Seeking Alpha

Why The Model For U.S. Oil And Gas Producers Is Changing

by: Tortoise

Energy stocks remain shackled with investors unwilling to take on risk.

Saudis are considering options to halt the drop in oil prices.

Why we remain believers in the U.S. energy sector and U.S. oil and gas producers.

Hello. I am Tortoise Managing Director and Portfolio Manager Rob Thummel with this week’s Tortoise QuickTake podcast.

Last week, investors debated how President Trump’s tweet suggesting China is manipulating its currency would impact the U.S. and China trade war. It ended up being a wild week on Wall Street with triple-digit movements in the Dow Jones Industrial Average occurring each day. When the dust settled, the Dow Jones Industrial Average ended up trading down by 0.6% last week. The energy sector represented by the S&P Select Energy Sector Index fell by 2%, as investor appetite for risk dwindled as the 10-year Treasury yield fell to 1.7%. Oil prices declined 2% last week as well, once again tied to global demand growth concerns, as there is an end in sight for the U.S.-China trade war. However, there was one interesting development in oil prices that is worth mentioning. Global oil prices represented by Brent crude fell into a bear market territory last week after closing over 20% below April 2019 highs. Shortly after bear market for crude oil headlines were flashed across the media, Bloomberg reported that the Saudis are considering all options to halt the drop in oil prices. Global oil prices rose by 4% after the Saudis' comments. Clearly, the Saudis need higher prices and could be willing to cut production even more if global oil demand growth slows.

Energy stocks continue to be shackled as rising uncertainty regarding the global economic expansion tied to the U.S./China trade war is reducing investors’ willingness to take on risk. Last week, the popular SPDR Oil & Gas Exploration & Production ETF (XOP) dropped to its lowest level ever. Yes, to lower levels than during the 2008/2009 financial crisis. Yes, lower levels than February 11, 2016, when oil prices bottomed out at $26.21 per barrel. Due to continued poor performance of U.S. oil and gas producers, many of you saw that we announced a distribution reduction in two closed-end funds that invested in U.S. oil and gas producers. Please see the press release and associated podcast found on our website for the details, but let me give you a few highlights. Following our quarterly comprehensive review of all funds and their distribution levels, we determined the Tortoise Pipeline & Energy Fund (TTP) and the Tortoise Energy Independence Fund (NDP) will decrease third-quarter distributions to $0.285 and $0.10, respectively. This represented a 30% and 77% distribution cut. NDP and TTP generate a significant amount of investment income from investing in oil and gas producers. The continued weak stock market performance of oil and gas producers has made generating the historical level of covered call income unachievable and resulted in elevated fund leverage. Our decision to cut distributions of NDP and TTP was a very difficult decision but a necessary one. We are still believers in the U.S. energy sector as well as U.S. oil and gas producers. We maintain our strong conviction in the future of the U.S. energy sector, and we believe the sector is undervalued and underappreciated. Global demand for energy has increased in 35 out of the last 36 years and is forecasted to continue on this rising trend. Global energy supply sources are changing, but the U.S. is days away from becoming a net energy exporter. The U.S. will play a critical role as a future supplier of oil and natural gas to countries around the world as it retains its title as the world’s largest producer of oil and natural gas in the years to come.

However, the model for U.S. oil and gas producers is changing. They are transitioning from production growth toward free cash flow generation to attract investors back to the sector. This transition is ongoing, with certain oil and gas producers further along in the transition than others. From here on, each successive earnings season will reveal the producers headed on the right path. Those producers that deliver will be rewarded, while the ones who don’t will be punished. This was on display last week as the second-quarter earnings season came to a close. Pioneer Natural Resources (PXD), Parsley Energy (PE), and WPX Energy (WPX) delivered production results that met or exceeded estimates, while maintaining or lowering capital expenditure forecasts. The result is that these stocks outperformed, their peers rising by an average of 6%, while peers declined by 4%. On the other hand, Continental Resources (CLR) and Cimarex Energy (XEC) came up a little short on production and cash flow per share, while leaving capital expenditures unchanged. The result was an average decline in prices of these stocks of 7%, significantly underperforming peers last week.

Energy infrastructure companies wrapped up second-quarter earnings as well. Plains All American Pipeline (PAA) and Energy Transfer (ET) capped off another strong earnings season for energy infrastructure companies. Both Plains and Energy Transfer raised 2019 EBITDA guidance, while Energy Transfer also lowered capital expenditures guidance. The essential nature of the energy infrastructure assets operated by both of these companies positions them well for the future.

Lastly, the purest way to play rising LNG exports reported results last week. Cheniere Energy (LNG) reported lower-than-expected EBITDA tied to weak LNG pricing across the globe. While weaker LNG pricing could be a short-term headwind, it could turn into a long-term tailwind, as global natural gas demand could accelerate due to cheap natural gas prices. In the meantime, Cheniere still expects to meet its full-year guidance, and management has increased its fee-based cash flow, therefore improving the quality of the company’s earnings, as future results will be less impacted by spot LNG prices.

Disclosure: I am/we are long TTP, NDP, CLR, XEC, LNG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The S&P 500® Index is a market-value weighted index of equity securities.

The PCE inflation rate is the Personal Consumption Expenditures Price Index. It measures price changes for household goods and services. Increases in the PCEPI warn of inflation while decreases indicate deflation.

Broad Energy = The S&P Energy Select Sector® Index is a capitalization-weighted index of S&P 500® Index companies in the energy sector involved in the development or production of energy products.

Producers = Tortoise North American Oil & Gas Producers IndexSM

The Tortoise North American Oil & Gas Producers IndexSM is a float-adjusted, capitalization weighted index of North American energy companies primarily engaged in the production of crude oil, condensate, natural gas or natural gas liquids (NGLs). The index includes exploration and production companies structured as corporations, limited liability companies and master limited partnerships but excludes United States royalty trusts.

MLPs = The Tortoise MLP Index® is a float-adjusted, capitalization weighted index of energy master limited partnerships (MLPs). The index is comprised of publicly traded companies organized in the form of limited partnerships or limited liability companies engaged in transportation, production, processing and/or storage of energy commodities.

The indices are the exclusive property of Tortoise Index Solutions, LLC, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) (“S&P Dow Jones Indices”) to calculate and maintain the Tortoise MLP Index®, Tortoise North American Pipeline IndexSM and Tortoise North American Oil and Gas Producers IndexSM (each an “Index”). S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and, these trademarks have been licensed to S&P Dow Jones Indices. “Calculated by S&P Dow Jones Indices” and its related stylized mark(s) have been licensed for use by Tortoise Index Solutions, LLC and its affiliates. Neither S&P Dow Jones Indices, SPFS, Dow Jones nor any of their affiliates sponsor and promote the Index and none shall be liable for any errors or omissions in calculating the Index.

Disclaimer: Nothing contained in this communication constitutes tax, legal, or investment advice. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation. This podcast 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 forwardlooking 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. This podcast reflects our views and opinions as of the date herein, which are subject to change at any time based on market and other conditions. We disclaim any responsibility to update these views. These views should not be relied on as investment advice or an indication of trading intention. Discussion or analysis of any specific company-related news or investment sectors are meant primarily as a result of recent newsworthy events surrounding those companies or by way of providing updates on certain sectors of the market. Tortoise, through its family of registered investment advisers, does provide investment advice to Tortoise related funds and others that includes investment into those sectors or companies discussed in these podcasts. As a result, Tortoise does stand to beneficially profit from any rise in value from many of the companies mentioned herein including companies within the investment sectors broadly discussed.