Tortoise Talk 2Q2020

Energy 7/20/2020
Some parts of the world, including the U.S. have begun to emerge from several months of quarantine-induced economic slumber. While the virus is still gaining momentum in some parts of the globe, it is slowing in others and we are seeing more indicators that life is slowly making the first hesitant steps back towards normalcy.
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The second quarter certainly had its highs and lows. When the period started, COVID-19 was becoming a serious concern in the U.S. and many other countries across the globe, with shelter-at-home orders and basic shutdowns of countries and economies becoming prevalent. By the end of the period, some parts of the world, including the U.S. began to emerge from several months of quarantine-induced economic slumber. While the virus is still gaining momentum in some parts of the globe, it is slowing in others and we are seeing more indicators that life is slowly making the first hesitant steps back towards normalcy. This has taken the form of direct data showing the narrowing gaps between oil and gas supply/demand, as well as untraditional metrics showing more people out on the roads requesting driving directions.

During the period, the broad equity markets were be driven by hopes and possibilities that the world could be closer to a COVID-19 vaccine. Markets vacillated as each drug saw successes or failures during trials but ended on a solid note with the S&P 500® Index returning 20.5% for the second quarter. Energy markets improved throughout the period as oil inventories declined with an increase in transportation demand and supply cuts and the market saw signs of balance. The broader energy sector, as represented by the S&P Energy Select Sector® Index, returned 32.1% during the second quarter.

Second quarter 2020 total returns (%)

As of 6/302020. 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

Rarely have we seen a sector experience two consecutive months with more extremes than energy did in April and May. In April, oil prices plummeted to negative $37 around expiration of the front-month futures contract. May’s front-month futures contract expiration did not result in similar theatrics. The massively oversupplied global oil market in April that resulted in higher inventories subsided, resulting in higher prices. In fact, oil prices had the largest monthly gain in history in May. Crude oil spot prices, represented by West Texas Intermediate (WTI), began the quarter at $20.48 per barrel, troughed at -$37.63 on April 20. Prices briefly surpassed $40 in late June and ended the period at $39.27.

Indications are that China oil demand is approaching pre-COVID levels. U.S. demand appears to be increasing as well. Increased demand from two of the largest energy consumers in the world are helping balance the global oil supply and demand equation. Meanwhile, on the supply side, Saudi Arabia, Russia, and other OPEC nations are cutting production along with the U.S. In fact, the U.S. rig count is at its lowest level since 2009 indicating further production declines.  According to Energy Information Administration (EIA) estimates, U.S. crude oil production fell from a record 12.9 million barrels per day (b/d) in November 2019 to 11.0 million b/d in June 2020. Baker Hughes reported that the U.S. had the fewest active drilling wells on record dating back to 1987. EIA forecasts that U.S. crude oil production will average 11.6 million b/d in 2020, and 11.0 million b/d in 2021, which would mark the first annual decline since 2016.1

While oil dominates the headlines, natural gas continues to provide a cleaner burning energy source. As a result, we continue to see natural gas as a critical source of energy supply going forward. A reduction in natural gas demand caused by COVID-19 has resulted in the convergence of global natural gas prices. Natural gas prices, represented by Henry Hub, opened the quarter at $1.71 per million British Thermal Units (mmbtu), peaked on May 5 at $1.93 before ending the quarter close to where it began at $1.76.

In the short term, the convergence of prices restricts the global liquefied natural gas (LNG) trade. It was reported that potentially 35-45 U.S. LNG cargoes scheduled for July loading could be canceled. On the demand side, the EIA expects U.S. LNG exports to decline through the end of the summer as a result of reduced global demand for natural gas, but to increase beginning in September as global natural gas demand gradually recovers. Longer term, lower natural gas prices are causing deferrals and cancellations of several LNG projects. Therefore, the global LNG market is expected to balance faster than analysts expected and there will likely be fewer players in the global LNG market. Existing LNG providers, with stable cash flows backed by long-term contracts will likely benefit from fewer market participants as LNG demand and commodity prices rise in the future.

However, low natural gas prices encourage coal-to-gas switching. We expect low natural gas prices in Europe to result in coal-to-gas fuel switching for electricity generation in countries like Germany this summer. Also, South Korea and Japan are expected to switch to natural gas from coal due to low prices as well. Clearly, more natural gas and less coal will reduce CO2 emissions. According to the EIA, U.S. dry natural gas production averaged 92.2 billion cubic feet per day (Bcf/d) in 2019, setting a new record and forecasts average dry natural gas production at 89.2 Bcf/d in 2020 and 84.2 Bcf/d in 2021 before production is expected to begin rising in the second quarter of 2021 in response to higher prices.1

Crude oil & natural gas prices

As of 6/30/2020. Source: Bloomberg. Note: MMBtu = million British thermal units

Midstream

Midstream energy had a strong second quarter with the Tortoise North American Pipeline IndexSM return of 23.2%. MLPs had a very strong recovery with the Tortoise MLP Index® return of 49.4% during the period. In general, first quarter earnings for midstream companies were treated as a non-event, with an exclusive focus on company outlooks. Conditions appear to be improving, but are still far from normal. Full year guidance is now 8% lower on average. Companies with significant natural gas businesses and/or take or pay contracts reaffirmed guidance, whereas others with cash flows tied to wellhead volumes provided a wider range of outcomes. This falls in line with the sensitivity analysis we conducted. Management teams are seeking to insulate and improve their balance sheet while investor focus has remained on the sustainability of company cash flows and ultimately the dividends. Companies continued to reduce spending to better align activity with the new environment and we estimate capex is now 25% lower than original 2020 plans. Although, in most cases these projects did shift out of 2020 capital budgets, many of these projects will be necessary when demand stabilizes and may reappear in 2021 capital programs or beyond.

Capital markets activity was driven mostly by debt issuance with midstream companies raising approximately $14 billion in total during the second quarter of 2020, down from the first quarter. Merger and acquisition activity was minimal with approximately $250 million for the period. The largest deal was Plains All American (PAA) selling its natural gas liquids (NGL) terminal assets to Crestwood Equity Partners (CEQP) totaling approximately $160 million.

MLP and pipeline company debt & equity offerings

Source: Company filings. As of 6/30/2020. Includes equity issued to sponsors.

Announced MLP and pipeline company acquisitions

Source: Company filings. As of 6/30/2020. Includes MLP and pipeline corporations, including transactions between MLPs.

On the regulatory front, in early July, a DC District Court judge announced that the Dakota Access Pipeline (DAPL) must shut down by August 5 while the Army Corps of Engineers completes an environmental impact statement (EIS). The court ruled that a federal permit for DAPL fell short of requirements to allow the pipeline to continue operating while the Army Corps bolsters their analysis. The completion of the EIS is expected in mid-2021. It is important to note that the pipeline has operated safely for that past three years, delivering oil from North Dakota to Illinois. The next likely step is that the Army Corps will appeal the decision to a higher court, with the potential for a quick decision. Without DAPL available for transportation, we think the
marginal barrel out of the Bakken will be transported by rail.

Separately, New York regulators denied a water permit for Williams Companies' proposed Northeast Supply Enhancement natural gas pipeline. Now, it is unlikely that Williams will pursue this project which would have resulted in lower heating bills for certain New York residents. The project cancellation immediately improves Williams’ free cash flow. And as we are emphasizing a free cash flow focus to management teams, we consequently view this and other project cancellations and deferrals favorably.

Downstream and renewables

Renewables and utilities have seen fairly modest overall impacts to fundamentals and valuations throughout the pandemic. The sector has remained highly defensive while maintaining its overall growth outlook. In terms of short-term impact across regions, the primary issue is intense disruptions from ‘stay in place’ policies. Europe has proved to be the most impacted, with short-run electricity demand falling in a range of 5% to 20% versus last year, which relates to a more significant short-term disruption in manufacturing and industrial activity versus other regions. We expect these declines to recover sharply over the next few months, consistent with a gradual relaxation of lockdowns, which will favor essential business activities. Regarding renewables, growth continues unabated. Renewable power generation technologies are the cheapest options globally, accounting for 72% of all new capacity additions in 2019.2

In the U.S. we have seen far more limited impacts, with electricity demand flat to down 5% broadly year-over-year, in part because U.S. industrial and commercial activity has been less disrupted. In China, which experienced an earlier disruption and recovery cycle, we are seeing signs of not only full power demand recovery, but also the potential for annualized power demand to continue to be higher year-over-year for the rest of 2020. Unsurprisingly, residential usage appears to have increased compared to last year, almost everywhere. ‘‘Stay in place” has fueled more usage of appliances, lighting, computers and general activity in the home that relies on ever more plug-in nodes. And importantly, residential mix tends to be more profitable for utility companies. Our views before the crisis and now, well into the crisis, now are consistent: we expect power demand to continue to remain relatively well underpinned, outperforming overall economic impacts during the economic downturn and to see gradual recovery as manufacturing activity bottoms and re-starts, especially in Europe. General sentiment from the International Energy Agency (IEA) concurs that renewables are growing and will continue to grow despite the generally weak economic environment and the decline in overall energy consumption in 2020.3

Concluding thoughts

Despite the ripple effect that the COVID-19 crisis has had on the economy, we remain optimistic about the recovery potential as the world works hard to return to a new version of normal. We believe that energy markets will continue to improve and the energy demand and usage mix will continue to transition to natural gas and renewables. We believe that the need for these essential assets will prevail.

1 EIA July 2020 STEO
2 The International Renewable Energy Agency: Renewable Power Generation Costs in 2019
3 IEA Renewable Energy Market Update, Outlook for 2020 and 2021

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 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.

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It is not possible to invest directly in an index.