Midstream Energy & MLPs

Midstream Energy and the Twin Shocks to Crude Oil Supply and DemandTyler Rosenlicht, Senior Vice President, Head of Midstream Energy & MLPs

Highlights

Low oil prices have upended the midstream industry, but we are seeing compelling value in companies with strong balance sheets, low sensitivity to commodity prices and sufficient liquidity to weather the downturn.

1. Severe oversupply driving decline in oil prices. An unprecedented collapse in demand driven by the COVID pandemic has coincided with a market share war between Russia and Saudi Arabia, driving crude oil prices below key breakeven levels for virtually all producers. Midstream energy share prices have repriced on expectations of reduced pipeline volumes and lower cash flows, especially for companies with assets closer to the wellhead.

2. Balance sheets in better shape to defend against counterparty concerns. Increased bankruptcy risk among levered upstream companies has focused attention on how midstream contracts would handle potential restructurings. While this is a concern, midstream companies have meaningfully improved their balance sheets and implemented reforms that should put them in a better position to manage through the current environment.

3. What we are doing in our portfolios. Technical pressures and forced selling have resulted in significant discounts to intrinsic value in some cases. We are focused on a) companies with strong balance sheets and substantial liquidity, b) firms with assets further downstream, where cash flow profiles are more stable, and c) Canadian midstream companies that should be less affected by production volume declines.

Unprecedented Oversupply Driving Decline in Oil PricesOriginal outlook (Brent crude $50–$60/bbl): Entering 2020, we expected the major oil-producing countries (OPEC+) to continue managing the floor price in crude oil at ~$50 per barrel and shale resilience to “cap” prices in the $60s. However, within a period of roughly 30 days, global energy markets were hit with two severe shocks, culminating in an unprecedented decline in oil prices.

Supply shock ($40–$45/bbl fair value): The failure of OPEC+ to maintain a production cut of 2.1 million barrels per day was compounded by Russia and Saudi Arabia’s decision to capture market share at the expense of price stability by producing at maximum levels. These actions increased supply into an already oversupplied market. However, OPEC+ returned to market management in mid-April, agreeing to the largest oil supply cut in history (9.7 MMb/d) and committing to cuts through April 2022.

Demand shock (<$30/bbl fair value): The shock from COVID-19 began to hit energy markets in February with steadily lower global oil demand. By early March, the magnitude of the impact began to be widely felt, and by early April, we estimate upwards of 20 MMb/d, or ~20% of demand, has gone offline. We believe this represents the largest crude oil demand shock in history.

Uncharted territory: Both supply and demand remain fluid and dependent on the duration of the virus’s impact on demand and OPEC+ following through on recently announced cuts. It’s clear that many global producers are struggling amid the current price environment, and we expect to see continued production responses in the short term given the unprecedented storage challenge facing physical markets.

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Midstream Energy and the Twin Shocks to Crude Oil Supply and Demand

Crude Oil Gathering Assets closer to well-head more sensitive to commodity prices and volumes

Storage Storage assets filling to capacity

Natural Gas Pipelines Lower crude oil production should firm natural gas prices

Mixed NGLs Pipelines Muted demand and slowing production growth

Barges Refinery utilization declining from virus containment

1 2 3 4 5

Natural GasGatheringPipelines

Gas Processing & Liquefaction

Natural GasPipelines

Mixed NGLsPipelines

Storage

Storage

Natural GasPipelines

NGLsPipelines

NGL Fractionation Ethane/Propane

Butane/Iso-Butane Natural Gasoline

LNG Ships

Crude OilGathering Pipelines

Storage StorageCrude OilRefining

Refined ProductsPipelines

Barges

Crude Oil

Natural Gas

2 2

5

3

4

3

1

3 2

24

Negative impactPositive impact

Exhibit 1. Midstream Value Chain

Midstream is not immune to the oil rout

Upstream producers represent the segment of the energy value chain most impacted by the severe decline in oil prices, and these exploration and production (E&P) companies are already drastically reducing capex budgets, cutting rigs and suspending drilling activity in many locations in response to lower prices. Midstream companies are more insulated to direct changes in oil prices. However, commodity prices do drive the two key risks for midstream businesses:

1. Throughput volumes—as commodity prices fall, volume & cash flow expectations also decline

2. Counterparty risk—at low commodity prices, counterparty risk increases, driving discount rates for midstream assets higher

Midstream entities with assets close to the wellhead, such as those in the gathering and processing sub-sector, are more sensitive to commodity price and volumetric risk (Ex. 1). Natural gas liquids (NGL) pipelines are also higher risk, as production is often a byproduct of upstream drilling activity—low prices combined with a sharp reduction in demand for purity products like propane has led to a significant decline in NGL volume expectations.

In addition, crude oil pipelines in basins with declining production will likely see heightened competition in coming years as pipeline utilization wanes. However, not all midstream companies suffer when crude oil prices are low. For instance, natural gas pipeline companies may benefit as lower associated gas production tightens market balances and in turn firms prices, while crude oil storage companies that benefit from contango in the futures curves should see more resilient cash flow profiles.

Given high leverage in the upstream industry, much focus is currently placed on counterparty risk and E&P solvency. Midstream companies generally have a good track record of retaining revenues amid contract disputes, even during customer bankruptcies. However, counterparty restructuring does bring uncertainty of outcomes, particularly in the current environment. We prefer companies that have large, investment-grade customers; provide services to a variety of customers, which helps diversify counterparty risk; or have a “monopolistic” claim on midstream services.

At April 15, 2020. Source: Cohen and Steers.

The views and opinions are as of date of publication and subject to change without notice. There is no guarantee that any market forecast set forth in this presentation will be realized. The mention of specific securities is not a recommendation or solicitation to buy, sell, or hold a particular security and should not be relied upon as investment advice.

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Balance sheets in better shape to defend against counterparty concerns

While the current environment for midstream energy seems reminiscent of 2015, when oil prices last collapsed, the industry is healthier today thanks to decisive actions taken in recent years. Midstream companies and master limited partnerships (MLPs) have been reducing leverage and strengthening balance sheets since then. Leverage is lower and reduced capital expenditure backlogs are increasingly funded with cash from operations, with less reliance on capital markets. For companies that have taken such steps (“reformers”), relative performance has been rewarded (Ex. 2).

We do expect some further material distribution cuts given the focus on liquidity and capital flexibility, but current yields in the space indicate the market is already anticipating this.

At March 31, 2020. Source: Wells Fargo, Bloomberg.

Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee investors will experience the type of performance reflected above. An investor cannot invest directly in an index and performance does not reflect the deduction of any fees, expenses or taxes. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. The views and opinions are as of the date of publication and are subject to change without notice. There is no guarantee that any market forecast set forth in this presentation will be realized. The mention of specific securities is not a recommendation or solicitation to buy, sell, or hold a particular security and should not be relied upon as investment advice.

(1) The Wells Fargo Reformers Index is an index of companies which have taken action to achieve or have committed to taking steps towards business model simplification. 10 companies are listed as midstream reformers, including CEQP, ENB, EPD, KMI, MMP, MPLX, OKE, PAA, WES, and WMB. (2) The Alerian MLP Index (Total Return) is a capped, float-adjusted, capitalization-weighted index, whose constituents represent approximately 85% of total MLP float-adjusted market capitalization.

Exhibit 2. Midstream Reformers Have Outperformed Broad IndexTotal Return, Indexed to 100 at May 2016 (Reformers Index Inception)

-5.5%

-19.9%

Annualized Returns

20

40

60

80

100

120

140

160

5/16 7/16 9/16 11/16 1/17 3/17 5/17 7/17 9/17 11/17 1/18 3/18 5/18 7/18 9/18 11/18 1/19 3/19 5/19 7/19 9/19 11/19 1/20 3/20

Inde

xed

to M

ay 2

, 201

6=10

0

Wells Fargo Reformers Index(1) Alerian MLP Index(2) (Total Return)

Midstream Reformers are companies that have taken action to simplify and maintain a healthy balance sheet through improved corporate governance, a reduction in leverage ratios, and a focus on total shareholder returns

Now vs. 2015Healthier balance sheets have put the midstream industry in a stronger position to manage this downturn:

Leverage is substantially lower (4x debt to EBITDA(1) is common)

Growth projects are increasingly funded with cash from operations, with less reliance on capital markets

Improved corporate governance

We expect some distribution cuts given the focus on liquidity and capital flexibility, but that will finalize the transition to MLP 3.0 (cash flows exceed capital spending and distributions)

Midstream companies are reacting much faster to current downturn vs. 2015

(1) EBITDA = earnings before interest, tax, depreciation and amortization

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Midstream Energy and the Twin Shocks to Crude Oil Supply and Demand

What we are doing in our portfoliosWhile fundamental headwinds will impact the outlook for all companies, technical pressures and forced selling are resulting in significant valuation disconnects and have created attractive investment opportunities in select companies. We favor businesses with high-quality balance sheets and adequate liquidity, and those that have taken necessary actions such as cutting distributions to protect equity value. Liquidity profiles can vary greatly, as indicated in Exhibit 3 below. In addition, we currently have a preference for firms further downstream, and continue to favor Canadian midstream corporations, which we expect will be less impacted by production volume declines.

What we like:

• Strong financial positions: We target companies with high-quality balance sheets, substantial liquidity, diverse business lines, strong management teams and exposure to multiple (vs. single) basins. A key factor in our investment screening today is identifying companies we believe have adequate sources of cash to meet all capital expenditures, debt maturities and distributions through the end of 2022.

• Downstream companies: Refinery-linked businesses should benefit from low prices as demand begins to reaccelerate, and contango in the futures curves has created a strong incentive to store oil and other products for future use, bolstering asset demand.

• Canadian midstream: We believe these companies remain more insulated given lower expected production declines and a more stable and supportive regulatory structure north of the border.

• Warming to natural gas: One casualty of low oil prices will be declining associated natural gas production. This should lead to a tightening of the natural gas markets and upside for companies in dry natural gas basins.

Where we are cautious:

• Assets near the wellhead: Gathering and processing companies are more exposed to oil and natural gas liquids (NGL) volumes that are most at risk, particularly in basins outside the Permian. We believe a reacceleration of production will lag the commodity price recovery.

• Heightened counterparty risk: We are carefully monitoring counterparty credit risk and reducing exposure to those midstream firms that may experience bankruptcies of key customers.

At April 14, 2020.This chart is for illustrative purposes only and does not reflect information about any fund or other account managed or serviced by Cohen & Steers. The views and opinions above are subject to change without notice.

Example A: Good Liquidity Profile

Current 2020 2021 2022

Unused Line of Credit 1,000

Cash on Balance Sheet 200

Beginning Sources of Cash 1,200

Add: Cash from Operations 500 475 450

Subtract: Dividends/Distribution (200) (200) (200)

Subtract: Capital Expenditures (200) (200) (200)

Subtract: Debt Maturities (500)

Annual Liquidity Excess / (Deficit) 100 (425) 50

Liquidity Balance 1,200 1,300 875 925

Example B: Poor Liquidity Profile

Current 2020 2021 2022

Unused Line of Credit 500

Cash on Balance Sheet 50

Beginning Sources of Cash 550

Add: Cash from Operations 500 475 450

Subtract: Dividends/Distribution (400) (400) (400)

Subtract: Capital Expenditures (250) (250) (250)

Subtract: Debt Maturities (350) (500)

Annual Liquidity Excess / (Deficit) (500) (675) (200)

Liquidity Balance 550 50 (625) (825)

Exhibit 3. How Different Approaches to Capital Allocation Can Affect a Company’s Liquidity Profile

Ample liquidity cushion Significant liquidity concerns

5

• Weaker financial positions: We seek to avoid companies with identified liquidity issues and debt refinancing risk, and are wary of certain high-distribution-yield companies that will likely reduce payouts.

• LNG exports: We have become more bearish on companies with liquified natural gas (LNG) export businesses. If global natural gas prices stay low and U.S. domestic gas prices rise, as we expect, there may be little economic value to exporting U.S. LNG. This may result in importers attempting to renegotiate or walk away from contracts.

ConclusionAs midstream contends with uncertain oil markets that will struggle to regain their balance in the short term, we believe midstream companies and MLPs with liquidity and healthy balance sheets should prove resilient. By contrast, those exposed to a refinancing crunch where equity values are impaired will not fare as well. With that view, we are steering clear of small-cap companies as well as those that will likely face rising competition or depleting throughput volumes in coming years. We continue to reposition portfolios as warranted toward midstream businesses that we believe are mispriced.

Important Disclosures Data quoted represents past performance, which is no guarantee of future results. The views and opinions in the preceding commentary are as of the date of publication and are subject to change without notice. There is no guarantee that investors will experience the type of performance reflected in this commentary. There is no guarantee that any historical trend referenced in this commentary will be repeated in the future, and there is no way to predict precisely when such a trend will begin. There is no guarantee that a market forecast made in this commentary will be realized. The mention of specific securities is not a recommendation or solicitation for any person to buy, sell or hold any particular security and should not be relied upon as investment advice. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice, is not intended to predict or depict performance of any investment and does not constitute a recommendation or an offer for a particular security. We consider the information in this material to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment. Please consult with your investment, tax or legal adviser regarding your individual circumstance before investing. This is not an inducement to buy or sell commodity interests. Risks of Investing in MLP SecuritiesAn investment in MLPs involves risks that differ from a similar investment in equity securities, such as common stock, of a corporation. Holders of equity securities issued by MLPs have the rights typically afforded to limited partners in a limited partnership. As compared to common shareholders of a corporation, holders of such equity securities have more limited control and limited rights to vote on matters affecting the partnership. There are certain tax risks associated with an investment in equity MLP units. Additionally, conflicts of interest may exist among common unit holders, subordinated unit holders and the general partner or managing member of an MLP; for example, a conflict may arise as a result of incentive distribution payments. MLPs are subject to significant regulation and may be adversely affected by changes in the regulatory environment, including the risk that an MLP could lose its tax status as a partnership. MLPs may trade less frequently than larger companies due to their smaller capitalizations, which may result in erratic price movement or difficulty in buying or selling. MLPs may have additional expenses, as some MLPs pay incentive distribution fees to their general partners. The value of MLPs depends largely on the MLPs being treated as partnerships for U.S. federal income tax purposes. If MLPs were subject to U.S. federal income taxation, distributions generally would be taxed as dividend income. As a result, after-tax returns could be reduced, which could cause a decline in the value of MLPs. If MLPs are unable to maintain partnership status because of tax law changes, the MLPs would be taxed as corporations and there could be a decrease in the value of the MLP securities. No representation or warranty is made as to the efficacy of any particular strategy or fund, or the actual returns that may be achieved.Cohen & Steers Capital Management, Inc., (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds.Cohen & Steers U.S. registered open-end funds are distributed by Cohen & Steers Securities, LLC, and are available to U.S. residents only. Cohen & Steers Asia Limited is authorized and regulated by the Securities and Futures Commission of Hong Kong (ALZ 367). Cohen & Steers UK Limited is authorized and regulated by the Financial Conduct Authority (FRN 458459). Cohen & Steers Japan Limited is a registered financial instruments operator (investment advisory and agency business and discretionary investment management business with the Financial Services Agency of Japan and the Kanto Local Finance Bureau No. 3157) and is a member of the Japan Investment Advisers Association.Notes for Readers in the Middle East: This document is for information purposes only. It does not constitute or form part of any marketing initiative, any offer to issue or sell, or any solicitation of any offer to subscribe or purchase any products, strategies or other services, nor shall it or the fact of its distribution form the basis of, or be relied on in connection with, any contract resulting therefrom. In the event that the recipient of this document wishes to receive further information with regard to any products, strategies other services, it shall specifically request the same in writing from us.

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Publication Date: April 2020 Copyright © 2020 Cohen & Steers, Inc. All rights reserved.

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