Amid the coronavirus pandemic, the energy sector has been hit by the worst of both worlds: an oversupply and weakening demand.
After weeks of falling oil prices, driven by government efforts to stop the spread of covid-19, energy-related assets experienced additional disruption in the sector on 8 March when a pricing dispute between Saudi Arabia and Russia erupted and led to climbing Saudi production volumes. In less than three weeks, US oil prices had fallen 34 percent to around $30 per barrel.
Midstream assets, which support the movement of oil and natural gas to market, may be the infrastructure sector hit hardest by ongoing market volatility, according to a report by UBS Asset Management’s Real Estate and Private Markets group. “Just as it is uncertain how long the coronavirus pandemic will last, it is also unclear how long Saudi Arabia will continue its oil price strategy,” the report stated.
For investors, this round of volatility is again underscoring how even midstream assets are exposed to commodity price risk, according to Brent Burnett, co-head of real assets at Hamilton Lane, a fund advisory and asset manager. Burnett told Infrastructure Investor that midstream assets may not have direct commodity risk, but even indirect exposure can be significant.
Midstream companies secure assets by agreeing to guaranteed minimum volume contracts with upstream producers, which pays additional fees based on usage volume. If producers stop drilling, midstream companies will be forced to rely on minimum guaranteed revenue from contracts signed over the past decade when oil prices were higher.
With the industry still on its “back foot” following an oil price plunge in 2014, Burnett said volatility is changing how investors view the midstream sector.
“You have an industry that was just emerging from its last cyclical downturn and is now getting slammed by both demand and supply shocks,” Burnett explained. “Investors are increasingly grouping energy assets together and saying that midstream may have more commodity price exposure than you think.”
In the short term, volatility is “crippling” the midstream sector and energy overall, Burnett said. After markets steady, whether there will be investor appetite for either remains to be seen.
Matt Hartman, co-head of midstream at EIG Global Energy Partners, said that even if investors cool from the energy sector, it doesn’t mean they will be gone forever. “To the extent that midstream is important, required and generates a sufficient return, then we expect institutional investors will have a desire to invest in the sector.”
But the emphasis is on “sufficient returns”. Hartman added that oil prices where they are now, hovering around $30 per barrel, “does not work for anyone in the US”.
“Once production volumes begin to decline,” which Hartman said could occur over the next six to 12 months, “midstream companies could be significantly impacted”, he explained.
“If these pricing levels persist, we expect to see a significant reduction in drilling. We expect to see a lot of bankruptcies, which will impact the midstream side as well,” Hartman said.
The midstream companies he sees as most at-risk are the ones acquired by private capital firms using significant amounts of debt. This is where the industry will “see the pain the soonest,” according to Hartman.
“[The] Pain [is] caused by covenant defaults on leveraged loans that these private capital firms are issuing at their portfolio companies,” he explained. “These firms have levered up their portfolio companies at somewhere between 7-10x EBITDA. Obviously, at these levels, there’s not much margin for situations like this.”
One bright spot Hartman pointed to is the natural gas part of the midstream sector, which has not seen commodity price volatility like oil has. Natural gas midstream companies operating in gas-only basins, as opposed to associated gas drilled in oil fields, stand to benefit from the volatility.
Hartman said that natural gas midstream opportunities will be found in infrastructure that transports natural gas to end users or through liquefied natural gas export terminals.