ClearBridge Investments Energy MLP Strategy Q1 2022 Commentary

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Market overview and outlook

Midstream energy stocks performed well in the first quarter, driven by strong oil prices, which significantly outperformed energy stocks. U.S. crude oil prices hit $123 a barrel, hitting a 14-year high as the reopening of demand has raised concerns that economic sanctions and heightened tensions between Western countries and Russia could lead to production shortages and lower supply levels. Global crude rose 33% to $100.28 a barrel as inflation rippled through the market. The S&P 500 index fell 4.6%, with the energy sector leading the market (+39.0%) by a wide margin.

The Alerian MLP index gained 18.8%, led by the natural gas transport and storage sub-sector (+35.3%), which attracted increased interest as Europe rushed to diversify far from the 40% of natural gas it currently uses supplied by Russia. The strategy’s overweight in natural gas contributed to the outperformance.

The COVID-19 pandemic has forced midstream companies to complete the transformation of their business model to generate free cash flow after dividends/distributions. Some intermediary companies have chosen to reduce dividends/distributions. Others have reduced their capital expenditures. Others have done both. While painful as in 2016, this final transformation leaves midstream companies in uncharted waters. The sector first found itself in free cash flow after dividends and distributions in 2021. This true free cash flow yield will likely increase in 2022 and 2023. Midstream companies are unlikely to need access to equity capital markets or debt capital markets to finance investment projects. They will also have excess cash flow after dividends and distributions.

Middle management teams will now naturally be able to deleverage balance sheets, repurchase shares, and increase dividends and distributions, as we saw recently with an announced $1.5 billion takeover of Enbridge (ENB), Kinder Morgan (KMI) noting $750 million in potential opportunistic buyout opportunities in 2022 and MPLX (MPLX) is expected to complete its $1 billion buyout in 2022 with $337 million of shares remaining to be repurchased.

This evolved business model has resulted in significant improvements in relevant interim financial measures. Free cash flow yield (after capital expenditures and dividends/distributions) is expected to approach 5% in 2023 after being perpetually negative in past years, leading to increased share buybacks, balance sheet deleveraging and an increase in dividends/distributions.

Dividend/payout coverage is expected to be above 2x going forward after consistently being in the 1.1x-1.2x range in the past. This should greatly protect intermediary companies from having to cut payments to investors in the event of an unexpected downturn in company fundamentals. Balance sheet improvements were also notable with debt to EBITDA ratios expected to end 2022 below 3.5x, having averaged close to 5.0x before the business model shift.

One of the counterweights to this more stable and sustainable business model is the slower dividend/payout growth than in the past. The old business model resulted in double digit dividend/payout growth. The new business model will likely result in annualized dividend/payout growth of 3% to 6% for the sector.

After hitting a record high of 100.9 million barrels per day in the fourth quarter of 2019, global oil demand plummeted with the onset of the COVID-19 pandemic. In the second quarter of 2020, global oil demand fell to 82.9 million barrels per day, down 18%. This sudden drop in demand left the global oil market with a large surplus and oil prices fell from around $60 a barrel to less than $20 a barrel in less than four months. With the deployment of the COVID-19 vaccine and the reopening of the global economy, global oil demand is expected to approach the previous peak demand in 2022.

Russia’s invasion of Ukraine makes it even more difficult to balance supply and demand. With reports of buyers refusing to accept Russian barrels, first-month crude oil futures traded well above $100 a barrel. This only increases the value of US oil and should continue to drive growing US drilling activity.

The path to US oil production approaching pre-pandemic levels is through increased drilling activity. With crude oil futures currently discounting around $91 per barrel over the next two years, economic returns should be sufficient to support a continued increase in rig count. Still, major publicly traded oil and gas producers have asserted that they will not significantly increase drilling activity, even with crude oil and natural gas prices at current levels. Their stated modus operandi is to return free cash flow to investors rather than increasing production, which is in direct contrast to previous cycles. Yet despite these claims, the number of rigs in the United States has rebounded from 172 in August 2020 to 546 rigs currently.

While perhaps to the contrary, our view remains that if the economic returns are there (and they are), capital will find its way to drilling more wells. The acceleration in the number of rigs may be slower than in previous cycles, but we believe that economic returns will incentivize capital to increase the number of wells drilled. This should result in a continued recovery in US production volumes and help generate growing cash flow for US midstream companies in 2022 and 2023. It is also important to note that a continued recovery in production volumes in the United States will be accompanied by low capital expenditure needs on the part of intermediate companies. Their infrastructure systems are largely built.

Our baseline assumption remains that global oil demand continues to recover to pre-pandemic levels in 2022, driving the need for increased oil supply in the global market. This increased level of drilling activity, in turn, is expected to increase throughputs in US energy infrastructure systems, allowing growing cash flows to fully show the benefits of the evolved US midstream business model.

Portfolio Highlights

The ClearBridge Energy MLP strategy posted a positive return in the first quarter, outperforming its benchmark. In terms of absolute return, the four sub-sectors in which the Strategy is invested made positive contributions, with the diversified energy infrastructure sub-sector contributing the most. The natural gas transportation and storage sub-sector contributed the least in absolute terms.

On a relative basis, the Strategy outperformed due to stock selection and sector allocation effects. Stock selection in the Liquids Transportation & Storage sub-sector and an overweight position in the Natural Gas Transportation & Storage sub-sector contributed the most, while stock selection in the Transportation & Storage sub-sector contributed the most. storage of natural gas has hurt.

In terms of individual contributors, Energy Transfer LP (ET), Targa Resources (TRGP), Williams Companies (WMB), Cheniere Energy Partners LP (CQP) and Enterprise Products Partners LP (EPD) made the largest contributions. Equitrans Midstream (ETRN) was the sole detractor.

During the quarter, we exited our positions in BP Midstream Partners LP and Shell Midstream Partners LP (SHLX).

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.