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COVID-19, OPEC, Midstream, and Comparisons to 2008
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All of us at Chickasaw Capital Management LLC fully INVESTMENT TEAM
respect and are engaged in the assessment of the novel Geoffrey P. Mavar – Principal coronavirus, COVID-19, as it relates to our employees, Matthew G. Mead – Principal clients, partners and friends. We share our sympathies Robert M.T. Walker – Principal Bryan F. Bulawa – Principal with the victims and their families. Paul R. Jacob – Vice President Below we offer our perspective for Energy and Midstream Scott B. Warren, CFA – Senior Analyst markets to give investors insights into our thinking. Luke B. Davis – Senior Analyst
Much has been said about the coronavirus and the potential impacts and outcomes to the economy. At this point we cannot claim to know fully how events will unfold since the new paradigm created by how this disease is manifesting itself and what is still not known may categorize this as a “black swan event”. What can be said is that over the past few weeks we have witnessed increased volatility in the market that has led to historic events. The Dow Jones Industrial Average closed at a high of 29,551.4 on February 12th and has declined to 25,864.8 through March 6th, representing a (12.48%) pullback, which has been one of only 15 such pullbacks outside of the Great Depression over the past century. The Fed’s inter-meeting 50 basis point cut on March 3rd was one of only a handful of inter-meeting cuts over the past two decades. The 10-year Treasury rates are at record lows closing March 6th at 0.77%. Energy has been hit harder in this pullback than other sectors. Even though Midstream has held up better than other parts of the energy sector with the Alerian MLP Total Return Index (AMZX) down (26.9%) quarter-to-date vs. the Energy Select Sector SPDR Fund (XLE) down (29.2%), the decline is still the most rapid pullback for our universe since the Great Financial Crisis in 2008. But is it as bad as the financial crisis? We don’t believe it is. Last week at its most recent extraordinary meeting in Vienna, the Organization of the Petroleum Exporting Countries (OPEC) was discussing an additional 1.5 million barrels per day (MMbpd) cut in crude oil production on top of the 2.1 MMbpd quota currently in place. However, Russia, which has previously been act- ing in concert with OPEC but is not a member, chose not support the proposed cut. Reports as of this weekend indicate “...the decline is still the that Russia and Saudi Arabia will most rapid pullback for our both be increasing production to universe since the Great retain market share thus leaving crude oil to find lower price levels, Financial Crisis in 2008. But and shaking out more vulnerable is it as bad as the financial producers. crisis? We don’t believe it is.”
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The Energy complex has already dealt with a recent Similarly, our research shows Midstream is much better commodity price correction from 2014 to 2016, where the positioned today than it was before the financial crisis, and this generic front month contract for WTI declined by over 75% improvement has been accelerated by the move to Midstream as it fell from $107.26/bbl in June 2014 to $26.21/bbl in 2.0. As a reminder the hallmarks of this shift include elimination February 2016. The ultimate impact to U.S. production from of incentive distribution rights (IDRs), increased distribution this price decline was a 1 million barrel per day (MMBpd) coverage, improved balance sheet leverage (measured as debt reduction year over year to 8.5 MMBpd. During that time to earnings before interest taxes depreciation and amortization period and since then domestic producers dramatically (D/EBITDA)), and increased cash retention for greater flexibil- improved efficiency, which helped to lower costs and has ity for corporate capital allocation. If we look back historically, allowed the United States to become one of the lowest cost coverage ratios in 2008 were closer to 1.1x versus nearly 1.5x producers of hydrocarbons globally. As of the end of 2019, now; access to equity capital markets is not needed today; and the U.S. was producing greater than 12.5 MMBpd. We believe we estimate D/EBITDA for the AMZX is currently 3.7x versus the vast majority of domestic producers should be able to our estimate of 3.6x in 2008. Ironically, with all these improve- withstand the front month WTI contract price decline, but ments the equity prices are currently indicating the future it’s logical to assume that there will at least be a flattening outlook for these companies is as bad as it was in 2008 when of growth or even a near term pullback. It’s important to measured by the Price to Distributable Cash Flow (P/DCF) met- emphasize that typically when these events have happened ric, which is registering a lower valuation than in 2008. We it is initially painful, but the effects are not long lasting. We strongly believe we have a severe, momentum-driven, discon- will obviously continue to be monitoring this fluid situation. nect between fundamentals and valuation. Alerian Weighted P/DCF
Alerian Weighted Price to Distributable Cash Flow (P/DCF)
The current Weighted Average Average P/DCF ratio is the 16x minimum for historic periods. 14x
12x
10x
8x
6x
4x
Source: Bloomberg, Chickasaw Average = 10.3x | Current = 4.7x | Minimum = 4.7x
Bloomberg, Chickasaw, 3/6/20 chickasawcap.com | 800.743.5410 See “Additional Information” at the end of the presentation. Midstream Valuation | 2
...... OBSERVATIONS & OUTLOOK . MARCH 9, 2020 ......
Let’s return to the fundamentals. Take or pay contracts in periods of dislocation to generate additional cash flow on long haul pipelines within our portfolio are largely beyond the requirements of their underlying contracts. covered by minimum volume commitments (MVCs). Put If we were to contrast the industry’s contract profile another way, the counterparty has to pay whether vol- to 2008, some important and crucial differences are umes flow on the pipeline or not. We recently examined apparent. In terms of similarities between 2008 and now, pipelines owned by our portfolio companies tied to two the security of the contracts on long haul pipelines and of the most important onshore basins — the Permian and other demand facing assets have remained alike. the Marcellus/Northeast. On a combined basis, we found Gathering and processing and certain other Midstream that even if volume growth slows materially, the maxi- activities, though, had much more variability as both cash mum impact to our portfolio EBITDA is less than 3% due flow and volumes were more equity-incentivized to align to the presence of MVCs. with producer activities, which created greater sensitivity There could be some variability around certain assets to swings in production and commodity prices. that are closer to production activities, which represents We believe the most significant improvement over ~20% of the portfolio’s cash flows, but a few things need the past 12 years is in company balance sheets, which to be considered. First, Midstream companies with gath- helps companies weather the global business cycle better ering and processing assets are by and large diversified when changes occur, such as now. Revolver balances, as a across basins. Second, the majority of these assets are percentage of total debt, are the lowest since we started integrated into large value chains truly connecting supply measuring in 2008 at 8.9% across the industry, and we to demand, and are not tied to single producers. Third, estimate there is $75 billion of available liquidity across the majority of these contracts have similar protection the sector (if needed). Today we face near term uncer- mechanisms as would large diameter takeaway pipelines. tainty around business conditions, which we believe will This is exemplified by our estimation that over 90% of the be resolved in time. However, in 2008, Midstream faced cash flow of our total portfolio is fee-based. Lastly, com- a greater uncertainty around their near-term business panies with large integrated systems will find opportunity fundamentals, which was coupled with a liquidity crisis. Revolver / Total Debt
Revolver / Total Debt
35% 30.9% 30%
25%
20% 14.2% 12.6% 10.7% 15% 18.3% 10.7% 9.4% 10% 12.8% 14.2% 9.8% 9.2% 5% 8.9%
0% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Bloomberg, Chickasaw, 2/29/20 Source: Bloomberg, Chickasaw
...... chickasawcap.com | 800.743.5410 OBSERVATIONSSee “Additional Information” at the& endOUTLOOK of the presentation. . MARCH 9, 2020 ...... Midstream Valuation | 1 ......
As a result of Midstream 2.0 and well-managed balance are non-investment grade companies, but the majority sheets, we don’t expect revolver liquidity to even be an of these companies are higher rated in this category issue. First, all of our companies’ capital budgets antici- and have ratings’ cushion. Additionally, there is diver- pate funding at least the equity portion and potentially sity across demand and supply facing assets, so there- more with free cash flow (FCF), which neutralizes capital fore the portfolio is not overly weighted to production markets risks and allows them much greater financial activities. Midstream companies have a long legal prec- flexibility as they operate. edent of being deemed a critical service provider, and Second, none of our companies have debt maturity are considered creditors senior to debtholders. We have cliffs that could create a liquidity concern if the debt cap- seen renegotiations in some cases, but they have almost ital markets freeze, a stark contrast to the environment in always been net present value (NPV) positive. There have 2008. Midstream companies have been diligent in raising been a handful of such contract renegotiations this year, $12.25 billion of debt capital through January 21, 2020. All predominantly outside of the bankruptcy process. If the of the companies with debt issuance maturing in 2020 are current environment becomes worse, it is likely we could investment grade and the investment grade bond market see bankruptcies and more renegotiations, but we do not remains quite attractive (and open) for Midstream, despite expect a material, if any, degradation in discounted cash the recent volatility. As an example, ONEOK Inc (OKE) flows. Please do not confuse media headlines ultimately priced $1.65 billion of notes on March 5th with the 10-yr describing areas of increasing or discrete stress as a panic tranche pricing 220 bp over the 10 Year U.S. Treasury (3 across the space tranches priced, all-in weighted, at 3.23%). Of our portfo- lio holdings, there are only $12 billion of debt maturities Conclusion this year, which represents, in aggregate, ~8% of those companies’ total debt. At the depths of the financial crisis, While we are not hearing many comparisons to 2008 investment grade Midstream companies had zero access to specifically, we are hearing similar questions and believe the debt capital markets, and when the markets re-opened that the differences today could not be starker, that is, interest rates were greater than 9%. We anticipate invest- except for valuation, which we believe is explained more ment grade funding will remain efficiently priced, even by negative momentum than fundamental issues. This is under a worst-case scenario of the coronavirus. If we an industry that produces a stable stream of cash flows expand our maturity analysis out two years we only have which we believe has been mis-valued, and now has one non-investment grade company with a maturing debt reached an extreme many did not expect to return to. issuance, and that is an $850 million bank-based term loan We thank our investors for your steadfastness with us we expect to be extended well before maturity. as markets have continued to dictate prices we believe We have been consistently asked the question about are massively disconnected from valuation. We are com- counterparty exposure in the case a Midstream cus- pletely available for your questions that we may not have tomer files for bankruptcy. We estimate only 19% of answered in this interim newsletter, and look forward to the portfolio’s cash flows come from customers that connecting with you.
Geoffrey Mavar Matt Mead Robert Walker Bryan Bulawa
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The figures for the indices do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices. The Alerian MLP Index is a composite of the most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index, which is calculated using a float-adjusted, capitalization-weighted methodology, is disseminated real-time on a price-return basis (NYSE: AMZ), and the corresponding total- return index is disseminated daily (NYSE: AMZX). Relevant data points such as dividend yield are also published daily. For index values, constituents, and announcements regarding constituent changes, please visit www.alerian.com. “Alerian MLP Index”, “Alerian MLP Total Return Index”, “AMZ” and “AMZX” are servicemarks of GKD Index Partners, LLC d/b/a Alerian (“Alerian”) and their use is granted under a license from Alerian. 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The Energy MLP Classification Standard (“EMCS”) was developed by and is the exclusive property (and a service mark) of GKD Index Partners, LLC d/b/a Alerian (“Alerian”) and its use is granted under a license from Alerian. Alerian make no warranties, express or implied, or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and hereby expressly disclaims all warranties of originality, accuracy, completeness, merchantability, suitability, non-infringement, or fitness for a particular purpose with respect to any such standard or classification. No warranty is given that the standard or classification will conform to any description thereof or be free of omissions, errors, interruptions, or defects. Without limiting any of the foregoing, in no event shall Alerian have any liability for any indirect, special, incidental, or consequential damages (including lost profits), arising out of any such standard or classification, even if notified of the possibility of such damages. DJIA Total Return Index: Tracks the total return of The Dow Jones Industrial Average, a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. Dividends are reinvested. The DJIA was invented by Charles Dow back in 1896. Energy Select Sector SPDR® Fund (XLE): Seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Energy Select Sector Index, which seeks to provide an effective representation of the energy sector of the S&P 500 Index. One cannot directly invest in an index. Distributable Cash Flow or DCF is calculated as net income plus depreciation and other noncash items, less maintenance capital expenditure requirements. Distributable Cash Flow (DCF) data is CCM-calculated consensus of Wall Street estimates. Distributions are quarterly payments, similar to dividends, made to Limited Partner (LP) and General Partner (GP) investors. These amounts are set by the GP and are supported by an MLP’s operating cash flows. Distribution Coverage Ratio is calculated as cash available to limited partners divided by cash distributed to limited partners. It gives an indication of an MLP’s ability to make dividend payments to limited partner investors from operating cash flows. MLPs with a coverage ratio of in excess of 1.0 times are able to meet their dividend payments without external financing. EBITDA is earnings before interest rates taxes depreciation and amortization. Free Cash Flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital. Incentive Distribution Rights (IDRs) allow the holder (typically the general partner) to receive an increasing percentage of quarterly distributions after the minimum quarterly distribution and target distribution thresholds have been achieved. In most partnerships, IDRs can reach a tier wherein the GP is receiving 50% of every incremental dollar paid to the LP unitholders. This is known as the 50/50 or “high splits” tier. Leverage is net debt divided by EBITDA. WTI is a grade of crude oil referenced for pricing. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.
...... OBSERVATIONS & OUTLOOK . MARCH 9, 2020 ......