Market Volatility and the OPEC Decision

PUBLIC SECURITIES GROUP | ENERGY INFRASTRUCTURE

Brookfield Portfolio Manager Roundtable: Market Volatility and the OPEC Decision

With Rob Chisholm and Jeff Jorgensen, Portfolio Managers for Brookfield’s Energy Infrastructure Securities Strategies

Can You Provide Your Perspective on the Current Market? What Set Off the Oil Price Decline?

We should start with a quick summary of the high-level news flow of the events from Friday, March 6 to Thursday, March 12.

• On Friday, March 6, OPEC and Russia concluded a meeting discussing additional crude oil production cuts in order to help stabilize crude oil prices, given demand concerns stemming from COVID-19. The two sides were not able to reach an agreement, as Russia refused to cut its production further. The following day (Saturday, March 7), Saudi Arabia effectively started a price war by slashing crude prices for its customers and messaging that it would cease restraining its production, unraveling the existing cuts that were in place prior to the meeting.

• On Monday, March 9, the S&P 500 Index experienced its worst day since December 1, 2008, dropping 7.6%. The broader market decline compounded what was already likely to be a rough day for crude oil prices. The price of a barrel of West Texas Intermediate crude oil dropped by over $10, or nearly 25%. As you could expect, energy equities suffered as well, with the S&P Energy Select Sector Index dropping over 20% on the day, to levels not seen since 2004.i ii

• In the midstream space specifically, the violent volatility was amplified by technical pressures, such as limited liquidity and closed end fund deleveraging. The Alerian Midstream Energy Index fell by 22%. The selling activity in equities did not let up over the course of the week, and as of market close yesterday (Thursday, March 12), the Alerian Midstream Energy Index was down by 36% since the end of last week.iii

We believe Russia did not think additional supply curtailments would be enough to shore up the short-term demand destruction from the coronavirus pandemic. Further, we think they believed a temporary price crash would curb U.S. shale growth, thereby forcing the shale industry to participate in the ultimate supply rationalization. Saudi Arabia responded by flooding the market almost immediately, likely in an effort to make the price pain sharper than Russia was expecting and bring them back to the negotiating table.

1 Any Insights on How This Will Get Resolved? the amount of “associated gas” supply from crude Unfortunately, the series of events discussed above have oil-focused basins. created a pretty dire situation for crude oil prices. The • This may provide some relief to natural gas-focused twin supply and demand shocks means that a significant producers (particularly in the Northeast U.S.) who have amount of crude oil production will have to come offline to been dealing with depressed prices for several years as balance the market. The uncertainty surrounding the extent associated gas production from places like the Permian and duration of global containment and mitigation efforts and the Bakken has increased. regarding COVID-19 makes demand projections a bit of a moving target right now, but in our view, if OPEC and Russia What Is the Impact on U.S. Midstream Energy? How Do ramp back up to unconstrained production levels, excess You Believe This Will Impact Midstream Energy Cash inventory will begin to build rapidly. Flows, Volumes and Distributions? Simply put, the midstream revenue formula is fee multiplied The U.S. shale industry immediately began responding, as by volume. While we believe most of our companies do not companies announced that they were dialing down activity have a great degree of direct commodity price exposure, levels throughout the week. As long as current price levels they will be impacted if we get to a scenario where volumes are sustained, we expect conditions will remain challenging roll over. If this challenging environment persists for a for U.S. shale producers. Meanwhile, Saudi Arabia and prolonged period of time, we could see another round Russia are effectively engaging in a game of chicken to of distribution cuts. While the underlying cash flows and see who can withstand crude oil prices at these levels the contractual protections may be strong, many companies longest. may simply decide that those distributions and dividends are better deployed to either reduce the balance sheet or Ultimately, we believe demand will rebound when the buy back stock. COVID-19 outbreak is contained, and supply/demand balances will tighten somewhat. But in the meantime, we do On the valuation front, the severity of the stock price expect to see modest supply reductions coming from U.S. movements has put us in a position where we are seeing shale, and we will be looking for indications that Russia and many industry bellwethers trade at yield levels that are Saudi Arabia are willing to come back to the table. higher and at EV/EBITDA multiples that are lower than at any point during the 2008 financial crisis. What Is the Impact on U.S. Oil Producers? Why Do You Believe Midstream Energy Is Competitively The good news: Positioned to Weather This Storm? • The U.S. shale industry has weathered a couple of difficult environments recently, and as a response, This is clearly a time of unprecedented volatility in the drilling technique and technology has improved, and energy space. Fear is driving the markets, and uncertainty is producers can make money at increasingly lower price high. While we are bracing for at least some duration of the levels. current dynamics, we do think it is important to keep some • In addition, supermajors have made dedicated long-term facts in mind: investments within U.S. shale in recent years, and those • We believe the cyclicality of crude oil prices means what companies may be better positioned to weather a is bad today may be good for tomorrow. storm. • We believe the assets we invest in are crucial • We believe the companies who come out on the other infrastructure assets with monopolistic-like features. side of this will find themselves in a pretty compelling • We believe the industry is better positioned today to scenario when the dust settles. withstand cycles than it was in 2015-2016, the last time that crude oil prices were at these levels. The industry The bad news: has largely eliminated IDRs (incentive distribution • We are now at a price level that makes most new rights) and reliance on capital markets. In addition, activity uneconomical in the U.S. If these prices persist leverage levels are lower. for a long time, we could see some bankruptcies in the • We believe midstream cash flow impacts will most likely exploration & production (E&P) space. be modest, and there may even be an opportunity • We believe the E&P companies most at risk of to scale back capital expenditures, which may help bankruptcy would be the ones with elevated balance midstream companies to generate free cash flow. sheets, relatively high fixed costs and a relatively high degree of unhedged production. We want to reiterate that our process throughout all this has not changed. We are still focused on investing in the Impacts on natural gas prices: strongest companies that we believe have the best asset • One other impact that we believe is worth mentioning footprints and the strongest management teams. We here is the relationship between crude oil prices and believe the indiscriminate selling we have recently seen natural gas prices. Natural gas prices are up over 7% may create investment opportunities, and we believe this past week (as of March 12), despite the weakness in that current times highlight the importance of active broader markets. management. • While the COVID-19 outbreak may impact natural gas demand as well, depending on the levels of activity slowdown, the impacts should be less severe than for crude oil demand. Importantly, as the market braces for a reduction in U.S. crude oil output, this will also reduce

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