Tortoise Talk 1Q2020

Energy 4/17/2020
The broad energy sector declined with the S&P Energy Select Sector® Index returning -50.7% for the quarter. However, in early April, Russia and OPEC met again and approved the biggest ever production cut to support oil prices during the pandemic and we are optimistic about the future and our investments across essential assets.
Tortoise Talk

First and foremost, our thoughts are with everyone affected by the COVID-19 pandemic. This virus has driven fear across the globe from a health, social and financial perspective. It has changed all aspects of our lives, from how we work and to how we interact with others. It has caused turmoil across the medical field and financial markets. However, we know that this too shall pass and our lives and the financial markets will return to some sort of normalcy. In the energy sector, we had the additional headwind of the crude oil price war that stemmed from Russia and Saudi Arabia’s inability to come to an agreement on production cuts. This led to a broad energy decline with the S&P Energy Select Sector® Index returning -50.7% for the quarter. However, in early April, Russia and OPEC met again and approved the biggest ever production cut to support oil prices during the pandemic and we are optimistic about the future and our investments across essential assets.

First quarter 2020 total returns (%)

As of 3/31/2020. 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

U.S. oil and gas producers turned down in the first quarter of 2020 as commodity prices continued to be pressured with global supply/demand concerns for both crude oil and natural gas. The Tortoise North American Oil and Gas Producers IndexSM returned -64.2%. In early March, Saudi Arabia decided to increase oil production after failing to reach an agreement with Russia to cut production. This decision caused a sharp decline in crude oil prices as global demand was already uncertain with the COVID-19 pandemic underway. Crude oil prices, represented by West Texas Intermediate (WTI), started the year at $61.18 per barrel, quickly peaked on January 6 at $63.27 following the U.S. military airstrike that killed the head of Iran’s Revolutionary Guard, and then continued to fall throughout the quarter to hit a low of $18.99 on March 25 before ending the period at $20.48. Natural gas prices, represented by Henry Hub, opened the year at $2.05 per million British thermal units (MMBtu), quickly peaked at $2.17 on January 7 and ended the quarter near the low at $1.71. Natural gas prices could see some support as oil production slows and the associated natural gas production that comes with it declines as well.

U.S. crude oil production projections have been revised down as a result of the drastic decline in oil prices and is now expected to average 11.8 million barrels per day (MMbbl/d) in 2020, which is 0.5 MMbbl/d lower than it was in 2019, which would mark the first annual decline in production since 2016. The more recent production cut agreement with OPEC+ could bring this number back up marginally if prices make a significant recovery in 2020. Production is expected to decline another 0.7 MMbbl/d in 2021.1 To the extent that COVID-19 results in even lower demand for crude oil, production estimates could fall even further. Natural gas production is expected to climb continuously through 2021 with estimates of 93.6 billion cubic feet per day (Bcf/d) in 2020 and 93.9 Bcf/d in 20212. Demand for U.S. produced natural gas is also expected to rise through 2021 with increased demand from Mexico, and to a greater degree, from global demand for liquefied natural gas (LNG).

Crude oil & natural gas prices

As of 3/31/2020. Source: Bloomberg. Note: MMBtu = million British thermal units

Midstream

Midstream energy fared better than broad energy in the first quarter with the Tortoise North American Pipeline IndexSM return of -41.0%. MLPs continued to face additional structural headwinds and the Tortoise MLP Index® returned -56.8% during the period. Demand fears due to COVID-19 continued to challenge broad energy and midstream companies. However, midstream cash flows have historically been resilient through crude oil price swings as these companies generate primarily fee-based cash flows from moving energy products. During the 2008-2009 financial crisis, when economic activity slowed for months, the energy infrastructure companies in which we invest experienced a volume decline of less than 5%. Even more telling, following those periods of market distress and price volatility, midstream companies have historically surged higher, for example, the Tortoise MLP Index® rose 76% higher from March 2009 lows to year-end 2009 and by coincidence, 76% higher from February 2016 lows to year-end 2016.

Midstream companies are reacting to the soft economic outlook by announcing drastically reduced capital expenditure budgets for 2020, ranging from 20-50%, and indicating that further reductions may be necessary in 2021. The outcome of these announcements has generally been one of modest impact to 2020 financial guidance, but with improved free cash flow profiles. This will allow management teams greater capital allocation flexibility in in the current crisis. In some cases, we may see reduced dividends or distributions with the cash flow instead used to reduce debt, or potentially to buyback shares. We think these actions are a long term positive, as they preserve credit ratings, provide more liquidity, and offer more capital allocation optionality.

We have continued to evaluate the liquidity of our holdings and have run a number of stress tests on our portfolios and continue to feel that we are well positioned in the current environment to weather the downturn and to capture the upside when it turns around. For more on our stress tests, please see our recent podcast on our website.

Capital Markets

Capital markets activity continues to be driven by debt issuance as midstream companies increase their ability to self-fund projects through internally generated cash flows rather than issue equity in public markets. During the first quarter of 2020, midstream companies raised nearly $19 billion in debt. As was a theme in 2019, companies continue to be able to access alternative options, like preferred securities, for capital as well.

MLP and pipeline company debt & equity offerings

Source: Company filings. As of 3/31/2020. Includes equity issued to sponsors.

Merger and acquisition (M&A) activity during the quarter was driven by simplification transactions as Equitrans Midstream Corporation purchased the units it did not already own of EQM Midstream Partners for nearly $1.9 billion and Shell Midstream Partners and CNX Midstream Partners both eliminated their Incentive Distribution Rights in transactions valued at $3.8 billion and $0.6 billion, respectively. Total M&A activity of nearly $6.6 billion for the quarter was slightly below the quarterly average in 2019.

Announced MLP and pipeline company acquisitions

Company filings. As of 3/31/2020. Includes MLP and pipeline corporations, including transactions between MLPs.

Downstream and renewables

Solar power sources accounted for nearly 40% of new electric generation capacity in the U.S. in 2019, which was the highest of all generation sources. Utility-scale continues to comprise the majority of the additions, but there was also strong growth in the residential market of 15% year-over-year in 2019. Growth in residential installations was caused partially by an increased focus on resiliency following power shutoffs in California due to the risk of wildfires. The visibility into continued solar growth is high, as evidenced by a record 30.6 gigawatts (GWs) of new power purchase agreements (PPAs) signed in 2019 for delivery over the next few years. This increased activity was driven by the need to qualify for the 30% Investment Tax Credit (ITC) by December 31, 2019. Elsewhere, there was strong continued demand for solar power from corporate buyers, who comprised 19% of new procurement during the year. Another noteworthy trend is the increase in solar power paired with storage. In fact, by 2025 Wood Mackenzie projects one in three residential systems and one in four non-residential systems will be paired with energy storage. Finally, while it remains too soon to determine impacts from COVID-19, we expect supply chain and regulatory approval delays. These delays could affect project in-service timelines, but the ultimate extent remains to be seen.

The U.S. wind industry installed 5,476 megawatts (MWs) of new wind power capacity in the fourth calendar quarter of 2019. This equates to 9,143 MWs installed in all of 2019, which is the third highest year for new wind power capacity on record (2012 and 2009 were first and second respectively). There are now more than 105,000 MWs of operating wind power capacity in the U.S. across 41 states. The near term project pipeline totals more than 44,000 MWs at the end of 2019, with half of this pipeline currently under construction, while the remainder is in advanced stages of development. Approximately half of this pipeline consists of projects with a PPA in place. Of note, the size of turbines continues to increase with 25% of turbines installed in 2019 rated between 3.1 MW to 3.6 MW and two thirds rated between 2 MW and 2.9 MW.

Concluding thoughts

Despite the extreme volatility we have experienced so far in 2020, we feel optimistic about the remainder of the year, once we move past the pandemic. We think private equity will continue to have interest in energy infrastructure and renewables and that natural gas and LNG exports will continue to change the electricity generation mix, not only in the U.S., but also globally. We believe times such as these underscore the essential nature of our investments.

1EIA April 2020 STEO
2 BTU Analytics 2/28/2020

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”).