oil production is projected to average 12.3 million barrels per day (MMbbl/d) in 2019 and 13.2 MMbbl/d in 2020.2 The U.S. Energy Information Administration
predicts that continued production growth will transform the U.S. into a net exporter of oil and petroleum products by the end of 2019. In addition, the Organization of Petroleum Exporting Countries (OPEC) and Non-OPEC partners formalized the OPEC+ Charter of Cooperation, agreeing to roll over the existing output reduction target of 1.2 MMbbl/d for another nine months through March 2020. OPEC also officially adopted the 2010-2014 five-year inventory average of 2.7 billion barrels, for the Organisation for Economic Co-operation and Development (OECD), as the baseline against which the OECD inventory overhang will be measured. Given the overhang of 236 million barrels as of July 2019, we expect that OPEC+ will continue production cuts forward through 2020 at the next OPEC meeting in early December.

Natural gas price pressure continued during the third quarter, hitting a new low for the year of $2.02 per million British thermal units on Aug. 5, 2019. Prices opened at $2.33 and peaked at $2.75 late in quarter, with warmer than average weather in the South and Midwest, before ending the quarter back down at $2.37. Natural gas demand remained robust supported by record levels of domestic power burn, increased exports to Mexico and strong liquefied natural gas (LNG) demand globally. However, surging natural gas production more than offset strong demand, resulting in an elevated pace of inventory builds and pricing pressure through much of the quarter. Natural gas production is expected to continue growing, averaging 91.6 billion cubic feet per day (Bcf/d) in 2019 and 93.5 Bcf/d in 2020.3 We believe production growth will continue to outpace domestic demand and global export needs, likely pressuring prices in the short to medium term.

Crude oil & natural gas prices

As of 9/30/2019. Source: Bloomberg. Note: MMBtu = million British thermal units

Midstream

Midstream sector performance fared slightly better than broader energy for the third quarter with the Tortoise North American Pipeline IndexSM return of -0.8% and the Tortoise MLP Index® return of -4.3%, bringing year to date performance to 22.2% and 14.2%, respectively. Phillips 66 Partners LP (PSXP) announced the elimination of its Incentive Distribution Rights (IDRs) in the third quarter. As the era of simplification comes to a close, the results have advanced the midstream sector and accomplished widespread cost of capital and corporate governance improvements.

Interest in publicly-traded midstream companies and assets, from both public and private entities, remains elevated, highlighting their strategic value and attractive valuations . In addition to the previously announced acquisition of Buckeye Partners by an Australian global institutional funds manager, current bids or announced transactions include ownership stakes in Tallgrass Energy (TGE) and SemGroup Corp (SEMG).

Capital Markets

Capital markets activity remained slow during the third quarter with MLPs and other pipeline companies raising approximately $9.0 billion in total capital, all of which was in debt.

MLP and pipeline company debt & equity offerings

Source: Company filings. As of 9/30/2019. Includes equity issued to sponsors.

Merger and acquisition activity among MLPs and other pipeline companies remained light at $9.5 billion for the quarter, almost entirely comprised of Energy Transfer LP’s (ET) purchase of SemGroup Corp (SEMG) and Pembina Pipeline Corp’s (PBA) purchase of certain businesses and assets from Kinder Morgan (KMI). Our outlook for capital investments remains at approximately $132 billion for 2019 to 2021 in MLPs, pipelines and related organic projects.

Announced MLP and pipeline company acquisitions

Source: Company filings. As of 9/30/2019. Includes MLP and pipeline corporations, including transactions between MLPs.

Downstream

Refinery utilization has remained challenged in 2019 due to heavy spring and fall turnarounds in preparation for IMO 2020, unplanned refinery outages and the closure of Philadelphia Energy Solutions’ 350 Mbbl/d Philadelphia refinery, the largest refining complex on the east coast. With the upcoming International Maritime Organization’s Jan. 1 2020 implementation of sulfur reduction regulations on the shipping industry, U.S. refiners are well positioned to take advantage of higher distillate pricing and more heavily discounted medium-heavy sour crude oils as they have the flexibility to use a wide range of crude oil feedstocks. It is expected that late in the fourth quarter of 2019 and through 2020, U.S. refinery utilization and throughput will exhibit strong growth as refiners attempt to capture margin upside driven by IMO 2020.

Incremental natural gas liquids (NGLs) supply from completed Permian takeaway projects and overall liquids production growth surpassed current levels of domestic NGL demand. As a result, prices of NGL products, which are used as feedstock in petrochemical facilities, continued to face headwinds, primarily on excess supply. We expect that downstream petrochemical projects coming online in the second half of 2019 and early 2020 will begin to draw down inventories, as low-cost NGL inputs translate to better opportunities for petrochemical margin growth.

Power/renewables

Solar accounted for 36% of new electricity generation capacity in the first half of 2019. This strong demand has been driven by traditional utilities, as well as by corporate buyers, which accounted for 17% of projects announced year to date. Solar power generation has continued to become more cost competitive, with voluntary procurement driving 55% of utility PV announcements in 20193. The growth outlook continues to increase as evidenced by the pipeline of contracted solar projects reaching 37.9 gigawatts, the highest ever on record. One area to watch between now and year end is a potential extension of the Investment Tax Credit which is scheduled to begin a phase down at the end of 2019.4

Wind installations are at record highs with 736 megawatts (MWs) installed in the second calendar quarter of 2019, the latest data reported, reaching a total installed capacity of 97,960 MW with an additional 41,801 MW of capacity currently under construction or in advanced development. Wind power is expanding rapidly in many regions of the U.S. with more than 200 wind projects underway across 33 states, and 15 of those states have more than 1,000 MW of wind capacity that will come online in the near term.5 The offshore wind sector saw significant activity in the second quarter with new targets legislated in Maryland, Connecticut and New York. New Jersey granted its first offshore renewable energy certificate award to Ørsted’s 1,100 MW Ocean Wind project— the largest offshore project planned in the U.S. so far.

Regulatory updates

The Financing Our Energy Future Act (formally known as the MLP Parity Act) was reintroduced in congress in June, with the goal of allowing clean energy resources access to the tax advantaged structure of the Master Limited Partnership (MLP) that combines the tax benefits of a limited partnership with the liquidity of publicly traded securities. Specifically, wind, solar, biomass, fuel cells, energy storage and other clean transportation related fuels would qualify for the MLP structure if the bill passes the legislative process and is signed into law. We believe this would greatly expand the potential MLP universe and would be positive for the sector.

The Environmental Protection Agency (EPA) allowed 31 refineries to be exempt from their biofuel volume obligations under the Renewable Fuel Standard. An average of 28 petitions for exemption were approved over the past three years versus an average of eight approvals over the three years prior, diminishing the value of credits generated by those in compliance. The EPA has said it will increase ethanol blending requirements in 2020 to offset the negative impact that elevated exemption levels have had on the biofuel industry, though no details have been provided.

Concluding thoughts

Given the geopolitical unknowns, volatility in the energy sector is likely to remain a constant through the end of the year. Despite that, the U.S. will play a critical role as a future supplier of oil and natural gas to countries around the world. As this happens, the U.S. will become the largest producer of LNG in the world. We maintain our strong conviction in the future of the U.S. energy sector, we believe the sector is undervalued and underappreciated and we think investors will want exposure to the long-term U.S. energy export story.


¹ Bank of America Merrill Lynch, June 2018
2 Energy Information Administration, Short-Term Energy Outlook, October 2019
3 BTU Analytics, September 2019
4 Wood Mackenzie, September 2019
5 AWEA, September 2019

This commentary contains certain statements that may include “forward-looking statements.” All statements, other than statements of historical fact, included herein are “forward-looking statements.” Although Tortoise believes that the expectations reflected in these forward-looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect, Actual events could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this publication. Tortoise does not assume a duty to update these forward-looking statements. The views and opinions in this commentary are as of the date of publication and are subject to change. This material should not be relied upon as investment or tax advice and is not intended to predict or depict performance of any investment. This publication is provided for information only and shall not constitute an offer to sell or a
solicitation of an offer to buy any securities.

The Tortoise MLP Index® is a float-adjusted, capitalization-weighted index of energy MLPs. The Tortoise North American Pipeline IndexSM is a float-adjusted, capitalization-weighted index of pipeline companies (MLPs, corporations, LLCs) domiciled in the U.S. or Canada. The Tortoise North American Oil and Gas Producers IndexSM is a float-adjusted, capitalization weighted index of North American companies engaged primarily in the production of crude oil, condensate, natural gas or NGLs. The S&P Energy Select Sector® Index is a modified market capitalization-based index of S&P 500 companies in the energy sector involved in the development or production of energy products.

Tortoise North American Pipeline IndexSM, Tortoise North American Oil and Gas Producers IndexSM, Tortoise MLP Index® (the “Indices”) are the property of Tortoise Index Solutions, LLC, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices) to calculate and maintain the Indices. The Indices are 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.