Thursday’s fall in equity markets was the worst since the October 19^th, 1987 stock market crash. I was a young interest rate trader then, and that evening I warned my wife that we should stock up on canned food while we prepared for another 1930s Depression. She scoffed that only Wall Street had a problem, and that Main Street was fine.

1987, 2008 and today have different causes, but the need for some solid valuation guideposts is the same. The Equity Risk Premium (ERP) is the difference between the S&P500’s Earnings Per Share (EPS) yield (inverse of the P/E) and ten year treasury yields. Assuming, EPS drop 15%, the ERP is showing stocks to be attractive. A 15% drop seems conservative, and would be approximately the same as 2008, but we’ll emerge from this crisis into a different world. Based on what we know today, broad equity exposure looks cheap.

Energy sector investors have endured several years of underperformance. The industry has invested more in exploiting the Shale Revolution than investors wanted them to. Crude oil has been hit by the Covid-19 demand shock, collapse of OPEC+ and Saudi Arabia’s subsequent decision to increase supply into an over-supplied market.

Domestic energy demand will drop, but it will eventually recover. The upstream companies that drill for oil are at the epicenter of the price collapse. Midstream energy infrastructure companies care about the financial health of their customers as well as the volumes flowing through the system. The sector entered this downturn with stronger balance sheets than in 2014 and with a developing very positive free cash flow story (see Updating the Coming Pipeline Cash Gusher).

We expect most to follow Oneok (OKE) in cutting spending on growth projects this year, which will free up cash to further reduce debt. The American Energy Independence Index consists of 75% investment grade companies doing about 80% of their business with investment grade customers. The index is down around 50% YTD, roughly the same as U.S. airline stocks, which are regarded as needing some type of short term Federal government support.

Finally, an interesting chart from Ethan Bellamy at RW Baird, which illustrates the shift in the crude oil curve over the past three months. Spot prices have moved much more that deferred futures contracts. Saudi Arabia and Russia are generally sellers into the spot market, while shale drillers tend to hedge future output for the next couple of years. Because the curve is in contango, sales in the spot market have the lowest realizations.

A strategy to damage the shale industry would create backwardation, as existed in December. In that environment, forward sales of output realize lower prices than spot, which is good for big producers like Saudi Arabia. Their goal is to drive down futures prices along the curve, and the chart shows that spot prices have dropped $30 to produce a far smaller change at, say, the 36 month point. It’s a very expensive strategy for the sellers. At least the Strategic Petroleum Reserve is being replenished cheaply.

Energy had the worst week any of us can recall, and few readers probably have much appetite for a bullish view. For investors and asset managers in the sector, Friday’s rally was welcome but well short of compensating for prior losses. So we’ll just let the chart speak for itself.

The spreading coronavirus and effective end of OPEC+ were a one-two punch that caused the worst  collapse in midstream energy infrastructure stocks any of us have ever seen.

The IEA forecasts a 2.5 Million Barrels per Day (MMB/D) drop in demand for 1Q20, but clearly oil markets are pricing a bigger drop.

Medical experts typically describe Covid-19 as a form of flu that we’ll eventually learn to live with, albeit more infectious and fatal than flu. The economic disruption caused by every-day life shutting down so as to avoid infection is far harder to forecast.

For pipeline investors, it’s helpful to look back at U.S. energy demand during the 2008 financial crisis.

Crude oil demand did roughly follow the path of the S&P500, with demand dropping as much as 2 MMB/D, or about 10%.

But natural gas demand followed its regular seasonal pattern with no discernible response to the economic contraction.

The pie chart shows where we consume natural gas. The question is, how much of each different segment is vulnerable to lower demand? If the U.S. quarantines entire regions, or bans mass gatherings such as sporting events, even natural gas demand may dip somewhat. But it’s most likely fairly robust. Whether people are at home or in the mall, they’re still going to want air conditioning. They’ll still need to cook meals. Industrial use isn’t going to disappear.

So in trying to assess the wreckage after yesterday, stable natural gas consumption seems like one of the more reliable assumptions.

Almost a year ago, we published The Coming Pipeline Cash Gusher. Midstream energy infrastructure companies, especially MLPs, have long relied on Distributable Cash Flow (DCF) as a measure of profits available for distributions. As the funding needs of growth projects increased, the difference between DCF and Free Cash Flow (FCF) became stark. FCF is a GAAP term and more widely recognized by the broad investment community. MLPs have destroyed the trust of their original investors, because the gulf between DCF and FCF led to distribution cuts. Drawing a new set of investors requires describing results in a recognizable form, and FCF is part of that effort.

Last April, we showed that the need for growth capex had peaked, and that existing assets were generating increasing amounts of cash. Both of these developments are positive for FCF. In combination, they produced a startling trajectory. We calculated that over 2018-21, FCF would leap from $1BN to $45BN – very meaningful for a sector with a market cap of around $450BN.

We did this analysis on the American Energy Independence Index (AEITR), because it’s the broadest representation of North American midstream energy infrastructure companies. It’s the only index that omits companies that pay Incentive Distribution Rights (IDRs) to a controlling general partner. Paying IDRs increases a company’s cost of capital and is the most visible evidence of a misalignment of interests between management and investors. We never invest in a company that pays IDRs, and where available we hold companies that receive IDRs from someone else.

Now that 2019 earnings have been reported, capex guidance for 2020 is available and we’ve updated our forecast. FCF is still set to soar – albeit not quite as fast by 2021 as we found a year ago. But a closer look at the figures reveals a story just as positive. Growing FCF remains the most compelling bull case for this sector.

We should note that the forward guidance that we’ve used was all provided by companies before the market’s sudden drop in response to Covid-19. There’s a strong case to expect domestic pipelines to fare better than most businesses in an economic slowdown, but we’ll explore that topic in more detail in another blog post.

We now forecast 2021 FCF to be around $41BN, $4BN less than we thought last year. $0.5 of this is because of changes to index membership. Some names have joined the index – either because they dropped IDRs which had previously disqualified them, or because they’re a recent IPO. Others left the index because they were acquired, either by another public company or by a private equity buyer. For today’s index members who were in a year ago, our 2021 FCF forecast has come down by $3.5BN.

For the 28 members of the AEITR who remained in the index since last year, 2019 FCF came in $4.5BN ahead of our April 2019 forecast. TC Energy (TRP) was the biggest surprise here, with $1.1BN of FCF versus our prior forecast of $0.1BN. As we’ve noted before, along with Enbridge (ENB), which also came in $0.6BN ahead of our expectation, the two big Canadian firms generated $4.9BN of the $9.2BN in AEITR 2019 FCF. As more American companies emulate the financial discipline of our neighbors up north, FCF will grow.

Other positive surprises came from Energy Transfer (ET) at $2.1BN versus $0.9BN, Cheniere Energy (LNG) at $1.0BN vs $0 and MLPX at $1.3BN vs $0.5BN. The biggest miss came from Enterprise Products Partners (EPD). Over the 2019-21 period, we estimate their FCF will now be $3.6BN less than we thought a year ago. Their growth capex guidance is now $1BN per annum more than it was previously. Following their 3Q19 earnings report, EPD added $3.6BN to their backlog.  The bulk of this spending is going towards expanding the Midland to Echo crude oil pipeline system. They’re also  investing $1.5BN in a second propane dehydrogenation facility, which will convert propane into propylene for later use in combustion and plastics. The Shale Revolution isn’t just about oil and natural gas – natural gas liquids, such as propane, have also created new business opportunities. EPD’s history of capital discipline and reliable distributions gives them more latitude than many to pursue growth projects.

EPD stands out in significantly increasing their growth capex – most companies have made only modest changes, although ET raised their capex guidance too, partly because of their acquisition of Semgroup.

For 2021, Kinder Morgan (KMI) and ENB each raised growth capex by $1BN. So the $4BN drop in 2021 forecast FCF for the sector is largely because these two companies, along with EPD, have raised their spending plans.

Nonetheless, some of the increases in FCF 2019-21 are big. Ten names will collectively increase FCF by $12BN over this period. ENB and KMI could both add almost $3BN apiece 2020-21.

Energy remains out of favor, with pundits like Jim Cramer dubbing it the “new tobacco” and some calling it “uninvestable”. Climate extremists direct their anger at 80% of the world’s energy supply with no practical solutions. Although it may sound as if investors are shunning stocks because of fear that public policy will harm their prospects, TRP and ENB both outperformed the S&P500 last year. That these two were most of the sector’s FCF suggests that explanations for poor stock performance are more driven by capital allocation. As FCF growth becomes more widespread, investors will find more to like.

S&P earnings are estimated to be +8% this year, according to Factset’s most recent publication. The sharp sell-off in stocks last week shows that markets are looking ahead to revised guidance. Covid-19 is a true black swan event that is challenging people to assess its impact. For example, my daughter just canceled a Caribbean cruise because she has three young children, including a four month old. The cruise line’s “Coronavirus update” spooked her, even though it only applied to Asia. My nephew, a UK-based virologist sequestered to work on the virus, advises that we will adapt to a new, seasonal flu for which annual vaccinations will eventually be available. A week ago I bought some face masks on Amazon.

In an abundance of caution, 14% of regular drinkers of Corona beer are shunning the beverage. Since comparing the fatality rate of Corona with coronavirus is a few clicks away on a smartphone, employed Corona drinkers likely exhibit limited mental dexterity.

Covid-19 is both more infectious and deadly than the seasonal flu, with a fatality rate that is estimated at 2-4% for Hubei Province where it started, and 0.5-1.0% in other parts of China. Locking down entire cities, as the Chinese government has done, promoting “social distancing,” and numerous canceled sporting events all hint at severe economic disruption. The results will show up in most corporate earnings reports for this quarter and possibly beyond. The S&P500 moved from another record high to a 10% correction in just six sessions, the fastest in history. On Friday it closed 12% below its February 19 high.

Crude oil fell $8 per barrel, dragging the S&P Energy ETF (XLE) down 17%, and the rest of the sector with it. Unlike the S&P500, XLE was not retreating from a recent all-time high either. The attractive yields on pipeline stocks offered only modest valuation support, with the American Energy Independence Index (AEITR) falling 14% from its February 19 recent high.

We updated our Equity Risk Premium (ERP) model to offer a guidepost in all the uncertainty. In December, we noted that the spread between the earnings yield on the S&P500 and ten year treasuries (the ERP definition) still favored stocks, but not as much as it had in the past. We also pointed out that fixed income buyers were keener to invest in energy infrastructure than stock investors (see Pipeline Bond Investors Are More Bullish Than Equity Buyers).

Today’s investors in stocks confront substantial near term uncertainty and the possibility that extended economic disruption will lead to a recession, a warning offered by ex-Fed chief Janet Yellen.

At its recent peak on February 19, the ERP was at 4.2. Following the recent drop, assuming 2020 earnings are flat rather than the +8% from Factset’s forecast, equity valuations are roughly unchanged with an ERP of 4.5.

The problem is that it’s still difficult to assess the earnings hit covid-19 will cause. Economic activity in China appeared to collapse, with coal consumption 40% below normal. Japan has closed all its schools until early April, affecting 13 million students. The U.S. Center for Disease Control (CDC) described the potential public health threat as high, both globally and to the United States. We can imagine the consequences of a U.S. region or major city confronting an outbreak.

A 20% drop in earnings would exceed the 2008 financial crisis. A very severe covid-19 recession in the U.S. would be required to cause this kind of fall in profits. The ERP might not be many people’s first thought in such an outcome, but suffice it to say that stocks aren’t cheap if you rate this as a real possibility.

Although crude oil’s fall in response to economic weakness has hurt energy infrastructure stocks, we continue to expect substantial growth in free cash flow this year and next. Other than Cheniere Energy, who have seen a couple of shipments of liquefied natural gas cancelled, the virus has had very limited impact on the sector’s outlook. The components of the AEITR yield 8.2%, with mid-single digit percentage dividend increases expected for the next several years.

We are invested in all the constituents of the American Energy Independence Index, which includes Cheniere Energy, Inc.

Earnings season for pipeline companies is drawing to a close, with just a few more names left to report. Results have been mostly as expected with a couple of surprises. Targa Resources (TRGP) handily beat expectations for 4Q19 EBITDA at $465MM versus $362MM. CEO Joe Bob Perkins drew criticism last year for his flippant comment about “capital blessings” when responding to investor questions about growth capex. A charitable assessment of TRGP’s capital allocation would concede that they embrace investing for future cashflow more than most of their peers. However, it does look as if they’re in the middle of a big swing in Free Cash Flow (FCF) 2019-2021. Following earnings, TRGP jumped 7%.

Energy Transfer (ET) reported another strong quarter and guided long term growth capex down to $2.0-2.5BN. 2018 FCF was ($412MM), and this year it should come in above $2.5BN, illustrating the very positive FCF improvement across most of the industry as financing of growth projects recedes. ET was also ready for the predictable question on structure – a “c-corp option” was their response, presumably meaning they’ll create a 1099-issuing entity that holds ET units. This will broaden the investor base but leave whatever concerns investors have about governance unresolved – by offering investors a c-corp without traditional corporate governance, its price may shed some light on the valuation discount partnerships endure.

Williams Companies (WMB) reported in-line earnings, but the conference call offered some useful insights. Upstream companies (i.e. oil and gas producers) are the customers of midstream energy infrastructure, and E&P bankruptcies often cause concern that pipelines will be left stranded, running to wells that no longer produce. WMB CEO Alan Armstrong had this to say,

“After a very long time in this midstream business, I have seen and experienced many instance of producers’ stress and even bankruptcy, and it’s very clear to me that the most protected service by far is that a wellhead gathering. Wellhead gathering is absolutely essential to any reserves that are going to be produced. Gas could not get to market and cash flow cannot be realized, if wellhead gas gathering is not available.

“While counterparty credit is important, the physical nature of the service is even better security.”

History has shown that in general an E&P bankruptcy just leads to a change of ownership – initially often the bondholders as equity is wiped out. Where production covers operating costs but earns an inadequate return on capital, the drilling lease was purchased at too high a price with excessive debt. Bankruptcy alters the capital structure. Pipeline operators are generally kept whole.

On another topic, opposition by environmental extremist to new pipeline construction represents an undemocratic effort to achieve what they’ve failed to democratically. For an investor interested in FCF, making pipelines harder to build lowers growth capex, leaving more cash to be returned to investors. So while pipeline opponents betray only a passing familiarity with how modern civilization functions, their wrongheaded moves aren’t necessarily unfriendly to investors.

Making new pipelines harder to build can also increase the value of existing ones. Alan Armstrong had this to say about Transco, WMB’s extensive natural gas pipeline network:

“The forces you see working in the market today are only increasing the competitive advantages of Transco. Low prices continue to incent demand in all sectors, and our access to many geographies and types of demand is unmatched. LNG, industrial, power, residential, commercial are all growing along Transco.

“Difficulties seen by Greenfield pipeline projects will also benefit Transco in the long run, as Transco has uniquely positioned to meet new capacity demand by expanding along its existing rights of way, which are irreplaceable and unmatched in terms of their proximity to demand.”

As we’ve mentioned in the past, growing FCF remains the strongest reason to invest in pipelines. Last year the two big Canadians, TC Energy (TRP) and Enbridge (ENB) were half the FCF of the sector as defined by the broad-based American Energy Independence Index. Consequently, TRP and ENB both outperformed the S&P500 in 2019, providing solid evidence that strong operating performance trumps any investor aversion to the energy sector.

This year the two Canadians’ share of FCF should drop if, as we expect, other companies finally start to emulate them.

We are invested in all of the names mentioned above.