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The Energy Market Is Down But Not Out

October 10, 2019

The energy market in the US has been lagging the general stock market.

The S&P 500 Energy Sector Index has only returned 2.29% year to date, which reflects the challenges not just for the underlying companies throughout the sector, but the expectations from investors and the market of further growth for energy.

Upstream companies—exploration and production (E&P) companies—are being challenged by low prices.

Most of the integrated companies like ExxonMobil (XOM) have global operations that are on the front line of global woes. And with limited traditional dividend distributions, yield is not a compelling enough case to own these companies.

The oil-field servicing companies, which provide support to onshore and offshore wells, have continued to see reduced demand.

With so much shale oil in the US, traditional fields are not justifying capital budget increases. That’s apparent when looking at sector leader Schlumberger (SLB), which is off nearly 50% in the past 12 months.

Downstream refiners in the US are also working out challenges.

First, many major coastal refineries were set up years ago to process heavy crude from South America and the Middle East. Now, lighter and lower-cost shale oil is coming in, as well as even heavier crude from Canadian fields.

This is beginning to help refiners, including Marathon Petroleum (MPC), which thanks to its merger with Andeavor last year has brought a broader ability to tap into US as well as imported crude for better margins.

The crack spreads for US WTI and global Brent crude are both improving recently but still are down from their levels in June.

The crack spread measures the overall value of refined products against the cost of a barrel of crude. But with the spread of WTI sitting near $15 and the spread of Brent sitting at around $12, this isn’t an overly profitable market right now.

One of the crucial refined products is US gasoline. Prices are currently running at $1.67 per gallon. While this is up from the lows in late December, it’s on a downward path since April’s price of $2.13 per gallon.

The midstream—the pipelines and related toll-takers—are where profits continue to flow. The Alerian Midstream Energy Index tracks the pipeline companies inside the US market. It has seen a total return year to date of 17.48%, vastly outpacing the overall energy sector.

Alerian Midstream Energy Index Total Return—Source: Alerian & Bloomberg Finance, L.P.

Pipelines and related assets, including gathering facilities from US shale fields as well as marine terminals for the increasing exports of US crude, continue to find very strong demand.

Regulatory relief and reformation have allowed more efficient management of pipes as well as expanded capacity. With the huge production from shale fields, pipelines have been expanding their capabilities to move crude oil and natural gas both for domestic consumption and for export.

Pipelines are also less at risk of spot prices for crude and natural gas. But they are not immune. If prices fall too much, margins can be squeezed for even the more efficient of fracking producers.

And if they stop pumping—even if they have contracts with pipelines—the pipeline companies could lose payments for transport, putting profits at risk. But the best midstream firms can manage this.

The key to being successful is managing counterparty risk, and this includes making sure that pipeline capacity is filled through markets that are thick or thin.

One of the best midstream pipeline companies is Enterprise Products Partners (EPD).

This is a massive oil and natural gas pipeline passthrough with related assets, including export-focused facilities. It has returned 16.84% year to date.

Revenues are up over the trailing year by 24.90% and operating margins are fat at 13.50%. This is delivering a return on shareholder equity of 21.50%.

Ample cash flows and controlled debt give this company the ability to adapt. And its dividend—currently yielding 6.45%—keeps rising.

All My Best,

Neil George
Editor, Dividend Digest & Profitable Investing