Companies who treat, transport and store natural resources such as natural gas, natural gas liquids (NGLs) and crude oil form part of the broader GLIO Index. This includes the transformation of crude oil, natural gas and other commodities into derivatives or transformed products such as NGLs.
The pipelines which transport these products act as the glue between upstream exploration and production (E&P) and downstream distribution. The term “storage” covers caverns, buildings or underground tanks for gas and liquids.
The figure above shows the broad infrastructure value chain to transport oil, gas and other commodities, from drilling via lattice gathering networks to processing plants to downstream markets via large volume transportation pipelines.
At downstream terminals, the commodities can be transported to end-customers via pipeline, rail or ship; refined at fractionation facilities; and stored or further manufactured.
Midstream assets are diverse by nature. The investability of the companies in the GLIO Index is determined by the quality of those assets, the contractual basis on which they are remunerated and whether the asset characteristics meet the GLIO infrastructure definition.
The evolution of the sector has advanced in the past few years – they now better resemble infrastructure with qualities like minimum volume contractual commitments, limited/zero commodity exposure, improved debt gearing positions, more sustainable earnings and dividends, less exposure to marketing businesses and greater capital focus on ‘core’ assets.
To get an idea of the depth and complexity of the sector, the figure above breaks down eligible asset types and quantifies associated business risks.
The mistakes of 2014-2015
To understand the shift that the sector has undergone, we need to look at the recent past.
From an August 2014 peak, midstream companies’ share prices fell sharply and the GLIO ETS Index had lost 47% of its value by December 2015.
(see the figures above and to the right).
During this period, retail and generalist investors fled the sector due to concerns about company credit quality, earnings disappointments due to commodity exposure and dividend cuts by management.
The GLIO Index (-9%) and MSCI World (-1.9%) were down slightly by comparison.
In a nutshell, corporate credit issues and prices were driven by the following factors – some of which were exacerbated by management mistakes:
Weakness in commodity prices, specifically crude and NGLs,
Management distributed cash proceeds to shareholders while financing capital investment and mergers with debt,
A major component of earnings was from the marketing and trading businesses,
Management invested in non-core businesses that underperformed,
Management overstretched with large projects with high regulatory risk,
Structural changes in the sector resulted in some assets being used less and sometimes stranded,
The sector was no longer supported by equity capital markets.
Recognizing that earnings volatility and poor performance needed to be addressed, management undertook a number of measures.
Management prioritized a reduction in gearing with varying degrees of success – some hitting targets, and some remain work-in-progress. Without the ability to easily sell equity in the public markets, de-leveraging takes time through growth and requires high returns on capital.
Non-core assets have been sold in many cases and shareholder pay-outs, or dividends reduced to pay down debt. Post this deleveraging, the industry will be in a much stronger place.
Speaking broadly, these actions were rewarded. So from December 2015 to January 2020, GLIO ETS gained 64% – albeit to a lesser extent than the GLIO Index, which itself rose 77% (see Figure 4 above).
Both GLIO ETS and the GLIO Index outperformed global equities which added a more modest 56%.
Why midstream companies are now in better shape
In general, 2020 midstream companies are in better shape than in 2015. Broadly, management teams have made progress since 2016.
The sector’s ability to withstand short-term oil and gas price shocks is robust for several reasons:
Little exposure to poor credit quality. On balance, many midstream companies are not significantly exposed to customers with poor credit risks.
Little exposure to energy commodity prices. Many midstream investment companies have limited direct price exposure to either crude or gas prices.
Limited sensitivity to energy volume volatility. Although the midstream sector does have indirect volumetric exposure to crude prices, during periods of crude-oil price weakness the sector has seen relatively minor long-term volume and earnings reductions.
Resilience of capital-intensive assets. Midstream assets are capital intensive and long-lived, with capital allocation based on long-run return requirements.
Assessing the risks & opportunities
Certain midstream subsectors have greater earnings exposure to lower production and crude price downside, such as Gathering and Processing (G&P) and marketing, and this may reduce growth outlooks. Others, such as pipelines, are largely immune.
Considering revised base case scenarios and current share prices (as at July 2020), many companies represent five-year internal rates of return above 20%. This would make them a “Strong Buy” according to many GLI managers valuations.
M&A could be a natural evolution, which could solve the competition and growth issues through efficiency and costs reductions. There is also near-term risk if private investors with significant capital and longer-term investment horizons bid for companies at low share prices. A ‘healthy’ premium could seal a transaction even while representing a large discount to fundamental valuation.
This is a real concern for the sector. Company boards and management teams hopefully exercise strong governance and good judgement in insisting that real fundamental value is recognized and paid by potential acquirers.
Regulatory risk needed to be factored into any investment decision. It has become costly and uncertain to build large-scale pipelines given local opposition, and even later this year this could be exacerbated by a change in US president.
What about ESG?
You cannot write about the sector without mentioning ESG.
While longer-term, midstream will be impacted by the move to a carbon-neutral economy, the sector clearly has an essential role to play as economies transition over to cleaner energy over the coming decades.
Investors should not lose sight of this as they talk about ‘terminal value’.
At this time, it is important companies embrace these changes and act transparently so investors can grasp the risk and opportunities the sector presents over the next 20 to 30 years.
The work GLIO is doing with GRESB on company disclosure of sustainability governance, implementation, operational performance data and stakeholder engagement practises will be important tools to help investors navigate through the sector.
"While longer-term, midstream will be impacted by the move to a carbon-neutral economy, the sector clearly has an essential role to play as economies transition over to cleaner energy over the coming decades.
Investors should not lose sight of this as they talk about ‘terminal value'."
The GLIO ETS Index offers a wide-ranging exposure to a number of operations and functions within the midstream portion of the energy value chain.
Investment opportunities will depend on the underlying operations, counter-party risk, volume and commodity price exposure and the type and length of contracts in place with customers, and ESG factors over the mid to long term.
While the sector has largely moved on from the mistakes of five years ago, it seems that many investors do not fully understand the newly developed resilience that has been built.
As such, it seems advisable that investors seek out an active specialist listed infrastructure manager to navigate through the variety of risks and moreover opportunities the sector presents.