East Daley: Midstream Outlook Favorable Despite Recent Struggles

Typically, we have to wait for spring to get in the mode for renewed faith, but as the new year begins there is already reason for optimism for midstream companies and investors.

It’s hard to read the tea leaves when it comes to energy markets. On the one hand, many midstream companies experienced production and earnings growth throughout 2018. On the other hand, the overall market sentiment for commodities like crude oil, natural gas and NGL was bearish as 2018 ended. However, the fundamentals for the midstream remain strong.

Indeed, East Daley Capital’s “2019 Midstream Guidance Outlook” is taking a bullish stance on the sector. “Production growth is likely the biggest factor to influence midstream performance in 2019,” the report said while noting that domestic liquids production rose by 13% and domestic natural gas production rose by 15% in 2018 compared to 2017 figures.

Though liquids prices experienced a 30% decline over the final weeks of 2018, East Daley noted demand will likely continue to grow even when factoring in the potential for an overall economic downturn or displacement by cleaner energy sources.

“The case for continued strong production growth is supported by the relentless increases in global demand for liquids. Global liquids consumption growth has average [about] 1.3 million barrels per day per year the past two decades, with only two of those 20 years have a contraction in demand,” the report said.

Over the past decade, the U.S. has overwhelmingly fueled the demand growth for liquids from developing nations. According to East Daley, U.S. shale producers have been responsible for supplying about 70% of global demand growth since 2011.

“While potential economic recessions or long-term displacement by cleaner energy pose risks, the trend of increasing demand is likely to continue into the foreseeable future as developing countries modernize and grow. From a supply standpoint, the U.S. appears to be the best positioned to continue feeding this incremental demand,” the outlook said.

Still, the report notes that there are several potential headwinds facing the midstream industry besides the recent downturn in liquids prices. These include a possible gas oversupply and the speed with which legacy asset declines offset the revenue growth from new capital projects.

Arguably the biggest headwind facing the midstream in 2019 is an oversupply of natural gas. This situation was avoided in 2018 due to very high demand that was able to offset extremely high supply growth.

Natural gas production rose by about 12 billion cubic feet per day in 2018, but heating demand was higher than expected with a cold start to spring in the Northeast and a very hot summer across the country that increased cooling demand. Additionally, the large number of coal-fired power plant retirements resulted in further demand for gas-fired power generation.

“This higher demand has left the U.S. historically low on natural gas storage heading into the winter which has caused prices to spike to well over $4 per million Btu. However, looking out in the forward curve shows prices remain depressed, with the 2020-2022 strip falling by 20-25 cents since early 2018, despite the current storage shortage,” the report said.

While there is increased demand for natural gas from newly constructed LNG export terminals and gas-fired power plants, production growth out of the Northeast is likely to result in an oversupplied market going forward.

In fact, companies such as EQT Corp. have begun to try and mitigate this oversupply situation by slowing production. In October, EQT officials announced the company is reducing its long-term production guidance from double-digit annual growth to mid-single digit annual growth over the next five years. East Daley anticipates similar guidance forecasts from producers in the Northeast, Haynesville and Rockies.

An overlooked headwind facing the midstream is what East Daley calls the treadmill effect of legacy assets in declining basins that experience a consistent decline in revenue due to rate cuts and contract termination. These declines undercut the revenue growth from new capital projects and keep companies from experiencing growth that had previously been anticipated when the projects were first announced.

One example of a company that may experience this effect is Kinder Morgan, which East Daley says will have a faster treadmill than other midstream companies over the next four years. According to the report, Kinder Morgan’s legacy assets may lose nearly $730 million through 2022 due to contracts rolling over and rate cases being settled. “This treadmill will create significant headwinds for Kinder Morgan over the next few years and make it very difficult to materially grow,” the report said.

The midstream outlook has gotten cloudier over the past few months, but East Daley’s forecasters are confident that the solid supply and demand fundamentals will outweigh the headwinds.