ClearBridge MLP and Midstream Fund : Energy MLP Sector Commentary

Key Takeaways

• Global economies continue to face multiple headwinds, led by a combination of stubbornly high inflation, rising geopolitical uncertainty and lingering supply chain and policy impacts from the COVID-19 pandemic.
• Several factors leave the crude oil market more insulated from a recession driving down global demand than in prior economic downturns; most oil market watchers still expect global oil demand growth in 2023.
• Recent increases in drilling activity give us confidence in a growing cash flow profile for midstream companies looking into 2023, while valuations for U.S. midstream companies remain well below the levels seen before the pandemic.

Market Overview and Outlook

Hopes for a soft landing in the U.S. and a renewal of Chinese economic activity boosting energy demand helped the energy sector to lead the broad market in the fourth quarter and supported strong returns for midstream energy infrastructure. The Alerian MLP Index rose 10.11%, ahead of the S&P 500's 7.56% gain.

Global economies continue to face multiple headwinds, led by a combination of stubbornly high inflation, rising geopolitical uncertainty and lingering supply chain and policy impacts from the COVID-19 pandemic. In the U.S., the Fed continues to tighten monetary conditions and we are beginning to see the dampening effects on the economy. At the same time, Russia's invasion of Ukraine has helped create a spiraling energy crisis in Europe as some of its natural gas supplies have been cut off heading into the winter. Finally, China has experienced slowing growth due to strict measures enacted to reduce the spread of COVID-19. Consequently, equity markets have begun pricing in a reasonable chance of recession, both domestically and abroad.

Crude oil prices have fallen from in excess of $120 per barrel in June 2022 to a current $80 per barrel. Recession fears have left oil market traders fearful of global demand downdrafts for

crude oil in 2023, much like those witnessed during the Global Financial Crisis (GFC). A strengthening U.S. dollar has also driven downside in crude oil prices. Finally, large-scale releases of crude oil from the U.S. Strategic Petroleum Reserve (SPR) further pressured oil prices over the last six months.

During the GFC, global oil demand declined by two million barrels per day (or 2%) and oil prices fell from $140 per barrel to less than $50 per barrel. We see several notable differences between the current environment and the GFC. First, due to Russia limiting natural gas supplies to Europe, there has been and will likely continue to be large-scale switching from natural gas to oil to generate electricity in Europe. This could add 0.8 million barrels per day of oil demand compared to prior to Russia's invasion of Ukraine. Second, the U.S. releases of crude oil from its SPR are coming to an end. These withdrawals added more than one million barrels per day of supply into the market over the last six months but soon will no longer do so. Further, the barrels of oil removed from the SPR will ultimately have to be replaced - potentially resulting in a meaningful demand uplift for crude oil heading into 2023 and 2024. Third, Russian crude oil production is expected to fall between 0.5 to 1.0 million barrels per day, largely due to lack of investment in its resource base as money is being diverted to fund its war machine.

The combination of these three factors leaves the crude oil market more insulated from a recession driving down global demand than in prior economic downturns. As such, most oil market watchers still expect global oil demand growth in 2023 by one to two million barrels per day (driven largely by emerging markets).

Despite recent pressure, crude oil prices in the U.S. remain well above levels that would lead us to expect a decline in drilling activity. Barring a fall in oil prices below $60 per barrel, we would expect the number of rigs drilling for oil to continue slowly moving higher. Even with the recent fall in oil prices, the number of rigs drilling for oil in the U.S. has increased from 574 to a current 621.

The pathway to U.S. oil production approaching pre-pandemic levels (and driving midstream company cash flows higher) is through increasing drilling activity. Recent increases in drilling activity give us confidence in a growing cash flow profile for midstream companies looking into 2023.

Valuation for U.S. midstream companies remains well below the

4Q22 | Commentary

levels seen before the pandemic. Entering 2020, enterprise value to EBITDA (EV/EBITDA) multiples stood at roughly 10.5x. Despite the rebound the sector has experienced since the March 2020 lows, the sector today trades at 8.6x - despite what we view as a vastly better business model today than entering 2020. Dividend/distribution coverage has moved from 1.1x to more than 2.0x. The sector has moved from being free cash negative to free cash flow positive (increasingly so in 2023) and balance sheet leverage (debt/EBITDA) has moved from in excess of 5.0x to below 3.5x. With no need for midstream companies to access capital markets for the foreseeable future, we increasingly expect excess cash flow (above and beyond capital spending and dividends/ distributions) to be used for increasing share buybacks and further increasing dividends/distributions.

With improving financial metrics and continued low valuations, we still see solid upside potential for the U.S. midstream sector despite strong performance in 2021 and 2022.

Note: Any oil, gas and energy data referenced are sourced from the U.S. Department of Energy. Distributions and distribution growth rates are subject to change and are not guaranteed.

Investment risks

All investments are subject to risks, including the possible loss of principal. Investments in MLP securities are subject to

unique risks.

MLP cash distributions are generally tax-deferred.Non-cash expenses, such as depreciation or depletion, usually offset income derived from an MLP's operations. To the extent that these expenses exceed income, cash distributions are considered return of capital under tax law. As such, they are not taxed when received. Instead, the distribution, in the form of return of capital, reduces a unit holder's cost basis. This adjusted cost basis, in turn, results in a higher capital gain or lower capital loss when the units are sold. Of course, there can be no assurances that distributions from an MLP will be tax-deferred. Distributions are not guaranteed and are subject to change.

Glossary

Investors cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

EV/EBITDA is the "enterprise value to earnings before interest, taxes, depreciation, and amortization ratio" which compares the value of a company-debtincluded-to the company's cash earnings less non-cash expenses.

Midstream involves the transportation (pipeline, rail, barge, oil tanker or truck), storage and wholesale marketing of crude or refined petroleum product.

The Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships, and it is calculated using a float-adjusted,capitalization-weighted methodology.