There's a price war breaking out in the oil space, with Russia and OPEC each going their separate ways. The main goal is to reign in the growth of U.S. production, which has upended global oil markets for years now. Despite that turbulent backdrop, Enterprise Products Partners (NYSE:EPD) sees a bright future for its midstream assets. Here's what underpins this view even in the face of low energy prices.
Ups and downs
The first thing to note here is that oil and natural gas are commodities prone to volatile and deep price swings. The current infighting in the industry between Russia and OPEC is notable, and has led to a massive price decline, but not really outside the norm for the industry. In fact, neither wants oil to be this cheap. They just want to flush out excess capacity from the sector, which is largely showing up in the onshore U.S. energy sector.
Enterprise's midstream focus is a key differentiator in the energy space given the cyclical up and downs in oil prices. Enterprise's pipelines, processing facilities, storage, and transportation assets help move oil and natural gas from where they are drilled to where they get used. Roughly 85% of Enterprise's gross margin is fee-based, meaning it gets paid for the use of the asset. The price of oil and gas isn't all that important. Even if a customer goes bankrupt, operating wells are more likely to change hands than stop producing oil and natural gas.
To be fair, oil prices do effect drilling activity and production, so weak oil prices can impact Enterprise's business and growth prospects, since low energy prices tend to reduce capital spending on new production throughout the energy sector. That, in turn, could make it harder for Enterprise to find new growth projects, and could make it difficult for it to find customers for the roughly $8 billion in projects that it currently has in the works. It could even lead to less oil and gas flowing through its pipes and facilities. In fact, existing contracts could, in a worst case scenario, get renegotiated.
But the key here is that the low prices in the energy space today are not a death knell for Enterprise, just a headwind. And if history is any guide, the current upheaval is a short-term issue. In fact, the price drop is likely to help balance global supply and demand, which would actually stabilize commodity markets over time. Enterprise's long-term outlook isn't driven by short-term prices, even though investors have pushed the midstream partnership's units lower because of oil price volatility and the 7.5% yield is the highest it has been in a decade. That opens up a potential value opportunity for investors who can think long-term along with Enterprise's management team.
The big picture
So what has Enterprise's leadership team so excited about the future? In one word: Demand.
Before getting too far into this discussion, however, there's a key fact to highlight. Enterprise believes that renewable energy will be a fast-growing and integrally important part of the energy landscape in the future. The problem is that renewable power alone isn't likely to be enough to supply all of the growing world's power needs. Thus, oil and natural gas will continue to play key roles in the future. In fact, taken together, demand for these fuels (driven largely by natural gas) will continue to increase through 2040, according to the International Energy Agency and OPEC.
A quick look at China and India helps explain what's going on. Between 1990 and 2017, energy demand increased 192% in China and 82% in India. Driving that was the fact that the residents of these two nations were moving up the socioeconomic ladder. It's pretty simple math: Energy use grows as economies get more advanced. While the rate of energy needed per percentage point of GDP growth has declined thanks to increased efficiency, we aren't likely going to see energy demand decline while GDP grows. As these nations continue their economic ascendance and smaller ones follow along a similar economic path, demand for oil and natural gas, and the products they get turned into, will remain.
The United States, meanwhile, has become an increasingly important supplier on the global energy stage. Enterprise is projecting different performances in the regions its massive and diverse portfolio serves, but overall the local ups and downs all add up to production growth. That may wax and wane with energy prices, but the long-term demand picture suggests that that U.S. production will eventually be needed, since oil and natural gas are depleting assets. Over time, wells simply don't produce as much as they used to, and upstream energy companies need to drill more holes to offset declines. And that doesn't even take into account increases in demand, which would likely require even more drilling. The current oil price drop disrupts this picture over the near term, but probably not the long term.
Although Enterprise made these estimates prior to the OPEC/Russia oil war, looking out to 2025, the partnership expects 35% of U.S. produced ethane to go abroad. That number jumps to 50% in the oil space and 60% for propane and butane. If oil prices stay at $30 forever, that won't happen -- but that's not likely, since so few producers globally can be profitable at this rate. Domestically, meanwhile, Enterprise highlights roughly $200 billion in capital spending in the downstream space (chemicals and refining) that will lead to growth in U.S. demand for these fuels. Moving all of the oil and natural gas, and the products they get turned into, is what Enterprise does.
In other words, there's a reason to be positive about the long-term global demand picture of oil and natural gas, as well as the long-term supply and demand dynamics in the U.S. market. And Enterprise sits in the middle, helping everyone get what they need. Yes, the oil market is a scary place today, but the biggest and best companies in the industry don't focus on short-term prices, they focus on long-term supply and demand fundamentals -- and you should, too.
Not as bad as it seems
There's no question that a price war between OPEC and Russia is going to be terrible for energy prices in the near term. And that's likely to be a huge headwind for many companies in the energy sector. However, the long-term supply and demand picture remains in place no matter what commodity prices do over shorter periods of time. This is why Enterprise is so upbeat about its future, and why investors willing to think differently from the pack may want to do a deep dive on this high-yield energy name today.