Energy Infrastructure Primer: a Guide for Both New and Experienced Investors
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Energy Infrastructure Primer: A guide for both new and experienced investors Version 1.1 April 2020 Alerian 3625 N. Hall St., Suite 1200 Dallas, TX 75219 alerian.com Table of Contents Introduction 3 Energy Infrastructure 101 4 Energy Infrastructure 201 9 Energy Infrastructure Investing 15 Classification Standard 21 Glossary 23 Disclaimers 27 2 // Introduction An investment in energy infrastructure is an investment in EI 101 is designed for those who are starting from the North America’s continued production and consumption of beginning or those who would like a refresher on the transportable energy over the next several decades. Energy basics of energy infrastructure. We’ve also detailed energy infrastructure companies own the pipelines, storage infrastructure business models, as well as the fundamental tanks, and processing facilities that bring energy from the backdrop supporting opportunities in this space. wellhead to America’s doorstep and increasingly to coasts for exports. In the energy industry, these activities describe EI 201 goes into further detail on energy infrastructure “midstream”, which is the bridge between production business models and gets to the importance of shale (upstream) and consumption (downstream). While still in growing US energy production. This section is for related to the energy industry, most energy infrastructure those investors wanting to have a firm grasp on energy business lines do not have direct exposure to commodity infrastructure economics before investing. We explain price fluctuations. Their businesses function primarily on the nuances of various midstream business models, a set fee per volume or fee for service basis. In short, the the regulations around pipelines and pipeline tariffs, business model is driven by volumes. and the valuation metrics typically used for the energy infrastructure space. The prices (or tariffs) that energy infrastructure companies can charge are determined either by negotiated contracts Energy Infrastructure Investing is designed for those who or are federally regulated. Typically, tariffs increase have decided to invest. This section walks through each each year by a measure linked to inflation. In terms of energy infrastructure access product, explaining the pros volumes, the significant growth in North American oil and cons as well as exploring which goals might be met and gas production has increased the need for energy by each. This section includes considerations for selecting infrastructure assets. While energy demand in North individual securities and investing in products, whether America remains fairly steady, global demand growth active or passive. continues, particularly for emerging markets, creating opportunities for energy infrastructure companies. Increasingly, these companies are processing, transporting, and storing hydrocarbons that will ultimately be sent to locations worldwide. 3 Energy Infrastructure 101 4 // Energy Infrastructure 101 The Very Basics volume side, growing production of North American oil and natural gas has necessitated more energy infrastructure Energy infrastructure companies are involved in the such as pipelines, storage tanks, and processing plants. transportation, processing, and storage of oil, natural gas, and natural gas liquids (NGLs). Historically, a majority of How Investors Make Money with Energy the midstream space has been structured as master limited Infrastructure partnerships, or MLPs (we won’t cover MLPs extensively in Energy Infrastructure 101, but those looking for more If you own a stock, there are two ways to make money. The information can find it in our MLP Primer). However, price of the stock increases and you can sell it for more than C-Corporations have become more prominent in midstream you bought it. Formally, this is known as price appreciation. in recent years. The stock also likely pays you dividends. The amount of dividends relative to the share price is known as yield. The Basic EI Business Models1 The historical average yield of energy infrastructure 1. Transportation over the past 5 years has been nearly 6.0%, which means Just like it sounds, transportation involves moving energy that if you invested $100, on average, you would be paid commodities like oil and natural gas from one place to another. $6.00 each year. The chart below shows yields for energy In North America, most energy travels through a pipeline, but infrastructure, represented by the Alerian Midstream it can also move via truck, railcar, or ship. Pipelines are the Energy Index (AMNA), compared to other asset classes. cornerstone of the energy infrastructure space. Energy infrastructure boasts a higher yield than utilities and real estate investment trusts (REITs), which are asset 2. Processing classes known for their income potential. Processing encompasses any business that transforms a raw commodity into a usable form. It involves removing MLP Historical Average Yield (5 Years) impurities like water and dirt from wellhead natural gas . and separating the natural gas stream into pipeline-quality natural gas and natural gas liquids (NGLs), which are used as heating fuels and petrochemical feedstocks. 3. Storage Storage includes tanks, wells, and other facilities both above and below ground. These assets provide flexibility to the energy economy, so there is propane available for winter heating, gasoline for summer driving, and jet fuel for the holidays. How Energy Infrastructure Companies Make . Money Energy infrastructure companies typically operate fee- based business models. EI companies earn a set fee for each barrel of oil or million British Thermal Unit (MMBtu) of . natural gas transported, stored, or processed (in the case of natural gas) regardless of the price of the hydrocarbon. This is because these companies typically do not own the oil or gas. EI companies generally sign long-term contracts (5 to 20 years in length) with their customers, which makes for stable cash flows. Accordingly, the revenue equation for most business activities is fairly simple: price multiplied AMNA REITs Utilities Bonds S&P by volume. As such, more volumes means more cash flows. Source: Alerian, Bloomberg as of December 31, 2019 On the price side, a federal agency sets the fee charged by interstate liquids pipelines, and the fee increases with inflation. Pipeline fees can also be negotiated with a customer based on the cost of operating the pipeline and market rates for liquids or natural gas pipelines. On the 1 Please see EI 201 for an in-depth look at all energy infrastructure business functions. 5 // Energy Infrastructure 101 The Pipeline Business, Explained applying these technologies, oil producers began implementing the same drilling technology, seeing strong production growth The modern pipeline network2 in the United States has from oil wells. its roots in the outbreak of World War II. Before the war, the East Coast was the largest consumer of energy in In 2009, the US became the world’s largest producer of natural the country. Refined products (such as gasoline, diesel, gas. By 2012, the US had an abundance of natural gas, leading and jet fuel) were delivered from Gulf Coast refineries to lower prices, but gas production continued to grow. In 2014, via tankers. Tankers also carried raw crude oil from the rapid growth in US oil production had led to a global crude Middle East. However, once the US became involved in oversupply and weakness in oil prices. A multi-decade ban on the war, German submarines began sinking these tankers. US crude exports was lifted by Congress in December 2015. Oil Together, the government and the petroleum industry built prices gradually recovered from their relative bottoming in pipelines that could cover long distances and transport February 2016, and US oil production continued to increase. large amounts of oil. This network subsequently fueled the In 2018, the US became the world’s largest oil producer and is economic boom that followed the war., and many of those now exporting millions of barrels of crude each day. Global oil original pipelines are still in service today. prices fell significantly in early 2020 due in part to the demand impacts stemming from the coronavirus. Price weakness may There are both large diameter trunklines that function lead to a temporary reduction in US oil production, though the like interstates (instead of being four lanes wide, they are long-term view for production growth remains intact. often 42” in diameter, or large enough for a child to stand inside), as well as smaller delivery lines which connect the The term “energy renaissance” refers to the overwhelming large pipelines to each town. Product traveling through growth in US energy production that has occurred over trunklines is fungible—the customer will receive product the last decade, culminating in projections that the US will on the other end that is the same quality as that which become a net energy exporter by 2020. was sent, but they won’t be the exact same molecules. It is as if someone sent $100 to a college student through a Long-Term Growth Expected for US Energy Production bank. That student will not get the exact same $100 bill as his or her benefactor sent, but the student doesn’t care because $100 is $100. Money is fungible. However, smaller delivery lines operate on a batch system, where the exact same molecules are delivered as were shipped. In this case, our lucky college student gets a couple dozen cookies, and the ones delivered are the exact same cookies his or her parents baked, not cookies that some other people made. Energy Renaissance Prior to the 2000s, much of the energy industry was focused on peak oil and the ways companies and our society would have to shift in response. While producers knew that oil reserves existed, accessing the oil in a cost-effective way was still difficult. Experts forecasted that expensive and complex recovery methods would be needed to continue to produce even a modest number of barrels. In the early 2000s, the natural gas industry in the US began widespread application of horizontal drilling and hydraulic fracturing.