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Frack to the future: opportunities in US energy bonds

Unless you’ve been hiding under a rock, you’ll know about fracking. The process involves drilling down into the earth and tapping gas and oil deposits in dense rock that is cracked open – or fractured – by a high-pressure mixture of water, sand and chemicals. The story of fracking in North America has been a fast-moving one. As the US stormed towards energy self-sufficiency, new companies rapidly made fortunes. However, traditional oil producers eventually fought back, upping production in a bid to protect market share and drive the fracking usurpers out of business.

As global supply rose, prices slumped even further. So, too, did the closely-watched rig count on the US mainland – an indicator of the shale industry’s health. From a high point of 1700, the rig count tumbled to fewer than 300. Investment in fracking’s infrastructure – pipelines and storage – also plummeted. As a result, the fracking industry is now under loved, under-researched and under pressure. But the industry has moved swiftly to control its cost base, at the same time improving the technology behind extraction and delivery of the shale gas.

Picking companies to invest in around this industry can be fraught with difficulties.

Now, the rig count is back on the rise again and the industry as a whole is stabilising, along with commodity prices in general. Picking companies to invest in around this industry can be fraught with difficulties – concerns around their environmental impact, balance sheet strength and viability at a lower oil price are just some of our considerations.

Using our fundamental approach to analysis we have identified some key parts of the industry that have potential to provide returns in a fixed income universe increasingly under pressure. Concentrating on the movement and storage of oil and gas is a key part of our approach as it generally entails fewer risks than pushing the liquids/gas out of the ground. Groups with a wide ranging pipeline network able to respond to the changing needs of the industry along with groups involved in the storage and export of the end products. Below, we cast an eye over a few of these businesses.

Pipelines

MPLX is a master limited partnership (MLP) formed in 2012 by Marathon Petroleum Corporation (MPC), The partnership operates a network of crude oil and product pipelines, as well as other logistical assets that were of strategic importance to MPC.

MLPs are attractive because they pay out most of their cash flow as dividends. To grow their dividends, MLPs typically use acquisitions to expand their asset base.

In the middle of 2015, MPLX acquired MarkWest Energy Partners in a deal worth over $10 billion. MarkWest, a premier MLP, is focused on gathering and processing natural gas produced in the north-east United States. While this transaction provided size and scale to support MPLX’s current low BBB credit ratings, the market generally viewed the deal as weakening its creditworthiness.

We thought differently. On peeling the onion – so to speak – we found that MarkWest holds a market-leading position in fields such as Oklahoma’s Utica shale and Pennsylvania's Marcellus shale. The former is one of North America’s largest natural gas finds, and the latter is one of the cheapest basins to produce in at the moment. Natural gas production out of this region has some of the most favourable economics in North America, being profitable down below $2 per 1,000 cubic feet of gas (Mcf) – note current prices are roughly $2.67 per thousand cubic feet. This provides protection in a volatile price environment. Put another way, if natural gas prices fall, production from this region will be among the last to be curtailed.

One concern uppermost in the minds of energy investors is counterparty risk. In recent years, many of the financially weak oil and gas producers have resorted to a variety of restructuring techniques to improve their financial position – including bankruptcy. However, the vast majority of gathering and processing contracts have limited exposure to this kind of risk – as long as the contract rates are below market prices, and production from the basin remains economically viable. Regardless, MPLX has exposure to five of the relatively stronger operators in the area.

MPLX’s profit margins are supported by over 1,000 miles of oil pipelines, a butane cavern capable of storing one million barrels, four tank farms, 50 gas processing plants and other related logistics assets. Earnings are set to grow in the coming years in our view, with implicit support remaining from Marathon.

The bond market’s generally unfavourable view on MPLX’s gathering and processing volumes as well as its perceived counterparty risk led to its bonds trading at a premium to other low-BBB rated MLPs earlier this year. Levels have since stabilised, with MPLX paper trading roughly 20-40bps behind low-BBB rated MLPs now.

Storage

The big upsurge in oil and gas production has resulted in a massive increase in demand for storage facilities. While Buckeye Partners is routinely described as an energy pipeline company – with over 6000 miles of pipeline – its primary asset is its 100-plus truck-loading terminals, including the Perth Amboy Marine Terminal in New Jersey. Its main focus is moving and storing finished product in its storage facilities in the north-east US, Gulf Coast and Caribbean. .

Roughly 65% of Buckeye’s earnings before interest and taxation come from storage. The Pennsylvania-headquartered limited partnership is one of the largest independent terminalling and storage operators in the US, with an aggregate storage capacity of over 115 million barrels.

Most of its revenue is fee-based. The major petroleum companies pay Buckeye to store its finished product – including some of the Brazilian operators. This puts it in a strong creditor position. If Buckeye doesn’t get paid, it doesn’t release the oil.

For a variety of reasons – size, scale, and a higher than industry average leverage ratio – Buckeye has largely been overlooked by investors. This is largely a product of Buckeye’s business model, which requires a heavy upfront outlay of capital expenditure. Earnings, therefore, only flow to the company as and when projects are completed. Buckeye has steadily reduced its leverage, and we are comfortable with a management that has a simple approach to growing its business. Small acquisitions and larger scale projects that are semi-complete, such as terminal storage and processing, make up the bedrock of their strategy. Clearly, growth by mergers and acquisitions involves exposure to execution risk, but current management have a solid track record on completing these deals and adding value to the business.

Processing

Back in 2008, the United States had been a net importer of oil and gas for decades. As demand for energy continued to grow, Sabine Pass Liquefaction was constructed. This is an industrial plant on the Louisiana coast designed to convert gas into a liquid for further transportation. Five huge storage tanks were built which, in combination, can hold a quarter of the United States’ daily consumption of gas. Now, with the fracking revolution, the plant – originally an import facility – has been repurposed as an export hub.

The US can now export gas at prices that can massively undercut what consumers in Europe and Asia are currently paying. Cheniere Energy Partners, the operators of Sabine Pass, has constructed or is constructing five industrial plants that liquefy natural gas. They are fully financed by $11 billion in bonds and $3.3 billion in bank debt.

Sabine Pass’s business model is interesting. Cheniere has access to an estimated 100 years’ supply of gas from five separate sources. Its long-term revenues are secured through long-term (20-year) contracts with energy giants including Total, Shell and Petrobras. Fixed fees from these contracts amount to $2.9 billion. Meanwhile, 50% of operations and maintenance are covered by a 25-year contract with General Electric.

Over time, as the contracts age and mature, the cash flows will be applied to pay off the debt. Ratings agency Moodys will not upgrade Sabine Pass to investment grade until four of the plants to convert the gas are up and running.

Over time, the bond’s extra yield over US Treasuries will tighten.

Over time, the bond’s extra yield over US Treasuries will tighten, and it will become eligible for introduction into the investment grade indices. When this happens, it is likely that we will see increased demand for the bonds with index funds buying and other funds with mandates restricting them to bonds in an investment grade index also becoming interested. All told, it is hard to see much of a downside risk. Pipes, storage and export remain the key areas of investment in a volatile industry providing the opportunity to leverage our expertise in the energy space for the benefit of our clients.

Conclusion

The energy industry is inherently volatile. Many factors, including geopolitical and weather-related developments, have the potential to disrupt the flow of oil and gas to markets, thereby influencing product prices. Furthermore, much of the world’s oil and gas is located in regions that are prone to political upheaval. By focusing on the movement and storage of oil and gas, the bond investor is generally exposed to fewer risks.

Image credit: Ikon Images / Alamy Stock Photo





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