Tortoise Talk 3Q2020

Energy 10/23/2020
The third quarter was largely driven by COVID-19 developments, the reopening of economies across the world, and anticipation of the effects that the upcoming election outcome may have on policy and the economy. While it appears the economy troughed, the path to economic recovery is uncertain and appears highly reliant on fiscal and biologic outcomes. The macro outlook for both is promising, but timing is far from certain.

Third quarter 2020 total returns (%)

As of 9/30/2020. 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.

Energy infrastructure

This backdrop has led to some interesting outcomes in the energy industry overall. The broader energy sector, as represented by the S&P Energy Select Sector® Index, continued to face headwinds returning -19.6% in the third quarter. We believe there are several signs that better days are ahead for the energy sector. Demand for refined products has increased with global consumption approaching pre-COVID levels, and U.S. oil production is forecast to start improving after bottoming in the second quarter of 2020.

The most significant fundamental theme from the earnings season continues to be free cash flow generation. Every subsector in energy emphasized free cash flow. There is improved visibility to cash flow from operations and continued progress in optimizing capital expenditures. Energy infrastructure companies highlighted operating leverage tied to underutilized pipelines that won’t require additional capital expenditures as production volumes return. We expect that the result will be a rise in free cash flow growth over the next several years, producing a free cash flow yield that is meaningfully higher than the S&P 500. We do not believe free cash flow will go toward incremental capital expenditures. Rather we believe companies will more directly return cash flow to shareholders in the form of dividends, debt reduction and share buybacks.

The most notable transformation announcement from the earnings season was BP’s announced plan to transition from an international oil company, which it has been for over a century, to an integrated energy company. BP will reduce its oil and gas spending and production and accelerate its solar and wind growth with the goal of becoming a global leader in wind and solar by 2030. BP joins Royal Dutch Shell, Equinor, and Total as international oil and gas producers in transition. These oil and gas producers in transition are following the course taken by several large global utilities over the last several years, which we refer to as “utilities in transition” as they are transitioning to cleaner fuel sources to generate electricity, typically transitioning away from coal to wind and solar.

As economies re-open, even if disorderly, energy demand recovered from its lows of the spring. Refinery utilization was operating at mid-sixty percent of capacity in April and May, but those utilization rates are now in the low eighties. This tepid recovery led to range-bound crude oil prices all summer, generally in the low $40’s per barrel in the U.S. Crude oil spot prices, represented by West Texas Intermediate (WTI), began the period at $39.27 per barrel, peaked at $43.39 on August 26 before ending the period at $40.22. According to Energy Information Administration (EIA) estimates, U.S. crude oil production rose in recent months after decreasing during the second quarter. August production is estimated at 10.8 million barrels per day (b/d) and is expected to increase to 11.2 million b/d in September once production in the Gulf of Mexico returns post Hurricane Laura.1

Natural gas prices, represented by Henry Hub, opened the quarter at $1.76 per million British Thermal Units (mmbtu), peaked on Aug. 24 at $2.57 and troughed at $1.33 on Sept. 21 before ending the quarter at $1.66. On the demand side, EIA estimates that liquefied natural gas (LNG) exports increased 19% from July to August as natural gas spot prices rose in Asia and Europe. EIA forecasts that LNG exports will return to pre-COVID levels by November 2020.

Crude oil & natural gas prices

As of 9/30/2020. Source: Bloomberg. Note: MMBtu = million British thermal units

Midstream energy performance was negative with the Tortoise North American Pipeline IndexSM return of -7.5% and the Tortoise MLP Index® return -12.7% during the period.

Capital markets activity continues to be driven by debt issuance with midstream companies raising approximately $14.5 billion of debt during the third quarter, up slightly from the second quarter. Merger and acquisition activity remains minimal with the only transaction during the quarter being Delek Logistics Partners’ simplification transaction in which the company purchased its Incentive Distribution Rights (IDRs) for approximately $500 million.

MLP and pipeline company debt & equity offerings

Source: Company filings. As of 9/30/2020. Includes equity issued to sponsors.

Announced MLP and pipeline company acquisitions

Source: Company filings. As of 9/30/2020. Includes MLP and pipeline corporations, including transactions between MLPs.

In regulatory news, the Army Corps of Engineers announced it began work on an environmental impact statement for the Dakota Access Pipeline, something the district court has been requesting for the better part of a year. Another requirement of the court was that the Corps determine a remedy for the fact that the pipeline no longer has a permit to cross Federal land. The Corps stated that it would require no immediate action and indicated it does not think the court has jurisdiction over the matter. We are closely monitoring Dakota Access Pipeline developments as the fate of the pipeline impacts several midstream companies. In other pipeline news, the Mountain Valley Pipeline received its expected biological opinion from the U.S. Fish and Wildlife Service. This is a necessary step for the construction of the pipeline to continue and for it to be in service in early 2021.

Politics will certainly play a major role during the last of 2020. For the Democrats and former Vice President Joe Biden, the predominant theme around energy was climate change and substantial job opportunities for Americans. In fact, the topic of climate change and related opportunities for the overall economy was one of the four pillars of their convention platform, integrated into an overall vision of revitalization of America. For the Republicans and President Donald Trump, there was no focus point around energy. In fact, for the first time since the party was founded in 1854, the party did not update or amend their stated party platform, but rather kept the 2016 platform. Regardless of election outcome, we expect market economics to dictate the trajectory of future energy supply and demand. Renewables and natural gas are more economic than coal in generating electricity and will likely continue to take share, while crude oil will likely remain the predominant fuel source in the transportation sector.

Sustainable infrastructure

The biggest focus in renewables is solar and wind power as other resources are gaining traction, but on a more limited scale. On the solar side, photovoltaics (PV) have completely taken over from what was a multi-technology beginning, which included solar thermal. Essentially, the incredible modularity of design, ability to construction and connect quickly, replace problem modules easily, combined with significant declines in manufacturing cost (via scale and efficiency) have conspired to entrench solar PV as the likely technology going forward. We continue to expect modest cost declines for solar technology via manufacturing efficiency and reduced raw materials, such as silver contact paste.

The key differentiated aspects to onshore wind are greater height and blade diameters. This enables higher speed and more frequent wind resources, improving capacity utilization. Over the past decade, the towers have doubled and even tripled in height, in part to access better wind resources, but also for avian accident mitigation. At the same time, blades have become very large and increasingly lightweight. The overall progression of the industry has been to increase the capture of the available wind resource through physical and computing technology, which drives down unit costs. Also, larger scale farms offer greater output, which absorbs the fixed cost aspect of connections and grid management. Offshore wind tends to be less intermittent and thus has a greater value to the grid as a more stable resource, particularly to baseload supply.

We are also seeing an explosion in battery technology, in terms of the costs and improvements in energy density and overall quality. Now, we are seeing a very large growth backlog emerging to complement many existing renewable projects. The overall availability profile expands and improves significantly.

Concluding thoughts

It is clear that future energy supply growth will be driven by a combination of natural gas and renewables. There are many tailwinds driving the move to cleaner energy. We believe that we are well-positioned to take advantage of the global trends driving the energy evolution that is underway. Our focus on essential assets positions Tortoise to make a positive impact on clients’ portfolios and our communities.

1 Energy Information Administration, September STEO

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.