Yesterday Williams Companies (WMB) provided an investor update on their business. WMB isn’t directly involved in crude oil, and they’re best known for owning Transco, a natural gas pipeline network running down the eastern U.S.

So far, natural gas demand is un-impacted, and slightly above historical norms.

WMB provided some information on their overall sensitivity to the drop in economic output. Natural Gas Liquids (NGL) prices have collapsed along with crude oil, and this affects 2% of their business on the Gathering and Processing (G&P) side. Somewhat counter-intuitively, natural gas prices have firmed with the drop in crude. This is because Permian oil production results in associated gas, which has weighed on prices in recent months. The looming drop in Permian output will reduce natural gas supply, benefiting natural gas dedicated plays where WMB earns 38% of its EBITDA and 85% of that is associated with gas directed drilling. 7% of their EBITDA comes from oil-driven G&P.

On the gas transmission side, which includes Transco, they expect no near term impact. Two thirds of their gas transmission customers are utilities and power companies, and 90% are investment grade credit.

Overall, WMB expects 2020 EBITDA to come in at the low end of their prior guidance, due to weak NGL prices and lower output from oil drilling. They expect cash flow to support their dividend, which currently yields over 12%, as well as any spending on growth projects which they expect to revise down.

We are invested in WMB.

None of us will forget the past couple of weeks. Investors and money managers are grappling with collapsing markets, working remotely and the challenges of ever stricter controls on our movement.

Below we’ll highlight some information that investors may have missed, combined with what we’ve learned from multiple conversations.

Pipeline companies that said anything publicly were reassuring. Ten days ago and well into the market crisis, Oneok (OKE) cut growth capex by 20% and reaffirmed 2020 guidance. On Monday Enbridge (ENB) provided a reassuring assessment of their business prospects (see Enbridge Fireside Chat). Since then, Pembina (PBA) cut growth capex by 40% and reaffirmed EBITDA guidance, and Enterprise Products Partners (EPD) declared their normal quarterly distribution. Targa Resources (TRGP) slashed their distribution by 90% which was no great surprise, and lowered growth capex by 30%. Williams Companies (WMB) announced a poison pill lasting a year, to fend off any unscrupulous buyer seeking to acquire the company at a rock-bottom price.

MLP closed end funds and leveraged MLP exchange traded notes were almost wiped out by forced develeraging (see The Virus Infecting MLPs). Incredibly, many of these funds, run by well-known MLP managers such as Tortoise and Kayne Anderson, were leveraged up to 40% as recently as the end of February. In looking at the size of these funds and volume figures, it’s plausible that they were a significant portion of the selling in this sector earlier last week. While coronavirus was unpredictable, the arrogance of these fund managers in maintaining maximum leverage exposes a complete absence of risk management at their firms, and others like them. They have caused a steeper fall than would have happened otherwise. Their NAVs have shrunk far enough that they’re now too small to have much impact going forward.

Entering 2020, midstream energy infrastructure was set for a doubling of Free Cash Flow (FCF) (see Updating the Coming Pipeline Cash Gusher). The analysis was based on guidance all provided prior to the coronavirus outbreak, although recent updates have been encouraging. We had estimated 2020 growth capex at $37BN for the components of the American Energy Independence Index (AEITR). Average reductions of 20% would free up $7BN in FCF, and since we’re almost through 1Q20 they represent a bigger cut in previously planned spending for the remainder of 2020. We see the industry as broadly in pretty good shape to withstand the type of drop in energy demand that seems likely.

Making forecasts over the next year or two is reliant on the path that the virus takes, the success we have in defeating it and resolving the economic damage. In countless conversations with investors this week, we have stressed that while we can offer our insights on the sector we cover, we won’t pretend to be virus experts. We have a constructive view that the severe health threat posed by the virus will be met within a few months. Someone with a more negative view might infer, say, a severe drop in domestic energy consumption for a couple of years, and that would alter the outlook for pipelines. Our portfolio companies are >75% investment grade with customers that are around 80% investment grade. Exposure to crude oil, and gathering and processing networks, is small because stocks with that type of exposure have already fallen so far.

We have found investors are mostly sitting tight, regarding the drop as too sudden and sharp to warrant a hasty response. There are investors with cash looking for a good entry point. And to bring home the widespread economic damage, we’ve spoken to clients who anticipate providing financial support to children and other family members who have lost their jobs.

The AEITR is down 55.6% for the year, and the S&P500 is  down 28.6%. From October 9, 2007 to March 6, 2009, the S&P500 fell 56%. On Friday, it was 32% off its high of February 19th, a very long month ago.

Finally, this chart caught our attention.

Outcomes vary widely by country. South Korea stands out as handling the health crisis as well as anybody. Germany is carrying out 160,000 tests a week, has 19K cases and 67 deaths (as of Friday 4:30pm NY time). The 0.3% fatality rate is still higher than flu, but contrasts with Italy’s 4,032 deaths and 8.6% fatality rate. Although there can be many reasons for the difference, infection numbers may be low depending on testing availability, while deaths are probably counted correctly. So Germany’s figures are likely more representative. U.S. infection numbers will increase as testing becomes more widespread. But if the curve eventually flattens to look more like South Korea, that would be the best news we’ve had in a while.

We are invested in ENB, EPD, OKE, PBA, TRGP and WMB.

 

Earlier today Enbridge (ENB) CEO Al Monaco held a “virtual fireside chat” with an analyst from RBC. ENB, like the other Canadians, is run more conservatively than many U.S. businesses. We’ve often noted that a bit more Canadian management would be beneficial in the U.S. energy sector.

The slides below are from the ENB presentation deck that was published at the same time.

We estimate that within the American Energy Independence Index (AEITR), 80% of the customers are investment grade. ENB does better than this with 95% as this slide shows.

This chart lists the profile of their natural gas customers. Monaco noted that these customers are often “must-run” facilities such as power plants in the north east U.S. and Canada. He also said that many of their liquids customers run the most competitive, complex refineries.

This slide shows how their EBITDA showed no visible hit from the 2014-16 collapse in crude prices, even though Canadian tar-sands is among the most expensive crude oil to produce.

This chart lists their top ten liquids customers along with their credit ratings.

ENB has been reducing their leverage in recent years. This is because their backlog of growth projects has been coming down. In 2015-16 they had a $25BN backlog, whereas today they have half that with $6BN remaining to fund for new investments over the next three years.

Monaco sounded very calm about his company’s position. We think they’re the kind of company that can get through just about any plausible economic disruption.

We are invested in ENB.

 

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.