Oil Demand May Have Bottomed: What Midstream Investors Need To Know

Summary

• Never in history have so many economies shut down all at once. The result has been an estimated peak oil demand decline of -30% in April.
• The International Energy Agency estimates that, for Q2, oil demand will decline 25 million bpd or approximately 25%.
• When it comes to the incredible uncertainty facing the entire North American Energy industry, and midstream in particular, you want to go with the largest, most diversified, and financially strongest.
• Looking for a portfolio of ideas like this one? Members of iREIT on Alpha get exclusive access to our model portfolio. Get started today »

This article was coproduced with Dividend Sensei.

We’ve seen oil crashes before. We’ve seen oil prices rise to excessive degrees as well. It all depends on what economic issues and political pacts are going on in and around the world.

• What is the U.S. dollar doing?
• What is OPEC doing?
• Are there any wars going on and where?
• How is global business doing?
• Have there been any new oil discoveries and where?

Source

The answers to those questions all go into determining whether oil is up or down in price. So when huge chunks of the global economy go on break all at the same time that OPEC decides to declare “war” on Russia?

Then you get the worst oil crash in history – one that’s so big and so bad that it’s shocked literally every energy analyst. Because literally no energy analyst – or anyone else – has ever seen anything like this before.

That means talking about it is tricky. But let’s try all the same, starting with (strangely enough) April 20, 2020: a day that will live in infamy.

The cause of that one-day plunge into deeply negative territory had more to do with the unique nature of futures contracts. For the record, no oil companies were actually paying -$38 per barrel for customers to take their oil.

Rather a WTI futures contract means that if you hold it to maturity, you must take possession of 1,000 barrels of crude in Cushing, Oklahoma. Each month, over 100,000 futures contracts representing more than 100 million barrels of theoretical delivery are traded by mostly speculators.

At the end of each month, only those customers (mostly refiners) who need physical oil are left holding contracts. The vast majority cancel out.

So, on April 20^th, one day before the May contract expiration, a lack of storage capacity and downright panic among speculators created forced selling unlike any witnessed in history.

Which is why WTI traded negative for the first time in history, and to a shocking and absurd degree.

An Entirely Unprecedented Decline in Oil Demand

Of course, understanding that blip doesn’t mean the bigger picture can be waived off as well.

Never in history have so many economies shut down all at once, resulting in an estimated 30% decline in peak oil demand last month.

(Source: Bloomberg)

Compare that to the Great Depression when demand fell 30%. From 1929 to 1933. It took four years to achieve that kind of carnage versus the six weeks in 2020.

In response, OPEC, Russia, and the G20 countries coordinated an unprecedented 14 million bpd production cut. But that wasn’t even to cover half the destruction. As such, storage tanks around the world – which IHS Markit estimates can hold up to 1.2 billion bpd – rapidly began filling up.

Goldman Sachs (GS), Morgan Stanley (MS), and other analysts think the storage facilities in Cushing, Oklahoma, where WTI is priced, will be at capacity in three weeks. And Goldman in particular believes that will be the case globally as well.

This has very big, very bad implications for short-term oil prices.

We expect extremely weak fundamentals to persist for at least the next month,” Deutsche Bank (DB) analyst Michael Hsueh wrote in a note to clients on Monday, adding, “Continued pressure on infrastructure may result in negative pricing at some point again before the end of May…”

But there is some good news.

Demand May Have Bottomed

Fortunately, we are seeing improvements in Europe, the U.S., and Asia, according to Darren Woods, CEO of Exxon Mobil Corp. (XOM). He calls them “encouraging early signs.”

Meanwhile, Olivier Jakob, managing director at consultant Petromatrix GmbH says, “Globally, we are at the inflection point where we are past the worst for oil demand destruction, but not for supply destruction. This should help price stabilization.”

And Torbjorn Tornqvist, head of commodity trading giant Gunvor Group, believes the worst of oil’s fall is probably over. Though he also warns that oil isn’t likely to go much higher than $40 before the end of next year.

(Source: NYT)

That’s because 15 states have begun to reopen since their Rts (the effective number of new infections per COVID-19 case) have fallen to below 1. As such, demand for gasoline and other refined products has started to increase for the first time in weeks.

And as a result of that, refinery capacity has begun to increase off its recent lows. (Refiners are the only primary customer for oil.)

Further good news – or at least better news – comes from Goldman Sachs.

Because other countries locked down before the U.S. (mostly in Europe), and Germany, Austria, Denmark, Spain, etc., have begun Phase 1 restarts, global oil demand bottomed the week of April 20. As such and all told, Goldman thinks the supply glut might hit zero as early as July.

However, that isn't necessarily as bullish on oil as you may think. It only means the pace of storage tanks filling will slow.

The Dark Realities of the Great Lockdown Recession

Remember that Goldman and Morgan Stanley estimated that storage tanks might be full within three weeks. Granted, those estimates were from a week ago. Plus, demand recovering faster than expected might push that prediction out a few weeks.

But even if it takes a full two months for global tanks to fill up entirely… the world will still be left with 1.2 billion barrels of stored crude.

Here's what that means for the oil markets. Assuming countries reopen as expected, the IEA estimates that full-year oil demand will be down by 9 million bpd.

It’s true that, if oil producers stopped pumping, the 1.2 billion barrels in storage could be wiped out in just 14 days. But they literally can’t stop pumping.

Shutting an oil well down can permanently damage it. That could easily cost several millions per well, which is why shut-in capacity is something you seldom ever see in history… other than during the Great Lockdown Recession.

In 2016, for example, North Dakota crude (not WTI) traded at -$0.50 for a few days. Yet shale producers literally paid customers to take their oil rather than permanently damage their investments.

As for 2020, U.S. oil companies will continue producing oil, just a lot less of it. So storage tanks will deplete very slowly. They won't even begin to be tapped until global demand is more than supply, and crude starts to climb.

(Source: CME Group)

The WTI futures market is far from perfect, admittedly. But even with the intense volatility of the last few months, it remains a good proxy for where energy speculators think oil will go in the future.

In which case, there’s good news and bad news.

The good news is futures traders see crude soaring by close to 50% by the end of the year. The bad news is that December 2023 WTI is coming in at just $38.

A Tough Few Years Are Likely in Store for Midstream

This obviously affects North American energy industry, which then affects midstream MLPs and corporations.

The good news is that even at $10 oil through the end of 2021, Rystad Energy, a consultant group that analyzed maturing debt profiles, estimates just 730 oil companies will go bankrupt. And that’s out of about 9,600.

Ipso facto, if oil is over $30 by the end of the year, just 170 companies might go bankrupt over the coming 20 months or so.

Other estimates put that total as low as 100 by the time the entire oil crash is over. Though those assume the global economy experiences a relative V-shaped recovery, which is far from guaranteed.

(Source: FactSet Research)

If the global recession results in too much permanent unemployment or if the virus returns in the fall – as Anthony Fauci and other experts believe is likely – we might see up to 18 months of rolling lockdowns.

This could be a long, hard road ahead of us until we get to either an effective therapy or a vaccine. And it's hard for me to see a V-shaped recovery under that scenario.

Here’s what Federal Reserve Bank of Minneapolis President Neel Kashkari said on the subject:

We could have these waves of flare-ups, controls, flare-ups, and controls until we actually get a therapy or a vaccine... If it ends up being shorter than that, that's great. We should prepare for the worst-case scenario."

And that’s from someone who’s actually optimistic we'll avoid a depression. Here's why this matters.

(Source: Kansas City Federal Reserve)

Oil giants like Exxon say that $40 oil is their break-even point for sustaining both dividends and current production indefinitely.

Most oil companies, however, are not so lucky. The April oil executive survey by the Kansas City Fed found that 50% of oil companies are at risk of bankruptcy should $40 crude persist for more than two years.

Delta Air Lines (DAL), meanwhile, estimates that global travel will take two to three years to fully recover… or until a vaccine has been approved and mass-produced, and 80% of the world's population is immune, thus allowing life to return to normal.

Oil prices will eventually rise, if only because production at current prices is so uneconomical.

However, how long it takes for crude to climb to the $50 mark that the majority of oil companies need to survive is anyone's guess. It probably depends on having sufficient testing capacity and enough contact tracers – which would require far more medical equipment than we currently have.

In short, this year has shown us that nothing is guaranteed… and that the oil markets can shock even veteran analysts.

So What's a Midstream Investor to Do?

Fortunately, income investors who invested in midstreams thinking that their cash flows are far more stable than other oil stocks are 100% correct.

(Source: Alerian)

Earnings before interest, taxes, depreciation, and amortization (EBITDA) estimates for midstreams have fallen by a small fraction of those for oil producers through the end of April.

(Source: Alerian)

Across the entire midstream space, just 20% have announced cuts in Q1 2020 through May 1. Still, the question is whether that can continue.

In “MPLX Today Represents an Attractive, Though Speculative, Long-Term Income Opportunity,” we walked readers through Morgan Stanley's stress test for virtually the entire safe midstream list. In our opinion, it shows the most conservative results out of 35 research reports/notes we've collected over the past five weeks.

Under its stress-test scenario, in which 1.5 million bpd of U.S. production is shut in through mid-2021, Energy Transfer (ET) and ONEOK (OKE) would have to cut their payouts.

MPLX (MPLX) is also at risk due to debt maturities in 2021 and 2022. These could potentially force management to focus on deleveraging. And distribution is the only easy source of cash flow in that regard.

Source: Morgan Stanley

Knowing all of this, the six safest names on the midstream list – ranked by safety, incorporating potential cash flow disruption, credit ratings, liquidity, and debt maturity schedules – are:

1. Enterprise Products Partners (EPD)
2. Enbridge (ENB)
3. TC Energy Corp. (TRP)
4. Pembina Pipeline Corp. (PBA)
5. Kinder Morgan (KMI)
6. Brookfield Infrastructure Corp. (BIPC)

There’s no question among analysts that EPD is the safest name in the industry. In fact, Morningstar expects the company to use its over $3 billion in retained cash flow (even accounting for EBITDA declines through 2022) to bring its leverage ratio to under three by 2024.

EPD's leverage is already 3.5. Credit rating agencies want to see a 5.0 if they’re going to give one of these entities an investment-grade rating. A 4.5 score comes with a BBB or BBB+ rating depending on the contract profiles.

At sub-3, EPD might end up earning the first A-rating in midstream history.

Then there’s ENB. Management says it has $6.1 billion in liquidity. Nor is that just what’s immediately available. It’s also what the company can tap into without hitting the upper end of its net debt/EBITDA 4.5-5.0 leverage range.

The Motley Fool’s Matt DiLallo writes that, “Because of that financial flexibility, Enbridge should have no problem maintaining its payout during these challenging times.”

Moving on to TC Energy – formerly TransCanada – it came into the recession with a 50% payout ratio. Even with consensus estimates declining in recent weeks, that's expected to be just 53% in 2020.

For context, 83% or less is safe for self-funding midstreams.

As for the other companies, here’s what S&P Global recently had to say:

We are affirming our 'BBB+' issuer credit rating on TC Energy. At the same time, we are affirming the 'BBB-' issue-level rating on the company's preferred stock and P-2(LOW) Canadian National Scale rating on the preferred shares.

“We are also affirming the 'BBB+' issuer credit and senior unsecured issue-level ratings on TransCanada PipeLines Ltd., as well as the company's 'A-2' commercial paper and short-term rating.

“The stable outlook reflects our view that TC Energy will maintain credit measures that are appropriate for the rating and manage its balance sheet given its large capital spending program and the Keystone XL's inherent construction and execution risk."

On March 31, S&P also reaffirmed TRP's BBB+ rating and stable outlook – a rating it shares with EPD and ENB.

All told, when it comes to the incredible uncertainty facing the entire North American energy industry and midstreams in particular, you want to go with the largest, most diversified, and financially strongest names.

That’s why EPD and ENB are the only two energy-sector names in the Dividend Kings' Phoenix portfolio.

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.

Analyst’s Disclosure: I am/we are long PBA, ENB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.