Is It Time To Buy Oil And Gas Pipeline Stocks?

This month we are taking another look at pipelines, specifically those used to transport oil and gas from the field to refineries. There is an odd disparity in the fortunes of these companies and the refiners we looked at last month, Valero Energy and Phillips 66, (NYSE:PSX). Refiners have continued a relentless upward march month over month, while most pipelines are flat to slightly higher.

I am not suggesting that there is a direct link between these two types of companies, because, although they are interdependent on each other, they have vastly different business models. That said, if you focus on the interdependence, i.e. pipelines are required to move oil and gas to refineries in order for the latter to make the refined products we all use and need, there should be some "sympathetic" price movement in one sector when the other is responding so rapidly to market forces.

Now if you were expecting me to solve this riddle for you, you are going to be disappointed. I have given up trying to prognosticate when the pipeline industry will be revalued to reflect the importance of its asset base, and the criticality of its presence in the energy security story. I still think it will happen, but it's anybody's guess as to when.

We are going to start thinking of pipelines as primarily income vehicles that in a rising market receive a stream of income that provides the funds flow to pay above-average distributions to unitholders. Their usually debt-laden balance sheets add an element of risk to owning them, but at current price levels, this risk has been substantially mitigated.

We are going to look at two companies. The first, Plains All American, LP (NYSE: PAA) is the smaller of the two but is paying a slightly higher dividend, 7.87% YOC vs 7.07% YOC. Energy Transfer, (NYSE:ET) is the largest of the companies in its sector with over 110K miles of pipe. ET has a bit of a checkered past with investors as regards runaway growth and unitholder returns. Debt is problematic for both of these companies and is a factor holding down the stock price of both.

But, as I said, as potential investors, we don't care about growth. Obviously when and if it comes, we will gladly take a higher price for our units, but what we are after primarily is income.

One quick caution before we dig in. Both of these companies are Master Limited Partnerships-MLPs. The units carry some complicated tax reporting that includes the dreaded IRS, K-1. Consult with your tax advisor to see if this type of investment is appropriate for your portfolio.

Plains All American

A five-year look at the performance of this stock to shows you that it has seen better days. As recently as 2019 it was bumping against $20-25. Oil and gas prices were much lower then. The stock had sagged down to around $20 when the world as we knew it ended in March of 2020. It has never recovered from that level, and for the last year and a half has knocked around in the $10s. This has been at least in part due to the fall-off in Permian production recently, to which it is particularly exposed.

Plains All American Pipeline, (NYSE: PAA) is a mid-cap pipeline with a broad array of gathering, trunk line, and storage services for crude oil and NGLs. In the key Permian basin area, it has ~6 mm BOPD of export capacity. It also serves the Western Canada Sedimentary basin with gathering and takeaway capacity. As the graphic below shows it has storage and processing for onshore and marine terminals.

Things could be on the up for this company as drilling has doubled over the last year and a half. Analysts have rated the company as overweight with 2/3 of about 20 total Analysts putting a BUY on the company. Price targets are supportive and range from $11 on the low side (about 6% higher than present levels), to $16 on the high side. The median is $14. So, some growth from current levels seems possible, but remember we are here for the distributions!

I would say PAA's main attraction at its current level is its yield. With cash flow rising, the company has little risk of needing to cut its distribution. Unit distributions are covered 250% by cash flow in the present market. 

The thesis for PAA

The slide below hits the major points pretty well and makes the macro case for Plains. Demand and supply have been tracking pretty closely, and recently in an Oilprice article, I've made a case there might be a gap building in supply. We're still gathering data points on that, but the market is tight. The oil market has been in Backwardation so long, that I don't remember the last time it was in Contango.

The takeaway is that the macro environment for these companies is strong, and nothing on the horizon changes that story. Even if my thesis about Permian production beginning to flatline or fall off is correct, the indicators are that for a while growth persists. In a growth scenario, PAA is primed to do well. Here's Willie Chiang's, CEO of PAA comments about growth in the Permian-

"In the Permian, we continue to expect at least 600,000 barrels a day of production growth in 2022, of which we anticipate capturing approximately an incremental 280,000 tariff barrels per day on our Permian gathering systems year-end of 2021 to year-end 2022."

Company filings

As with many companies in this space, Plains is focused on deleveraging, and maximizing unitholder returns in coming quarters. The dividend yield we have noted is attractive, and recently the company has begun to repurchase units under a previously authorized program.

Potential catalysts for PAA

An MOU has been signed for a hydrogen electrization feasibility study, for storage in Windsor, Ontario salt caverns with a technology provider, Atura Power. This is a long-term potential as the MOU has just been signed.

Growth in the Permian matrix and export from Canada through their trunk line from the Edmonton area provide this potential as shippers compete for limited space. This is buttressed by the need in the Gulf Coast for heavy Canadian crude and NGLs.

Q-1, 2022

Revenues of $13.6 bn in the first quarter drove adjusted EBITDA of $614 million, which includes the benefit of NGL seasonality, higher volumes and commodity prices, and the startup of the Capline and Wink-to-Webster pipelines.

They've increased full-year 2022 adjusted EBITDA guidance by $75 million to plus or minus $2.275 billion. The increase is driven by several factors, including the benefit of improved frac spreads and volumes in our NGL business and improvements in the crude oil segment, including increased volumes benefiting the Permian system as well as higher pricing on pipeline loss allowance barrels.

Willie Chiang, CEO comments on the pricing outlook for 2022-

"As production and long haul utilization continue to increase, spare capacity will begin tightening and tariffs to the water should return to a more normalized level."

Company filings

For 2022, excluding the anticipated impacts of the Line 901 legal settlement and the estimate of timing of the insurance reimbursement, the free cash flow guidance is relatively unchanged. Given the effect of this timing, they have conservatively reduced OCF guidance by $150 million. Importantly, the impact is expected to reverse over the next 12 months, and the year-end 2022 leverage guidance remains at plus or minus 4.25 times, with no impact on DCF guidance.

They remain committed to capital discipline and expect consolidated 2022 investment capital of plus or minus $330 million and maintenance capital of plus or minus $220 million.

In the first quarter, PAA repaid $750 million of senior notes and repurchased 2.4 million common units for $25 million, leaving up to $75 million available for potential discretionary repurchases over the balance of the year.

The thing that is of particular interest to me in the slide above is their 2023 target for leverage. The company is carrying about $7.9 bn in long-term debt, and there is no question that's been a drag on the stock with interest rates rising. The leverage ratio is way out of whack at 4.5X, with a target set for 3.75X for exit YE 2023. Which is not all that great, but at least their heads are pointed in the right direction.

As a combination of cash and credit lines, the company has $3.0 bn of liquidity presently.

Energy Transfer

I was down on the company for a long time, particularly after a distribution cut in 2018. ET was in the high teens then and has not been above $15 since. The market is supportive of a multiple expansion for ET. But, that's been true for a while now, and still the company fails to achieve the escape velocity needed for breaking through that $15 level.

Long-time holders are pretty passionate in their disdain for the company, having been savaged over the years by the company's relentless debt assumption for growth. Some will admit to having been brought to near even on the generous distributions that prevailed...until they didn't. Most are just too bitter at the loss of their capital.

I changed my mind on ET when their CEO and founder, Kelcy Warren, took a step back and turned day-to-day management of the company over to a couple of co-CEOs. "Kelcy'd" has become a verb for shareholder abuse, among the legions of long-time unitholders. When he left, you began to see changes for the better.

As the company sank into the single digits, a light dawned on me and blinked "yield." For a time it was around 15%, but then was cut in half. Even today with the distribution far below the level it held prior to them absorbing their general partner, Energy Transfer Equity, it's a tasty 7+ %. The company has the most extensive network of petroleum products pipelines in the business and has turned in an outstanding quarter for Q-1, 2022.

When you combine those three facts, ET begins to look pretty good. 

The generally supportive environment for ET

Higher products prices and the need for additional takeoff in key basins to support LNG export opportunities have pumped up cash flow for ET. Tight supplies of gas have spurred drilling in these basins which are predominantly gas prone. The Permian, our nation's petroleum piggy bank is the home base of many of the shale drillers we discuss frequently. The Hayneville languished by comparison for several years, but the buildout of LNG projects along the Gulf Coast has renewed interest in this gassy play. There is a global energy shortage backdrop to this story that is well known. Europe and Asia need our energy and are willing to pay handsomely for it.

What's new with ET?

Well for one thing capex has been declining sharply over the last couple of years. Building pipelines is expensive. Permits, court hearings, placating Native American tribes, lawyers, and a few bucks here and there to dig ditches and run pipe, all add up. The decline in capex suggests to me the era of empire building is taking a pause at the company.

Authors, including myself, have always talked about a time when the relentless quest for growth might abate at ET. How the cash flow that had previously gone into putting braces on a legion of lawyers kid's teeth, and second homes in Vail, might now go in the direction of shareholders. If priorities have truly shifted at ET, shareholders could see substantial gains in the near term.

Tom Long, Co-CEO comments about cash flow allocation and the 30% rise in the dividend over the past year-

"On April 26, we were pleased to announce a quarterly cash distribution of $0.20 per common unit or $0.80 on an annualized basis, which represents a more than 30% increase over the first quarter of 2021. As a reminder, future increases to the distribution level will be evaluated quarterly with the ultimate goal of returning distributions to the previous level of $30.5 per quarter or $1.22 on an annual basis, while balancing our leverage target, growth opportunities and unit buybacks."

Company filings

Current and prospective shareholders can perhaps take some comfort in this mindset. Assuming it prevails in the face of new projects being reviewed for FID. The "ghost" of Kelcy still stalks the halls of ET, as we will see.

On the other hand

In the conference call and in the slide presentation a number of new projects were previewed, and if they all achieve FID they could turn the capex line toward the upper right-hand corner of the graph.

Highlighted in the call were:

The Warrior Permian basin takeaway pipeline is now under FID review, this pipeline project from the Permian Basin is planned to address the growing needs for additional natural gas takeaway from the Permian. The company views it as having significant advantages over competing projects, as it parallels existing rights of way. They are targeting the FID for later this year and two years of construction. That sounds optimistic to me. Troubles permitting new pipelines in existing rights of way aren't completely unknown. But that's Michigan, and this is Texas, so the odds are pretty good.

Nevertheless, the RBN blog notes the level of competition for carrying this gas to market.

"Matterhorn Express Pipeline (MXP), a joint venture (JV) between WhiteWater, EnLink Midstream Partners, Devon Energy and MPLX, announced its final investment decision (FID) late yesterday. There are a number of green field gas pipeline projects entering this summer's race to increase egress out of the Permian. To recap, at the time there were three greenfield projects percolating: Kinder Morgan's Permian Pass, which is assumed to be a 2.0-Bcf/d pipeline that would terminate near the Katy, TX, area; Energy Transfer's Warrior Pipeline, which would move 1.5-2 Bcf/d of gas east from the Permian toward the Dallas area, where it would then access existing pipes to the Gulf Coast."

RBN Blog

ET is expanding its Permian basin footprint with a number of smaller infrastructure builds. Currently, they are processing volumes of about 2.2 Bcf per day in the Permian. Construction of a new 200 million cubic foot per day GrayWolf processing plant in the Delaware Basin has commenced. The GrayWolf plant is supported by new commitments and growth from existing customer contracts and is expected to be in service by the end of this year. There is also a second processing plant planned once a location is selected.

Lake Charles LNG also was featured prominently in the call.

The company has it pretty well laid out in the slide below. They've been doing a good job lining up SPAs to support the project with discussions ongoing with additional purchasers. Tom Long comments in the call-

We are also in active negotiations with a number of other high qualified customers, and we expect to make an announcement of additional offtake agreements in the weeks ahead.

Source

Now, it's been pretty well documented, and logic dictates, that LNG plants are ridiculously expensive and take years to build. When you add in the inflationary environment that persists today, this is a budget buster to end all budget busters. Tom Long, Co-CEO informs us they have a plan to put a lid on some of their exposure-

"As we have previously stated, we expect to finance a significant portion of the capital cost of this project by means of the sale of equity in the project to infrastructure funds and possibly to 1 or more industry participants in conjunction with the LNG offtake agreements. We are currently targeting FID for this project in the fourth quarter of this year."

Company filings

This is a time-honored ploy and in this environment, I would expect they will have no trouble getting the financial support they seek. Still, ET will be taking the risk and fronting the capital. As always.

Ethane expansion

Petrochemicals - NGLs are the bedrock of modern life and ethane is one of the key building blocks used to provide consumers with things they want. ET is a major player in the NGL export business and claims to export more NGLs than any other company or country. They view their share of the worldwide NGL export market as being nearly 20% of the total. Demand is on the up as increases in NGL demand and the associated market value both here in the U.S. and internationally make a fertile field for expansion. Tom Long, CEO comments-

"We expect to participate in this growth as well as increase our market share as our franchise is uniquely well situated to benefit from this expanding market. We are seeing strong from overseas customers seeking additional supply from the United States, and we have recently secured sufficient commitments to move forward on the ethane expansion."

Company filings

ET is looking at expanding its ethane export capabilities at both the Marcus Hook and Nederland Terminal terminals. Using the commitments discussed by Mr. Long, the company is in the process of selecting one of them for expansion in ethane processing. Additionally they are evaluating the possibility of developing a petrochemical project along the Gulf Coast. Tom Long is bullish on the prospect as his commentary on the call notes-

"If we are able to reach FID, we believe that our cracker will be a very unique world-class facility, providing unparalleled access to the lowest cost feedstock through our pipeline systems, as well as unparalleled access to downstream domestic and international ethylene and propylene markets through our pipelines, our storage facilities and our export terminal. We're in discussions with a number of high-quality customers as we work to secure long-term tolling type commitments prior to reaching FID."

Company filings

And, if all of that wasn't enough, last year the company signed an MOU with the government of Panama to study the development of an LNG plant in that country.

Your takeaway

Plains All American has a strong macro underpinning to its business base. Its core Permian area is very gassy. Many operators in the Delaware report 60% gas. This should create uplift for the stock. It's trading at only ~5X EBITDA/DCF. I think that's pretty cheap. I am going to stick with the analyst estimates for PAA. I think it's a good choice for modest growth and a nice unit distribution. I think the shares are largely derisked in the current price environment.

While excessive, debt is a characteristic of this industry segment but a scenario a few years hence, where D/E ratios fall toward 2X, could provide substantial uplift for the stock. Patience would be necessary on the investor's part and, of course, some risk tolerance for the scenario where revenues fall and the debt becomes an issue. 

Now let's look at Energy Transfer. There is an emerging buzz that this might be the year ET achieves escape velocity and moves the stock price higher out of the $10-$12.00 range it has occupied for so long. The positive sentiment for ET is effervescent.

Two things could keep this lift-off from happening. The first is concerns the investment community has about some of the expansion projects. Concerns regarding this potential framed most of the questioning that took place in the call. Here is an example, as Thomas Mason, company president comments-

Analyst-Brian Reynolds

"And then as my follow-up, a lot of progress on the LNG front with the recent flurry of contracts. Just kind of curious if you could provide some thought process around the ultimate ownership structure and potentially bringing in partners, whether that's a financing partner or a strategic partner, just given the ultimate interest in LNG and ultimately, how that would fit in the ultimate Energy Transfer portfolio?"

Thomas Mason

"Yes. This is Tom Mason. We -- as we previously announced, we plan to do some portion of equity sell down to primarily infrastructure funds. There's lots of money that are looking for high-quality, long-term cash flow from a project like this. So we think that's going to be a really good way of financing it. We expect that we keep at least 25% of the project, haven't made final decisions on that yet, but it's going to be -- there's just a lot of interest in the equity side of this project."

Company filings

The second is debt. The company is still carrying $58 bn in debt, and has just achieved a leverage ratio of debt to EBITDA of 4.5. That's still pretty high, and interest costs could rise sharply in the tightening environment we have now. Enterprise Products Partners, (EPD) carries a debt to EBITDA ratio of 2.6, for comparison. Tom Long, co-CEO addressed this in response to a question on how fast the company might raise the distribution toward $1.22 per unit-

"We have made great progress toward moving toward our target of that 4 to 4.5. As you know, each agency calculates that a little bit differently. So I encourage you to reach out to each of them to see kind of where they're at. But we're getting closer to the 4.5, so let all those -- let us look at all those factors quarter-by-quarter as we move through the year, and that will go into that decision each quarter."

Company filings

In the final analysis, I don't know if growth should really matter to investors. I see ET as an income play more than growth. Pipelines, storage terminals, and LNG plants are inherently expensive capital outlays. I think they will always be a factor that will tend to keep the stock in a range of $10-20 per share. The good news is the distributions are well covered by cash flow, $3.3 bn in this quarter vs DCF of $2.1 bn, and the mindset is to increase them toward that upper target of $1.22.

I think investors should view ET as derisked for price at current levels.

Now we have to disclose our top pick of these two. For my money, Plains gets the nod. Their yield on cost-YOC is better than ET's in the first place. If you're a yield seeker, the near eight percent yield catches your eye. But as a seasoned investor, you have an aversion to rising capex and empire building. In spite of declines in recent years, ET shows signs of leaning toward mega-project, capex intensive projects. You need look no further than their Lakes Charles LNG plant. These were notorious for cost overruns in the world a few years back. With the supply chain woes we have today, I honestly don't know how costs can be tabulated.

As a yield investor, you have to be conscious of what the company is doing with its money. Capex is on the rise for ET in 2022, while PAA is primarily concerned with deleveraging and shareholder rewards. Music to my ears as an income investor.