Energy Income Weekly: Caught In Macro Trade Crossfire

Energy Income Performance

The energy sector was caught in the crossfire this week, with the XLE plunging 5.8% during a massive short-covering rally that saw long running stock market trends abruptly reverse.

Throughout 2021, the energy sector was the standout while the technology sector got pummeled. But this week, the “long energy/short tech” momentum trade by herd-following hedge funds unwound in dramatic fashion. The trade pushed the tech-heavy S&P 500 (SP500) 3.1% higher by Thursday, but its retreat on Friday reduced the index’s weekly gain to 1.6%. WTI ended the week down 7.9%, and natural gas plunged 15.4%, adding to its 40% loss in January.

The following excerpt from a Financial Times article published today captures the genesis of the week’s price action.

The short-covering—which violently pushed stock prices higher as traders outbid one another for scarce supply of heavily-demanded shares—was concentrated in the technology sector. It drove the Nasdaq 5.6% higher from Monday through Thursday, then pulled back on Friday. The Nasdaq ended the week with a 3.3% gain. Despite the short-covering nature of the rally, it emboldened tech bulls, many of whom are now calling for sustained tech outperformance. The only way we view this as likely is if interest rates enter a sustained downtrend. Even then, it’s questionable whether fundamentals justify higher stock prices. Nevertheless, pervasive tech bullishness means that investors may not have seen the end of the violent price moves that push energy equities lower.

Midstream emerged relatively unscathed from the energy selloff since its income characteristics make the sub-sector less desirable for use in macro short trades, as short sellers have to pay dividends on the shares they borrow. The Alerian Midstream Energy Index fell by 0.9%, and the Alerian MLP Index fell by 0.7%.

Not surprisingly, E&Ps were badly battered, as they’re the go-to energy sub-sector for traders looking to short oil without the hassles involved in buying crude futures. The XOP fell by 5.6%.

The defining attribute of the week’s price action is that it didn’t correspond with fundamentals. For instance, there has been no meaningful change in the energy market’s outlook from a week ago. Brent time spreads—which provide a short-hand read on the physical market’s health—were flat during the week, as shown in the chart below.

Meanwhile, the broad measures of refining margins, another gauge of the physical market, held up at relatively high levels.

For crude oil, we expect inventory builds to keep prices under pressure in the first quarter. We’d be surprised if WTI can be sustained at levels above $80 per barrel. However, we expect the builds to transition to sustained draws during the second half of the year. The draws will be driven by a remarkable recovery in jet fuel demand and the far-reaching impact of higher demand from China, which has abandoned lockdowns and is coming out of its major Covid wave.

Our bullish oil outlook is longer-term in nature. We expect softness in the market over the coming weeks, so this week’s bearish price action in oil futures may be justifiable on a very short-term basis. Keep in mind that most oil futures have a shelf life measured in weeks and months. However, the week’s price declines in oil-related equities are silly from the perspective of investors looking for a strong performance in the second half of the year. We, therefore, view the energy stock selloff as an opportunity to add to high-quality oil-weighted names.

Where to Look for a Bargain

We believe the best opportunities after this week’s selloff are Western Midstream (WES), Black Stone Minerals (BSM), and Enterprise Products Partners (EPD).

WES can’t seem to get any respect. The company is a major gathering and processing (G&P) operator in the Permian and the DJ basins. Its favorable prospects in the Permian are well known, but the pricing of its units indicates the market is ignoring the improvement set to occur in the DJ Basin. Already, companies are reporting that the worst of the DJ Basin’s permitting issues are behind it. If WES’s anchor customer, Occidental Petroleum (OXY), follows other E&Ps’ lead and increases activity in the basin, it would drive WES’s Adjusted EBITDA and free cash flow to outperform quarterly analyst consensus expectations. WES’s management is among the best capital allocators in the energy space, so we’re confident that any cash flow growth will be directed to unitholders’ benefit.

We’ve discussed Black Stone Minerals (BSM) extensively as our top royalty company pick, which we’ve held since late 2020. BSM will benefit in 2023 from its significantly hedged natural gas production base. The company will also get a cash flow uplift if oil prices recover later this year, as we expect. Management has recently bought units in the open market, and we suspect its activity is an indication of the prospectivity of its Austin Chalk acreage. None of this acreage is reflected in BSM’s current stock price, so good well results could move the stock significantly higher.

Enterprise Products Partners (EPD) reported an outstanding fourth quarter on Wednesday, but its units failed to get traction in response. EPD is one of the crown jewels of U.S. midstream. It has some of the best assets, management, and long-term prospects in the business. With its units trading at a steep discount from intrinsic value, it’s the ultimate set-it-and-forget-it proposition for energy income investors.

For investors looking for an attractive non-MLP pick, Targa Resources (TRGP) stands out as a particularly good choice for long-term capital appreciation, as the company will continue to benefit from its integrated natural gas and NGL system. The combination of a system that enables it to pursue high-return investment opportunities and TRGP’s significant retained cash flow are likely to benefit shareholders for years.

For non-MLPs that offer income, Antero Midstream’s (AM) 3.4% selloff, in which it was caught up in the general G&P equity selloff, provides an opportunity to scoop up a safe 8.5% yield. The company recently won $242 million in damages after a favorable court settlement. We expect management to allocate the proceeds toward debt reduction. If it does, it would lower interest expense and improve AM’s longer-term prospects for distribution increases.

Weekly HFI Research Energy Income Portfolio Recap

Our portfolio badly underperformed its benchmark, the Alerian MLP Index. It was down 2.4% versus its benchmark’s 0.7% loss, underperforming by 1.7%.

The poor performance was attributable to Martin Midstream Partners’ (MMLP) report that it refinanced its revolving credit facility and 2024 and 2025 bond maturities at a high interest rate of 11.5%. Frankly, we figured management would opt for a sweetener such as a convertible feature to lock in an attractive interest rate. If it did so, it would have made it much easier for the company to pay down debt and ensure long-term value and growth for its equity. Instead, management’s move will fail to reduce MMLP’s total interest expense. Its equity therefore remains at risk in the event that an economic downturn lowers interest coverage.

What MMLP public unitholders have going for them is that management’s interests are highly aligned with theirs. Management is the largest owner of MMLP equity, and we assume it has a reason for executing this refinancing the way it did. We’re eager to hear its commentary on its fourth-quarter earnings conference call, which should be held in the next week or two.

Aside from MMLP, our G&Ps were also weak, which is to be expected during a vicious commodity price selloff. Our commodity theses are long-term in nature, so we expect these equities to bounce back as the commodity outlook firms up in the coming months.

News of the Week

Feb. 1. More operational issues cropped up for TC Energy (TRP). The company increased its cost estimate for its Coastal GasLink project in western Canada to C$14.5 billion. The higher spending caused the company to revise its 2023 capex budget higher by more than C$2 billion to C$11.75 billion. Management attributes the cost overruns to labor costs, labor availability, and drought conditions. The latest announcement comes after TRP nearly doubled its Coastal GasLink project cost estimate to $9 billion. The magnitude of TRP’s latest snafu suggests its operational woes are not one-off in nature but are part of a larger pattern of mismanagement. Continued cost overruns on TRP’s major projects risk a dividend cut. Until the company’s operational problems stop surfacing, we recommend investors avoid adding to an existing TRP position. Investors looking to add new capital would be better served in Pembina (PBA) and to a lesser extent, Enbridge (ENB).

Capital Markets Activity

Feb. 2. MPLX announced the pricing of $1.6 billion of senior notes, consisting of $1.1 billion of 5.00% senior notes due 2033 and $500 million of 5.560% senior notes due 2053. MPLX intends to use the proceeds to redeem $600 million of its Series B preferred units and repay some of its $1 billion of 4.500% senior notes due July 2023. We’re glad to see the company redeeming its preferreds—more prudent capital allocation from MPLX.