Where to find opportunities as oil rallies

Midstream energy sector poised to thrive on increased production and exports, says Cohen & Steers portfolio specialist Evan Serton

Despite the oil price rallying more than 30 per cent since mid-June, the fallout from the market’s sharp collapse in 2014 is still impacting large parts of the industry. One area of the energy complex showing resilience in the current environment, however, is the midstream industry, which is involved in the transportation and storage of oil and natural gas from upstream drilling companies to downstream processing facilities.

In the wake of the oil price collapse, many midstream operators have lowered their distributions to shareholders, in order to shore up their balance sheets. As the oil price recovers, many of these companies stand ready to take on increasing volumes of commodities with healthier business models and better corporate structures.

US production rebounding

In our view, the clear beneficiary of the global oil market downturn over recent years has been the US. As the price rout became more entrenched in 2015, a showdown emerged between US shale producers and Opec. In fact, it took a significant production cut from Opec to help gradually draw down global oil inventories and stabilise the market.

While Opec has cut production, US shale producers have been able to meet rising global demand, as its supply is relatively quick and inexpensive to bring online. Indeed, US shale oil production has rebounded sharply in 2017. This trend is likely to extend for the foreseeable future, as Opec and Russia are set to continue production limits into 2018.

This growth in US oil production is particularly supportive of the midstream market, which is not as sensitive to the oil price. Fresh falls in oil prices would not necessarily damage the prospects for midstream companies, as long as production volumes continued to grow—most midstream companies charge fees by volume. Further, despite the recent widespread balance-sheet deleveraging throughout the midstream sector, many companies still offer yields of about 5 per cent, and they trade at greater than average spreads to the 10-Year Treasury.

Export growth is a growing tailwind

Other factors are also increasing the appeal of the midstream sector. A key contributor is the strength of US oil and natural gas exports. In 2015, the government lifted a ban on crude oil exports to countries outside of Canada. The proliferation of shale producers has resulted in an ample supply of oil able to be exported, and the attractiveness of having the US as a trade partner, compared with various regimes throughout the world, has already triggered a significant increase in oil exports. This is helping to drive volumes for midstream companies.

For example, US crude oil exports to China in 2016 averaged 10,000 barrels a day, but this has since climbed to an average of 200,000 barrels a day – an exponential growth rate. Also, Cheniere Energy’s Sabine Pass liquefaction terminal — the first US Lower-48 LNG export facility — has quickly become the biggest single-use recipient of natural gas in the U.S. From February to June 2016, natural gas deliveries to Sabine averaged little more than 500m cubic feet per day. In the first seven months of 2017, volume was at 1.5bn cf/d. Destinations include Mexico, Asia, South America, Middle East, and Europe.