FGPR - OPEC Strengthens The Outlook

2023-04-12 18:27:06 ET

Summary

• Energy equities outperformed during the week, reversing their year-to-date trend of underperformance.
• Liquids-weighted equities got a boost from rising oil prices.
• The OPEC production cut will accelerate the onset of tighter oil-market fundamentals, which will favor liquids names.

Energy Income Performance

The stock market took a break from the long technology/short energy trade that has dominated price action over the past few months. Stocks ended the week flat, while the 10-year Treasury yield declined to 3.41%, down from its high of 4.3% in October.

It was a good week for energy equities, as WTI rose 6.3% after OPEC announced a surprise production cut on Sunday. The 1.6 million barrels per day (bpd) headline cut will translate into roughly half that amount once each member's output is accounted for. But even at the lower amount, the cut will dramatically tighten the supply/demand balance, assuming the major OPEC members implement their share.

While energy equities were strong on a relative basis, they failed to keep up with oil prices. Large caps accounted for most of the 2.6% gain in the (XLE), while the E&P-weighted (XOP) was up only 2.1%. Oilfield services and midstream were relatively weak, rising 0.4% and 0.7%, respectively.

Plunging natural gas prices were the main culprit behind energy stock underperformance versus WTI. Speculation that low natural gas prices would force E&Ps to pull back on drilling, particularly in the Haynesville, created a headwind for oilfield services operators. Less drilling could also threaten to lower throughput volumes for certain midstream players.

Oil Market Fundamentals Set to Strengthen

Turning to the near-term outlook, we believed oil prices were poised to march higher throughout 2023 even before news of the OPEC cut due to strengthening oil market fundamentals. The cut will accelerate the market's tightness and with it, the onset of higher oil prices.

Higher oil prices are likely to reverse the recent trade that has favored growth stocks over energy equities. The trade has driven technology sector outperformance versus energy to an extent not seen since before inflation began its sustained rise. The dynamic is captured in the year-to-date performance chart below, which shows technology stocks ending the week up 20.1% on a year-to-date basis, while energy declined by 2.7% over the same period. Only the financial sector, rattled by a banking crisis, has performed worse.

Rising oil prices will also put upward pressure on inflation, making it less likely that the Fed can mount a swift pivot to cut its federal funds rate. This dynamic could strengthen the headwind for growth stocks and drive further energy-sector outperformance.

Liquids-Weighted Energy Income Equities Outperform

The best-performing energy income stocks during the week were those with liquids exposure. Royalty trusts like Sitio Royalties ( STR ) and Viper Energy Partners ( VNOM ) were among the top five gainers on no company-specific news, up 7.4% and 6.9%, respectively. Approximately 80% of STR's predecessor revenues in 2022 were sourced from liquids production, while 90% of VNOM's 2022 revenues came from liquids. Both companies are well-run and will generate high dividend yields on their current stock prices, even after the fall in oil prices that occurred over the past few months. We consider STR and VNOM to be among the best equity investments for conservative income investors seeking to profit from rising oil prices.

NGL Energy Partners ( NGL ) continued its run higher, gaining 6.6% after it has successfully deleveraged over recent months. Today's lower interest rates will help NGL deleverage further if they persist. Nevertheless, NGL has a long way to go until its equity is safe enough for investment, and we recommend that investors avoid the name.

Tellurian ( TELL ) was the top gainer during the week, gaining 17.9% after the company entered into a binding letter of intent to pursue a sale-and-leaseback transaction with an unnamed "New York-based institutional investor with $120 billion in assets under management." In the deal, TELL will be leasing its Driftwood acreage for 40 years at a capitalization rate of 8.75% and a letter of credit equal to 12 months of rent. The lease deal is set to cost TELL $87.5 million annually, and that amount will escalate by 3% annually. The deal is contingent on Driftwood securing financing for Phase 1 of its Driftwood LNG project.

We don't believe this announcement changes the dim prospects for TELL to secure financing for Driftwood. And as long as financing remains in doubt, TELL will be negotiating with counterparties from a position of weakness. Moreover, with the shares at today's low level, common shareholders remain at risk from egregious compensation packages for management, which could eliminate significant upside from positive developments. We recommend that all but the most speculative accounts avoid TELL stock.

Oneok ( OKE ) stock was up 3.3%, a surprisingly strong performance amid falling natural gas prices. OKE benefitted from an analyst upgrade.

Equitrans Midstream ( ETRN ) experienced another setback for its Mountain Valley Pipeline ("MVP") project when the Fourth Circuit Court of Appeals vacated its West Virginia water permit . The ruling will require the West Virginia Department of Environmental Protection to reconsider the permit application in light of the court's findings. The process will push the construction needed to finish the project back to 2024.

We believe there is hope for the MVP, as discussed in our Monday article , which could make ETRN stock an attractive investment.

Our holdings Calumet Specialty Products Partners ( CLMT ), Cheniere Energy ( LNG ), and EnLink Midstream ( ENLC ), were all weak-down 5.1%, 2.8%, and 2.8%, respectively-on no company-specific news. Each of these equities has its own unique investment thesis, and we rate them all as Buys. The selloff provides an attractive opportunity for those looking to add to the names.

Weekly HFI Research Energy Income Portfolio Recap

Our portfolio underperformed its benchmark, the Alerian MLP Index, by 1.0% due to its large positions in equities that traded lower during the week.

The price action for our weakest holdings is insignificant in light of our longer-term investment theses. This week's selloff in CLMT units was particularly nonsensical due to their extreme discount to intrinsic value, and the existence of catalysts will come into play over the coming weeks and months.

The price weakness among our largest holdings has pushed down our year-to-date performance versus our benchmark to negative 1.7%. The chart below depicts the year-to-date performance of our holdings relative to the other equities in our coverage universe. Our holdings are circled in red. Note that we removed NGL Energy Partners' ( NGL ) 171% gain from the chart to improve clarity.

We're not concerned about the recent underperformance because we believe our weakest performers either have well-defined catalysts and/or will benefit from an improving fundamental backdrop that we expect over the course of this year. Meanwhile, our stronger holdings benefit from either superior economics and/or improving fundamentals, so we expect their relative strength to continue.

News of the Week

April 3. Kinder Morgan ( KMI ) announced the full commercial in-service of its Southern and Northern renewable diesel hub projects. KMI reports that its hubs are the least carbon intensive method of transporting renewable fuels from Los Angeles to various destinations throughout California. KMI management has prioritized a push into renewables to a far greater extent than its large midstream peers. However, given management's underwhelming capital allocation track record, we don't view its new strategic focus as a significant factor in its equity value. We rate KMI as a Hold.

April 6. This was a doozy of a story: The Wall Street Journal reported that utility companies Dominion Energy ( D ) and National Grid ( NGG ) of the U.K. are considering selling their U.S. natural gas distribution companies due to concerns about a wider push to phase out natural gas use in home heating. We've discussed our view that eliminating natural gas from home heating and cooking and replacing it with electricity is not possible without massive utility investments that would send consumer electric bills soaring, akin to what is happening in parts of Europe. Moreover, it's questionable whether such a move would have a material impact on carbon emissions. Barring a concerted, wide-scale rollout of nuclear-which itself would be a decade-plus prospect-the idea effectively calls for substituting the direct burning of natural gas in homes for space-heating and cooking purposes with burning natural gas in a far-off power plant to generate electricity and then delivering that electricity over miles of transmission lines to facilitate the same heating functions. We caution investors against betting on the stock of any company with a management team that believes such a natural gas phaseout is feasible. However, we'd be interested in any company that would buy these out-of-favor midstream assets, presumably on the cheap. We should add that if a large-scale move to phase out natural gas from home heating were to actually occur, it would be a boon for Suburban Propane ( SPH ), UGI Corporation ( UGI ), and could even provide a shot in the arm to the units of beleaguered Ferrellgas Partners ( OTCPK:FGPR ).

Capital Markets Activity

None.

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