The Midstream “Emerging Markets”

I have long since been bullish on the prospects for the MLP sector as the domestic oil and gas boom continues to plow ahead. Regular readers are very familiar with Plains All American (PAA), my preferred play in this space.

MLP’s continue to be incorrectly associated with fixed-income investments that are susceptible to higher rates. This is an old view that is no longer valid in the current environment, particularly in PAA’s case. 

PIMCO recently put out an interesting piece on the future of the domestic oil and gas industry going forward that I thought was worth sharing.

Some key takeaways from the article:

• In our opinion, the midstream energy sector will grow more quickly than the overall U.S. economy over the next several years, which will provide continued support for current fundamentals.
• North American crude oil production is expected to increase at an average of 10% per year from FY2013 through FY2017.
• Bentek estimates that from 2013–2020, approximately 50% of all incremental global crude oil production will come from North America, totaling 4.5 million barrels per day, with four key producing regions the primary sources of the increase: 1) South Texas’s Eagle Ford Shale, 2) North Dakota’s Bakken Shale, 3) West Texas’s Permian Basin and 4) Western Canada.
• Due to ample access to capital, increased productivity and added drilling infrastructure, we believe production growth in Texas, North Dakota and Western Canada should grow 10% per year over the next 3 years.
• Overall, the emerging trends in North American energy, and especially in crude oil production, are likely to have dramatic ripple effects on U.S. manufacturing, foreign policy, defense spending, current account balance and the looming budget deficit.

In my opinion, the recent Fed tapering induced sell-off has created an attractive entry point for PAA here as the stock has not participated in the rally of the last month. Additionally, it has bounced nicely off its 6 month lows for the third consecutive time. But the sell-off was really unjustified for a number of reasons.

MLP’s continue to be incorrectly associated with fixed-income investments that are susceptible to higher rates. This is an old view that is no longer valid in the current environment, particularly in PAA’s case. The company is experiencing the best operating environment it has ever seen. Rising rates will not inhibit their ability to grow in the least with such strong tailwinds behind them. Further, management has proven their commitment to returning money to shareholders through consistent distribution growth. And given the operating outlook, they should continue to be able to grow the payout for years to come. So, at best, PAA is more akin to a floating rate investment, as opposed to the classic fixed rate context in which MLP’s have historically been viewed.. with significant equity upside to boot.

I added to my core PAA position last week. I don’t expect it to be a home run, but in this lackluster environment of minimal top line growth, political discourse, and expectations for the economy to continue to “muddle along”, there are few better places for patient investors to be right now in my opinion.

The US Energy Landscape

Several months ago I wrote about the broader implications of the domestic energy boom on US foreign and fiscal policy, arguing that the shale boom will continue to be underpinned by positive factors in both of those areas.

In a recent FT article, that issue was explored further in light of the recent developments in Syria. That article supports the idea of US domestic energy policy as a growing foreign policy tool in an ever increasing complex international context.

Tom Donilon, formerly Obama’s National Security Advisor, characterized shale as a “transformational moment” and went on to say:

“Sanctions against Iran were more successful than people thought they would be because we were able to replace the lost supply in world markets and thus get co-operation from China and India and others,” says Jason Bordoff, a former senior White House official now at the Center on Global Energy Policy at Columbia University.

“We could pull 1.5m barrels per day off the market without causing a spike in prices, which would have hurt our economy and helped Iran.”

The article goes on to note:

“US shale knowhow can also be a useful export. The administration has been working with countries including Poland, Ukraine, Jordan, China and Mexico to help them develop their shale resources so they can meet more of their own energy needs from domestic production rather than from Russia, Iran or other potentially unfriendly countries.

The shale boom is creating jobs and profits and boosting tax revenues. As Mr Donilon says: “A country’s political and military primacy depends on its economic vitality.”

 However, the opportunity is certainly not without its own challenges :

“Yet as America’s confidence in its energy resources climbs ever higher, there is a danger of the optimism running ahead of reality…

“It would be wildly irresponsible to make defence policy decisions based on the assumption that the US is going to be energy self-sufficient in 10 or 20 years,” says Michael Levi of the Council on Foreign Relations. “If that turns out to be wrong, it could be disastrous. One of the big lessons here is: don’t be too confident.”

Nonetheless, this is clearly an opportunity that the US cannot afford to squander. The long-term investment thesis for energy infrastructure remains as robust as ever. Indeed, the US is in the process of a massive re-tooling of its pipeline networks to accommodate new sources of oil and gas which is flowing in new directions. My preferred means of playing this trend remains the pipeline MLP’s, which offer high, tax-advantaged yields that will grow over time as more infrastructure continues to come on line in the future. Stay tuned for an update on PAA, my preferred MLP, in the coming days.

U.S. Oil, fiscal policy, and the growing rift within OPEC

The U.S. oil shale boom is clearly a game changer for the domestic energy landscape in this country. This WSJ article looks at the global implications of this new source of supply and what it means for OPEC, particularly the more marginal producers. Obviously it’s an important issue with considerable uncertainty in terms of its impact on geopolitics and trade. But delving further under the surface, the same issue is also a clear reason why the U.S. shale boom will continue, relatively unimpeded by the environmental lobby.

As the Journal article notes, the political sway and domestic stability of a number of countries (particularly Iran, Venezuela, and Algeria, and to a lesser extent Nigeria) is going to be squeezed as their ability to influence the global oil market is diminished in a world of increasing supply. And that highlights the importance of the U.S.’s new found crude supplies as a tool of foreign policy. With dramatically less reliance on these sources going forward, the US has more leverage when dealing with threats from the likes of Iran and others.

But underlying support for continued growth in the industry doesn’t stop there. Given the dire fiscal situation in the US, domestic oil represents a substantial source of incremental tax revenue that is badly needed in Washington. Thus, the shale boom represents a boon to the government from both a foreign policy and a fiscal policy perspective.

Environmentalists will certainly continue to press for restrictions on the industry.  The good news is that, because the government arguably has little choice but to foster production growth in the long run, environmental pressure is likely to result in improved safety conditions and a more sustainable operating environment rather than an outright restriction of growth. And that’s a definite win-win for the country.

PAA: Just Plain Awesome

Plains All-American Pipeline (PAA) reported Q1 results last week that absolutely shattered Street estimates. Supply & Logistics (S&L) margins soared to $3.95 / barrel as crude spreads remained incredibly favorable. Management raised its distribution to $.575 / unit, a 10% increase vs the same period last year and 2% higher than February’s distribution. Additionally, they raised the 2013 EBITDA outlook by 7% to $2.16 bn.

Notables from the call include:

• Acknowledged that spreads should narrow significantly over time and guided S&L margins down to 2.83 / bbl accordingly
• Increased current year capex plan by 300mm to 1.4bn; the plan is still entirely prefunded based on previous capital raises and cash on hand
• Future capex plans also guided higher – 99% to be directed toward the transportation segment (fee-based business characterized by more stable cash flows). Expect this segment to take up much of the slack created by lower margins in S&L going forward as regional bottlenecks continue to pervade creating additional opportunities for their well positioned transportation assets (ie. rail). Going forward, still expect the combination of Transportation and S&L to provide significant growth, albeit with uneven contributions from S&L as spreads continue to vacillate, as Transportation investments begin to realize increased value.
• Guided distribution growth of 9-10% annually with an estimated coverage ratio of 135% (vs target of 105-110%)
• Contributions from PNG (gas subsidiary) expected to tread water for foreseeable future but with solid upside potential ~2 years out
• Balance sheet remains in impeccable shape with EBITDA / interest coverage of 9.6x and 2.8bn in committed liquidity
• Remain active on the acquisition front but unable to disclose specifics at this time
• A downturn in capital markets would likely spark increased consolidation in the industry

Political Points

At a recent BAML industry conference, PAA (among others) cited ongoing discussions with Congressional leaders regarding the tax advantaged MLP structure. Washington appears to recognize the benefits of keeping the advantages to the structure intact, has acknowledged that changes to it would represent extremely small contributions to deficit reduction on balance, and thus they appear supportive of traditional MLP plays (of which PAA is definitely one). Therefore, political risk, while not zero, seems low.

Takeaway

The stock is up ~20% since my initial post outlining the thesis here and has reached my initial fair value estimate of high 50’s. Given the expectation of normalized spreads going forward, additional upside from here seems less likely in the near term. However, PAA continues to build out a best-in-class asset base by investing for the next stage of growth which will realize additional synergies over time as production growth will continue to outpace infrastructure development  Further, given management’s track record of consistently growing the distribution and healthy coverage levels, their forecast of 9-10% growth is indeed conservative.

Recommend holding the position here as the stock consolidates. Catalysts going forward include new acquisitions and the possibility of extended spread dislocations. Suggest adding to the position on pullbacks as the long-term fundamentals remain very positive (target low 50’s). Moreover, to management’s point re industry consolidation, a significant lull in capital markets could well set the stage for the next stage of growth given PAA’s healthy balance sheet. In short, PAA should continue to handsomely reward the patient investor over the long term.