CTR - ClearBridge Energy MLP Strategy Q4 2023 Portfolio Manager Commentary

2024-01-21 09:30:00 ET

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• Energy MLP stocks stood out from a challenged S&P 500 energy sector in the fourth quarter, making gains despite lower oil prices.
• The incremental barrel oil supply in 2024, given current demand expectations, will almost have to be a barrel of U.S. oil — continuing to drive visibility in growth in U.S. oil production to the benefit of U.S. midstream companies.
• The short-term outlook for natural gas is decidedly negative while the intermediate- to long-term outlook remains robust.

By Michael Clarfeld, CFA, & Chris Eades

Midstream Outpaces Broad Energy Sector

Market Overview and Outlook

Energy MLP stocks stood out from a challenged energy sector in the fourth quarter, with the Alerian MLP Index returning 4.98% and leading the S&P 500 Index ( SP500 , SPX ) energy sector, which retreated, returning -6.94% as high U.S. production and slower growth from China led to lower Crude WTI oil prices from $88 per barrel to $72. The S&P 500 Index advanced 11.69% on increased hopes for an economic soft landing and interest rate cuts in 2024.

Global economies faced multiple headwinds, led by a combination of stubbornly high (though recently moderating) inflation, elevated geopolitical uncertainty and lingering supply chain and policy impacts from the COVID-19 pandemic. In the U.S., we began to see the dampening effects on the economy of tighter monetary conditions. During 2022, equity markets began pricing in a reasonable chance of recession, both in the U.S. and abroad. In 2023, global equity markets generally recovered the losses incurred in 2022, and expectations are increasing that developed economies might avert a severe recession in 2024.

Crude oil prices fell from more than $120 per barrel in June 2022 to ~$70 per barrel at year-end 2023. Recession concerns left oil market traders fearful of global demand downdrafts for crude oil in 2023 much like those witnessed during the Global Financial Crisis. A stronger U.S. dollar and large-scale releases from the U.S. Strategic Petroleum Reserve ('SPR') further pressured oil prices. On the other hand, demand fear was partially offset by some optimism for a rebound in China demand with the lifting of COVID-19 restrictions. The surprise OPEC+ supply cut of 1.1 million barrels per day at the end of March 2023 and again in November 2023 have also likely put a floor on oil prices over the near term.

The trajectory of oil prices over the next year or so will likely be dictated by demand factors — not supply. Most oil economists forecast an increase of roughly 1.0 million to 1.5 million barrels per day in global oil demand to ~103 million barrels per day in 2024. Essentially all of this oil demand growth is expected in developing nations, rather than OECD nations. We would argue that oil prices of roughly $70 per barrel at the end of 2023 discounted that demand growth will not approach levels expected by oil economists in 2024. Said differently, oil traders seemed to expect a material contraction in global oil demand growth rates compared to oil economists. A final twist to oil demand analysis remains the timing of the U.S. refilling its vastly depleted SPR. After depleting the SPR by roughly 275 million barrels (or ~45%) in the previous 18 months, in June 2023 the U.S. government announced initial plans to begin refilling the SPR beginning in September and it has slowly begun doing so. Thus, what has been a meaningful source of supply in the crude oil markets will become a source of demand looking forward.

"If global oil demand growth does approaches estimates in 2024, we see upside in oil prices in 2024."

If global demand growth does approach those estimates in 2024, we see upside in oil prices in 2024. The supply side of the global oil market will meaningfully struggle to meet that kind of demand growth. We would also argue that the incremental barrel oil supply in such a scenario will almost have to be a barrel of U.S. oil — continuing to drive visibility in growth in U.S. oil production to the benefit of U.S. midstream companies.

Looking at natural gas, the short-term outlook is decidedly negative while the intermediate- to long-term outlook remains robust. An almost complete lack of typical weather last winter left natural gas storage levels 32% higher at the end of March 2023 than a year before. Higher storage levels entering the spring and summer simply also equated to lower natural gas demand to refill storage levels. As a result, U.S. natural gas prices fell from above $5 per mmbtu at the end of March 2022 to $2.50 per mmbtu at the end of 2023. In our view, pricing for U.S. natural gas will not meaningfully recover in the near term unless normal winter weather occurs in the U.S. Amid continued organic domestic demand growth and increasing demand for U.S. liquefied natural gas in the international markets, the intermediate- to long-term outlook for U.S. natural gas prices and necessary production levels remains constructive for U.S. midstream companies.

Valuation for U.S. midstream companies remains well below the levels seen before the pandemic. Entering 2020, enterprise value to EBITDA multiples stood at roughly 10.5x. Despite the rebound the sector has experienced since the March 2020 lows, the sector today trades at 8.4x — despite what we view as a vastly better business model. Dividend/distribution coverage has moved from 1.1x to more than 2.0x. The sector has moved from being free cash flow negative to free cash flow positive (increasingly so in 2023) and balance sheet leverage (debt/EBITDA) has moved from more than 5.0x to below 3.5x. With no need for midstream companies to access capital markets for the foreseeable future, we increasingly expect excess cash flow (above and beyond capital spending and dividends/distributions) to be used for increasing share buybacks and further increasing dividends/distributions.

With improving financial metrics and continued low valuations, we still see solid upside potential for the U.S. midstream sector despite strong performance in 2022 and 2023.

Portfolio Highlights

The ClearBridge Energy MLP Strategy outperformed its Alerian MLP Index benchmark during the fourth quarter. In terms of absolute performance, three of the four subsectors in which the Strategy is invested made positive contributions, with the gathering/processing subsector contributing the most and the natural gas transportation & storage subsector the detractor.

On a relative basis, the Strategy outperformed due to sector allocation. An overweight to the gathering/processing subsector and stock selection in the natural gas transportation & storage subsector contributed the most. Stock selection in the gathering/processing and liquids transportation & storage subsectors, as well as an underweight to the latter, detracted.

In terms of individual holdings, Western Midstream Partners LP ( WES ), Enbridge ( ENB ), Genesis Energy LP ( GEL ), Antero Midstream ( AM ) and MPLX LP were the main contributors. The main individual detractors were Cheniere Energy Partners LP ( CQP ), Enterprise Products Partners LP ( EPD ), Holly Energy Partners LP ( HEP ), Energy Transfer LP ( ET ) and Crestwood Equity Partners LP ( CEQP ).

During the quarter holding Holly Energy Partners LP was acquired by HF Sinclair ( DINO ), which the portfolio inherited with the acquisition but did not retain. In addition, holding Crestwood Equity Partners LP was acquired by holding Energy Transfer LP ( ET ).

Michael Clarfeld, CFA, Managing Director, Portfolio Manager

Chris Eades, Managing Director, Portfolio Manager

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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