Midstream oil sector facing end of growth era as ominous earnings season looms

Houston — The midstream oil sector enters the earnings season for one of the toughest quarters in the industry's history as its struggles to manage lower crude volumes, project delays, and wary investors all amid an ongoing pandemic that's far from under control in North America.

After years of rapid growth from Texas to Alberta to keep up with surging oil production volumes, the midstream sector suddenly sees itself overbuilt much more quickly than expected and facing shrinking flows of both crude and cash.

The second-quarter earnings cycle kicks off first with reports from rail companies and then gets into the biggest pipeline players, such as Enbridge and Enterprise Products Partners, at the end of July with analysts mostly looking past weak quarterly earnings and paying more attention to forward-looking guidance. Existing contracts with minimum-volume commitments keep the pipeline firms' bottom lines from being decimated as badly as the oilfield services sector, but the pain is still tangible.

"The midstream companies are frustrated because they want more investors to take a look at them," said Pearce Hammond, a midstream analyst with Simmons Energy. "There are supply-and-demand worries, and concerns that the dividends aren't sustainable. And then the environmental issues are even more tricky and challenging."

It certainly doesn't help that earnings reports are coming following a series of major setbacks for individual pipeline projects, including the still-pending, court-ordered shutdown of the three-year-old Dakota Access Pipeline, the continued legal suspension of the long-delayed Keystone XL Pipeline, and the decision to outright cancel the Atlantic Coast gas pipeline that was still facing a myriad of legal and regulatory hurdles.

As Morningstar's director of oil research, Sandy Fielden, put it, "No one is building any pipeline anymore. And, if they are, it's against the backdrop of a never-ending struggle in the permitting process. And what's the value of doing that anyway?"

Supply and demand

The broad consensus is the second quarter likely will represent the low point in the coronavirus-induced crash in the oil sector. But US crude production remains about 2 million b/d below its mid-March level and there are a wide variety of opinions about how quickly global demand will recover and whether the US shale sector will be able to follow.

"They built for 13 million b/d of US oil production or higher, and we're way below that right now," Hammond said. "US oil production is not going to hit its previous highs for awhile, so global demand is really going to be key."

"And the midstream companies are wanting to save on capital spending, so they're not eager to move on new projects right now," he added.

With front-month NYMEX WTI hovering near $40/b and the OPEC+ group beginning to restore more barrels to the market in August, there's not a lot of optimism that crude prices will become healthy anytime soon.

More drilled wells will be completed and shut-in production will slowly return if crude stays just above $40/b, Hammond said, but there won't be much new drilling activity. Since mid-March, the US drilling rig fleet has plunged by two-thirds, dropping nearly 560 rigs in four months. Fewer than 280 rigs remain active in the US with almost half of them drilling in the Permian Basin, according to rig count provider Enverus.

So the midstream sector also will be paying close attention to the earnings reports and calls of the oil producers and integrated majors. While OPEC is bullish for oil demand to almost fully rebound next year, many analysts expect jet fuel demand to remain weak for much longer and for gasoline demand to also be impacted as more people continue to work from home for the foreseeable future.

As more producers declare bankruptcy, such as Chesapeake Energy and others, midstream companies also face legal issues with restructured or canceled contracts, analysts said.

And the issues aren't just with pipelines. The race to build a series of deepwater oil-exporting terminals offshore Texas in the Gulf of Mexico has slowed to a crawl. The only two projects analysts still consider particularly viable, Enterprise's SPOT project and Phillips 66's Bluewater terminal, are delayed to at least 2021.

Environmental backdrop

Apart from the 2020 oil price collapse, arguably the bigger, long-term challenge facing the midstream industry is the environmental and regulatory pushback facing the sector. Dating back to the fight against the Keystone XL project during the Obama administration, crude oil pipelines have arguably become the epicenter of the environmental battle against fossil fuels.

After being brought back to life under President Donald Trump, TC Energy hoped to build as much of the Keystone XL Pipeline as it could in 2020, but court rulings have again put it on hold. And, if Democratic presumptive nominee Joe Biden beats Trump in November, then the presidential permit could be permanently yanked and other pipeline projects likely would face even steeper regulatory hurdles.

It's gotten to the point that more investors are increasingly putting midstream firms on their "do not touch" lists, Hammond said.

Likewise, the Dakota Access Pipeline from the Bakken Shale was completed in 2017 after a series of protests and arrests from environmentalists and indigenous groups. Fast forward three years, and a federal judge has now ordered it shut pending a more extensive environmental review, arguing the fast-tracked approval process favored by Trump cut corners. The planned shutdown is on pause for now pending appeals.

In the meantime, if the pipeline shutdown occurs, other Bakken pipelines will fill to capacity and crude differentials in the basin will weaken to at least Dated Brent minus $12-$18/b to accommodate more spot rail movements, according to S&P Global Platts Analytics. But that bump up in crude-by-rail activity likely will only last until mid-2021 when lower drilling and completions activity causes production to further decline.

"The DAPL ruling is very significant because it's effectively saying these pipelines are built, but you didn't do it properly, so we're going to tell you to stop and empty it out," Fielden said. "It's not only a threat to new development, but also to existing infrastructure. Years down the road you could be looking at liability. It certainly increases the risk factor."