Brookfield Energy Infrastructure Overview: What the Ukraine-Russia Conflict Means for Midstream

• Midstream equities rose in February, outperforming broader markets and rallying alongside energy commodity prices as Russia’s invasion of Ukraine and subsequent energy market developments intensified global supply/demand imbalances.
• Prices for crude and other energy commodities increased in February, reflecting the removal of some Russian barrels from the marketplace via voluntary corporate actions and expectations that further sanctions were on the horizon.
• We believe there may be an irreversible push to decrease reliance on Russian barrels over time. In our view, this push will require additional renewables deployment as well as additional production of U.S. hydrocarbons in order to supply global markets.

Summary Observations

Midstream equities rallied in February along with energy prices, as Russia’s invasion of Ukraine exacerbated energy market supply/demand imbalances. The broad midstream universe, as measured by the Alerian Midstream Energy Index (AMNA), increased 5.52% in February, while Master Limited Partnerships (MLPs), as measured by the Alerian MLP Index (AMZ), gained 4.82%, and crude oil spot price benchmarks quickly rose to well above $100 per barrel following the invasion.

The increasing prices for crude and other energy commodities reflected the removal of some Russian barrels from the market via voluntary corporate actions and expectations that further sanctions were on the horizon. They also highlighted the dependence of global economies, particularly those of U.S. allies in Europe, on Russian hydrocarbons. Russia accounts for roughly 10% of global crude oil supplies and about 20% of Europe’s overall energy mix, according to J.P. Morgan.

We expect to see an irreversible push to decrease reliance on Russian barrels over time. We have long argued that the world stands to benefit from increasing its dependence on North American oil and gas as an affordable and reliable source of energy (see our paper from last November 2021, “The Case for U.S. Hydrocarbons During Today’s Energy Crisis Today’s Energy Crisis”). The tragic events that have developed following the invasion have highlighted this concept for global leaders with a renewed sense of urgency, and we could see additional renewables deployment as well as additional U.S. hydrocarbon production, as a result. Further, we expect increasing volumes will flow across existing infrastructure footprints, generating additional cash flows.

We See Few Near-Term Solutions for The Current Supply/Demand Imbalance

While immediate attention has been rightly dedicated to addressing the senseless bloodshed and humanitarian crisis occurring in Europe, energy affordability and reliability have also begun to permeate policy agendas. At the time of this writing, global leaders continue to be reluctant to impose full sanctions on Russian energy exports—despite the economic damage this would inflict on Russia—due to concerns about energy availability and the impact to energy prices.

Spot crude oil prices are important and do correlate closely to prices consumers are paying at the pump today, so that can explain some of the hesitancy in announcing full sanctions. The unfortunate truth is there is no obvious quick supply-oriented fix, outside of an abrupt normalization of Russia relations, that would address immediate-term prices.
U.S. producers are facing supply constraints and labor shortages of their own, and the OPEC+ alliance continues to under-deliver on the supply increase promises it has made to the market, calling into question the true amount of spare capacity it currently has sidelined.

In any case, OPEC+ has not yet shown an interest in accelerating exports of crude oil beyond its previously stated plan. In addition, coordinated releases from global strategic petroleum reserves are not a sustainable source of supply and have so far been inefficient in reining in rising prices. And the prospect of a return of Iranian barrels to the market has also failed to put a meaningful dent in crude prices, as skepticism abounds about how many incremental Iranian barrels would actually be additive to global supply.

The World is Seeking to Move Away from Russian Hydrocarbons

While Russian oil and gas has yet to be sanctioned fully, many corporate counterparties have stopped accepting deliveries, creating an environment of de-facto partial sanctions on the Russian-sourced barrels. We believe the current spot price of crude oil has significant two-way risk built in: If the war were to de-escalate quickly, there is the potential for a substantial geopolitical risk premium (estimated by most analysts to currently be $15-25 per barrel) to dissipate. If escalation continued and full sanctions are imposed, analysts estimate spot prices could go up by a similar amount.

Importantly, beyond the immediate supply/demand conundrum, countries are taking steps to address their more medium-and-long-term energy mix:

Germany’s Response

Germany perhaps offers the most obvious example of the need for a shift in its long-term energy policy. According to J.P. Morgan, Germany relies on Russia for 35% of its oil consumption and close to 60% of its gas consumption. In the days leading up to the Russian invasion of Ukraine, Germany was generally regarded as the most reluctant of the major NATO partners to impose severe economic sanctions on Russia, and this reluctance was perceived to be largely due to its energy dependence. After the invasion occurred, Germany did take the notable step of halting the Nord Stream 2 pipeline, which would have increased the dependance on Russian gas even more. In order to minimize its longer-term dependence on Russian hydrocarbons, Germany announced a set of measures that can best be described as an “all-of-the-above approach” that included both accelerating renewables development as well as building new liquefied natural gas (“LNG”) terminals and authorizing the purchase of additional LNG cargoes.

The U.S. and EU are United on Policy

Meanwhile, the U.S. White House has communicated a stated objective that it is trying to “degrade Russia’s status as an energy supplier over time,” and the U.S. and EU have imposed sanctions targeting the export of technologies that would hinder the ability of Russia to upgrade and modernize its refineries over time. In addition, several oil majors, including Shell, BP and Exxon, have withdrawn from their Russian operations voluntarily, contributing to a talent, technology and resource drain that may have already set the degradation of Russian production capabilities on an irreversible trend. Finally, in early March the EU released a blueprint for substantially reducing Russian dependence in 2022 and effectively eliminating it by 2030, replacing it primarily with a mix of increased renewables deployment and additional sources of LNG.

If significant volumes were to back up into Russia through a prolonged conflict, due to either voluntary or formal sanctions, there is the prospect that Russia would run out of storage and have to shut in production, which could permanently impair existing wells. This potential loss of supply from the country, which accounts for a significant 10% of total global oil production and is a major source for European gas consumption, comes against a commodity backdrop that implied tight medium-and-long-term supply/demand fundamentals even before the invasion occurred.

Potential Replacements for Russian Hydrocarbons: Renewables and U.S. Hydrocarbons

This setup of course begs the obvious question: What will replace Russian production in the event that it is degraded over the long term? We believe plans for renewables development will be accelerated. However, that acceleration will neither entirely replace the lost energy capacity nor will it be able to materially replace it in a timely fashion—as we have witnessed by now, the energy transition is a massive, multi-decade undertaking that requires vast amounts of resources, and supply chains globally are already squeezed. In the meantime, governments have to ensure their citizens have access to basic functions such as electricity, heating, and driving, without increasing energy costs to the point where they are further hindering economic development.

With this backdrop in mind, we are currently seeing increased attention being devoted by U.S. policymakers and industry participants in growing the U.S.’s global energy market share. Anecdotally, at a recent conference numerous industry participants told us that the White House had reached out to them to see how quickly they could get new export infrastructure up and running, particularly as it relates to liquified natural gas (LNG). We believe additional U.S. LNG capacity is perceived by the White House to be crucial in shoring up the domestic markets of NATO allies.

With energy inflation running hot in the U.S. even prior to the Russian invasion, it seems obvious that any increase in domestic export capabilities would have to be matched with an increase in domestic production. To this end, a growing group of lawmakers are starting to call on the administration to find ways to support increasing domestic production—including a growing group of Democratic lawmakers, in what has the potential to be a monumental shift in energy policy. On the producer front, where capital discipline in the face of rising commodity prices ruled 2021, momentum is building as well.

The Implications for Midstream Investors

This potential medium-to-long-term environment of rising domestic production and rising market share of U.S. energy abroad has implications for our North American energy infrastructure constituents. As a reminder, North American energy infrastructure assets derive their earnings from moving hydrocarbon volumes through their asset systems.

Prior to the COVID-19 pandemic, these companies had built out systems set to accommodate production growth from a crude oil production base that was about 10% higher than where current U.S. production sits, as production has still not rebounded from the forced shut-ins of the early days of the pandemic. Importantly, we believe this means that U.S. energy infrastructure companies can, for the most part, service substantial increases in volumes without devoting meaningful additional capital, in some geographies.

While some parts of the value chain may see the need for incremental build-outs (particularly LNG terminals), those assets are generally owned by well-capitalized midstream companies, utilities or majors. Regardless, a rising production and rising market share environment could create a tide that lifts all boats, as those incremental volumes have to move throughout integrated systems before they get on the water, all-the-while servicing resilient domestic demand as well.

When we do get to a point where additional infrastructure is needed, we firmly believe the midstream industry is in a significantly healthier free cash flow and balance sheet position than in the past, and that this financial health, along with newfound discipline, will prevent the over-reliance on capital markets that defined the initial shale buildout of the prior decade. Quite simply, the midstream industry has never been in a better balance sheet position to handle increasing capital requirements, should the need arise. Although the better part of the last decade has been painful at times for investors, the overhaul of the industry corporate finance model has made a leaner, meaner industry tailor-made to capitalize on the opportunities that we believe lay ahead.

Even if investors were to discount the seemingly obvious fundamental tailwinds, midstream valuations, dividends and free-cash flow yields remain compelling—whether or not we see increased U.S. production levels.

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