The impact of a lower oil price on infrastructure assets
In this article, we explore the issue of falling energy prices and assess what it means for infrastructure.
The price of oil was relatively stability between 2010 and mid-2014, sitting at around US$105 a barrel. But since June 2014 the market for oil has declined sharply, and is expected to remain low for some time. While there has been some improvement in oil prices since the lows recorded at the start of 2016, the general weakness in the market represents the end of the commodity super-cycle that began in the early 2000s.
Supply glut: a driving force for plunging oil prices
At around US$46 a barrel (as at 15 August 2016), Brent crude oil prices are down more than 55 per cent from their levels two years ago. AMP Capital’s analysts agree it has been supply rather than demand that has pushed energy prices down. The shale boom in the US saw a surge in production in recent years, while major producers like Saudi Arabia have also dramatically increased their supply of oil. We expect it will take a while for the excess supply to work through the system.
On the demand side, new vehicle technologies such as fuel-cell motors and electric cars have reduced oil consumption and demand for oil. Typically, when oil prices decline by more than 50 per cent demand rises. But this has not happened this time.
Implications for the ‘midstream’ infrastructure sector
The midstream supply chain of the energy sector includes transportation systems by pipeline, rail, barge, oil tanker or truck, as well as terminals and storage of crude or refined petroleum products. Midstream assets are typically underpinned by fixed-fee or minimum volume commitment contracts that are not exposed to commodity prices, which are typically passed through in the contract to the end-users. For instance, in the case of an oil refinery, it’s the refinery that is exposed to the oil price, rather than the organisation that manages the pipelines to the refinery. Given the stable and transparent nature of cash flows, midstream assets are highly sought after infrastructure investments.
Depressed oil prices often present opportunities to acquire fee-based or contracted midstream assets from constrained energy and production (E&P) companies or partner with master limited partnerships (MLPs).
A significant decrease for MLPs
There are two types of structures prevalent in the current market environment:
- E&Ps monetising non-core midstream assets - E&P companies with non-core midstream assets may be forced to monetise assets, de-risk or de-lever their balance sheets or fund growth capital relating to their core business. As such, we see mergers and acquisition activity picking up in this sector.
- Equity-linked investments into MLPs - In an effort to fund growth, MLPs have sought outside capital to make equity-linked investments directly into the MLP’s capital structure. These are typically made via preferred equity investments to fund ‘drop-downs’, where assets or ownership interests are transferred from parent E&P companies or to fund future growth expansion. Continued growth in capital expenditure is needed to expand the pipeline capacity for the shale gas and oil basin discoveries in the US.
MLPs are publicly-traded US partnerships that invest in midstream energy infrastructure. They typically have efficient cost of capital to acquire assets, as they only pay investor-level taxes and don’t pay corporate level taxes. However, in doing so, MLPs must distribute all cash flow to investors. As such, they are reliant on external debt and equity capital markets to fund future growth. This model works well when MLP stock prices are high (that is, the cost of equity is low to issue additional stock). However, in the depressed oil price environment, MLP stock prices have decreased significantly. This is because the cost of equity is high and the MLP initial public offering – or follow-on – equity market has been dormant since 30 September 2015.
The reliance on equity capital markets to fund necessary pipelines and growth in capital expenditure is presently muted and we expect it will continue to be subdued for the remainder of 2016. This creates an opportunity for infrastructure fund capital to partner with MLPs and acquire midstream assets. At the moment AMP Capital is focused on well-located, fixed-fee or contracted midstream assets that are not too exposed to commodity swings.
AMP Capital expects environmental policy responses over the next decade such as the Paris Climate Change Agreement will ultimately lead to a significant decrease in demand for fossil fuel, most notably coal.
The degree of structural change these agreements will produce will mean that investment in long-life assets in the energy, transport and associated infrastructure sectors will be challenged. This is because asset life will be shortened (requiring higher returns). Some assets may also be ‘stranded’ in the future. So markets are likely to favour fossil-fuel companies that can respond quickly to incremental changes in demand, such as US oil and gas shale companies.
The energy industry is used to investing in assets over a 20 to 25 year period. But when there’s a risk that what’s built now may not be around in 20 years’ time, investors may want to see a return on capital within a shorter 10 to 15 year timeframe.
The decline in oil prices has significantly dampened investor sentiment about oil-exporting emerging market economies, and could lead to substantial volatility in financial markets, as was observed in a number of countries in the last quarter of 2014. However, declining oil prices also present a window of opportunity to reinvigorate reforms in the energy sector and diversify oil-reliant economies.
In terms of what this means for goals-based investors, the oil price shocks of the 1970s serve as a reminder of the potential impact energy prices can have on economies and markets. While the global economy is no longer as sensitive to oil prices, investors designing portfolios to fund consumption goals in the future should pay close attention to the energy price sensitivities of their strategies.
The decline in oil prices has significantly dampened investor sentiment about oil-exporting emerging market economies, and could lead to substantial volatility in financial markets, as was observed in a number of countries in the last quarter of 2014. However, declining oil prices also present a window of opportunity to reinvigorate reforms in the energy sector and diversify oil-reliant economies. In terms of what this means for goals-based investors, the oil price shocks of the 1970s serve as a reminder of the potential impact energy prices can have on economies and markets. While the global economy is no longer as sensitive to oil prices, investors designing portfolios to fund consumption goals in the future should pay close attention to the energy price sensitivities of their strategies.
About the authors
Scott Robinson is an Associate Director in the Global Infrastructure Equity team at AMP Capital.Peter Harris is a Senior Analyst in the Resources team at AMP Capital. Ian Woods is the Head of Sustainable Funds at AMP Capital.