Best-in-Class Enterprise Products Is Undervalued

While many other midstream operators are playing checkers,

The company has built out a dominant position in natural gas liquids. Its Houston Ship Channel and Beaumont Terminal and its Mont Belvieu assets (NGL fractionation, storage, pipelines) means it will be the primary beneficiary as U.S. NGL exports increase in the coming years. The partnership generates nearly 60% of its gross operating margin from this business. We view the forthcoming NGL demand-pull toward the Gulf Coast as the key growth driver for Enterprise. From its vast NGL system, Enterprise’s connection with every ethylene cracker on the Gulf Coast, its sold-out propane dehydrogenation splitter, and the upgraded isobutylene unit make it adept at converting low-cost NGLs into higher value-added olefins. We expect its dominance in this area to grow materially over the coming years, supporting healthy growth prospects.

As an example of how this diverse footprint supports a wide moat, consider management’s response to concerns about excess NGL fractionation capacity and propane prices. Rather than risk return compression through exposure to solely propane molecules, Enterprise elected to build a propane dehydrogenation plant to capitalize on low-cost feedstock coming through its system. Not only is this expansion a natural hedge against its NGL exposure, but by extending its participation in the value chain, Enterprise mitigates prospective volatility from propane prices in its processing and fractionation assets.

Outstanding Asset Quality We believe Enterprise Products Partners has a wide economic moat based on its efficient scale moat source. On each of the major factors we use to evaluate midstream companies--asset quality and location and contract quality--Enterprise stands out with differentiated advantages. We expect returns on invested capital to average about 13% over the next five years, well above the company's cost of capital of around 6.9% by our estimates.

New pipelines are typically constructed to allow shippers or producers to take advantage of large price differentials (basis differentials) between two market hubs because supply and demand is out of balance in both markets. Pipeline operators will enter into long-term contracts with shippers to recover the project’s construction and development costs as well as a return on capital, in exchange for a reasonable tariff that allows a shipper to capture a profitable differential, and capacity will be added until it is no longer profitable to do so.

Pipelines are approved by regulators only when there is an economic need, and pipeline development takes about three years, according to the U.S. Energy Information Administration. Regulatory oversight is provided by the Federal Energy Regulatory Commission and at the state and local levels, and new pipelines under consideration have to contend with onerous environmental and other permitting issues. Some midstream entities earn an intangible moat source for operating under a particularly difficult regulatory environment, such as being overseen by both Canadian and U.S. agencies. Further, project economics are locked in through long-term contracts with producers before even breaking ground on the project. If contracts cannot be secured, the pipeline will not be built.

A network of pipelines serving multiple end markets and supplied by multiple regions is typically more valuable than a scattered collection of assets. A pipeline network allows the midstream company to optimize the flow of hydrocarbons across the system and capture geographic differentials. Finally, it is typically cheaper for an incumbent pipeline to add capacity via compression, pumps, or a parallel line than it would be for a competitor to build a competing line.

To assess the strength of a midstream company’s moat, we consider two factors: the location and quality of the company’s assets and the strength of the company’s contract coverage.

Enterprise’s asset base quality is outstanding and easily merits a wide moat. For producers seeking options for their hydrocarbons, Enterprise offers an extensive menu. The partnership is connected to every major U.S. shale basin, every ethylene cracker, 90% of the refineries east of the Rockies, and offers export facilities out of the Gulf Coast. The heart of the asset base is clearly its NGL network, which is comprehensive and offers deep access to Mount Belvieu. Its regulated NGL network makes up 20,000 miles of pipelines across 27 states transporting over 1.8 million barrels per day. The unregulated assets include over 1 million bpd of NGL fractionation capacity, over 170 million barrels of storage, multiple export terminals with dock access, and isomerization units. To further its control over the NGL value chain, Enterprise has built out a number of petrochemical assets, including propylene pipelines, propane dehydrogenation facilities, and isobutane dehydrogenation facilities, which allow the partnership to extract higher value olefins from feedstock. In effect, the company is creating more of a demand pull for the ample supply of NGLs traveling through its network. Enterprise, in our view, was one of the first in the industry to recognize the shortage of NGL infrastructure in the U.S., and the eventual shift toward exports and has built an impossible-to-replicate collection of assets across the value chain, positioning it to capture differentials between U.S. and international markets.

Enterprise’s natural gas assets have been affected by its considerable exposure to Eagle Ford and Haynesville, where production is well off peak levels. Natural gas throughput at Enterprise has declined about 10% since 2012, though it saw some improvement in 2017 off very low levels. Still, the impossible-to-replicate network makes up 12,000 miles of natural gas pipelines across New Mexico, Texas, and Louisiana with 400-plus interconnection points to demand centers as well as 5.8 billion cubic feet per day of net gas processing capacity. The vast majority of the network is in Texas, with 16 bcf/d of transport volumes and nearly 13 bcf of storage, which is about 80% contracted by our estimates. Enterprise has benefited more recently from its exposure to the Delaware/Permian basin, where rich gas volumes have more than quadrupled since 2013 by our estimates and the partnership has been added processing capacity to feed its existing asset base.

Enterprise’s 5,700 miles of crude pipelines are primarily located in Texas, Oklahoma, and New Mexico, connecting the Eagle Ford, Permian Basin, Cushing, and Gulf Coast exports hubs, and transport about 1.8 million bpd. The company also owns about 37 million barrels of storage. The reversal of the Seaway pipeline to flow oil to the Enterprise Hydrocarbons Terminal was a smart move, and the planned construction of a new pipeline transporting crude to Sealy (on the coast) from Midland will strengthen the overall network. We’re particularly impressed by the partnership’s position on the Houston Ship Channel in terms of storage and export opportunities. The EHT controls 21 million barrels of storage with six deep-water dock ship and two barge docks, and it can accommodate Suzemax tankers, which are the largest tankers that can navigate the channel. The company also controls the Beaumont West, Freeport, and Texas City systems, which adds additional dock access. We think the dock access is important, given geographic constraints, and it allowed the company to export 34 million barrels of crude oil in 2016 following the lifting of the export ban in December 2015 as well as another 17 million barrels of processed condensate. Replicating Enterprise’s crude oil asset portfolio will be very difficult, in our view.

We view its marketing operations as a strong asset that lets Enterprise collect significant additional fees from its network versus being a pure toll-taker. With its marketing operations, Enterprise takes ownership of the hydrocarbon and seeks to exploit differentials based on time, location, or product arbitrage across the hundreds of connection points across its system. This type of asset is very difficult to replicate due to the complexity and richness of Enterprise’s system, and the few producers that do undertake marketing activities focus on the relatively few basins they operate in versus the entirety of the U.S. oil and gas complex. It also lets Enterprise take full advantage of profitable opportunities in secondary markets across its pipelines for capacity not being used under firm contracts, versus ceding those fees to the shipper. Other examples would include taking advantage of seasonal changes in demand for propane, upgrade opportunities for raw NGLs to be converted to higher grade and more profitable olefins, and being able to use Enterprise’s network to move product to markets where differentials are the widest. Rather than operating as a separate group, the marketing operations are embedded in the natural gas, oil, and NGLs teams at Enterprise, providing insights to help them make investments across the portfolio. Finally, we believe the marketing operations provide an added benefit in terms of sourcing and developing relationships with producers to serve as committed shippers for future investments but also sources of internal demand (for example, opportunities to Enterprise to take ownership of hydrocarbons) to support incremental investments. Peers without this robust level of marketing operations will face higher hurdles in terms of being able to obtain commitments for large investments.

We have a favorable view of Enterprise’s contracts. About 80% of them are firm contracts by shippers to reserve capacity on Enterprise’s assets for a decade-long time frame, and the company typically signs 15- to 20-year contracts for its pipelines. These industry-standard contracts provide shippers with reserved capacity for which they pay an origination fee, but do not obligate them to use the line if better opportunities exist elsewhere, for which the shipper would pay an additional transport fee. For Enterprise’s latest investment, the propane dehydrogenation plant, 100% of the 750,000 pounds per day are contracted for 15 years, and the isobutane dehydrogenation plant is also fully contracted for 15 years, split between investment-grade companies and internal Enterprise marketing capacity. In times of market stress, Enterprise has been creative with its assets, obtaining area dedication contracts where the producers would be obligated to provide a certain number of barrels per day and then looking to convert the contracts to long-term fee contracts as the markets recover. We think this supports developing long-term relationships with important producers.

Demand for NGLs Is Biggest Risk The single greatest risk to the Enterprise story is failure of demand for natural gas liquids from the petrochemical industry in the Gulf of Mexico to materialize. In addition to making up over 50% of the partnership's gross operating margin today, Enterprise's NGLs business will serve as its primary growth engine through the rest of the decade. We anticipate demand for ethane due to ethylene crackers under construction in the Gulf in the next few years. However, much of this demand is out of Enterprise's control. Any delays or reduced demand would have a materially negative effect on Enterprise's earnings. Even as much of the downside risk is mitigated by sufficiently contracted capacity, failure of NGL demand to materialize would cap Enterprise's earnings upside.

Enterprise holds some commodity price risk from both volumes and equity ownership of natural gas, crude oil, and NGLs. The partnership addresses some of this risk through hedges and its diversified asset base. We maintain that management’s efforts to vertically integrate insulate the business, proving natural hedges against much of the commodity price volatility. However, the main risk to Enterprise’s marketing business is a narrowing of spreads.

Like many yield-oriented investments, Enterprise is exposed to interest-rate risk. If interest rates increase faster than expected, Enterprise’s units could underperform, as a steepening yield curve increases the expected distribution yield for competing assets.

We view Enterprise’s financial health as very strong. The partnership has a solid investment-grade credit rating with considerable liquidity to meet any near-term financial obligations. As management has carefully managed distributions and earnings growth, the partnership has retained considerable distributable cash flow. Through the trough of the recent cyclical downturn in the energy patch, the partnership has retained well above 1.15 times coverage on its distributions. We see excess distribution coverage as not only a prudent way to ensure a margin of safety in prospective downturns but also a way to mitigate some need for dilutive equity and further debt issuances.

Enterprise bought out its general partner interest and associated incentive distribution rights in 2010. A clean limited partner structure has helped keep the partnership’s cost of equity capital much lower than that of its peer group. The current governance structure affords LP unitholders almost no say in the management of the company, but the company’s exemplary stewardship of its business mostly mitigates our concern about this. As long as returns continue to grow and remain robustly above the cost of capital, we are willing to concede some control in corporate governance.

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