Enterprise Products' Petrochemical Pivot Holds Promise

It may be too early to call the oil and gas businesses of Enterprise Products Partners EPD legacy businesses, but that day could be coming. The prospects for midstream investors are potentially unnerving, and we think the better management teams are laying the groundwork for future growth that fully incorporates the rise of renewables and the ongoing energy transition. While Enterprise remains on the offense with its oil and gas efforts, we think its petrochemical business offers some of the best near- to medium-term growth prospects as the partnership plans to expand the gross operating margin for the business to $1.3 billion in 2024 from an estimated $764 million in 2020. We think this growth opportunity is unique in our U.S. midstream coverage, as no other company has petrochemical investments. This growth doesn’t come without risks, as there are ample environmental, social, and governance considerations that Enterprise must manage better, in our view, but we think the upside is compelling.

A Larger Petrochemical Business Has Positive Valuation Implications

The petrochemical industry transforms hydrocarbons into more valuable commodities that are part of many commercial and industrial products. Steam crackers, which use high heat to break apart natural gas liquid molecules, are the most common facilities that convert hydrocarbon feedstock into more valuable olefins, but propane dehydrogenation plants and refineries are also used. The most important light olefins are ethylene and propylene for various industrial end uses such as plastics, synthetic fiber, rubber, coatings, and solvents.

We expect flat results from Enterprise’s core business (natural gas liquids, oil, gas) in the midst of a difficult market with limited opportunities to put new capital to work outside of petrochemicals. Thus, we see petrochemicals as Enterprise’s main growth engine.

Chemical businesses typically attract significantly higher valuations. Enterprise is a petrochemical manufacturer but also transports petrochemicals, which we consider a lower-risk business. Many comparable specialty and commodity producers are trading at enterprise value/EBITDA multiples above 15 times, with a median EV/EBITDA of about 18 times across our comparable coverage. Specialty chemical giant DuPont DD is valued at 14-15 times EBITDA and commodity producer Dow DOW is valued closer to 10 times, but neither is a perfect comparable, given the additional activities that Enterprise performs. We think a more appropriate potential valuation for Enterprise’s petrochemical unit is about 14 times EBITDA, valuing it closer to a commodity chemical producer. This valuation is materially higher than the 10-11 times EBITDA multiple we award Enterprise as a best-in-class midstream partnership, which is a multiple that has been under pressure over the past few years as industry valuations have declined.

As petrochemicals become a larger contributor to the business, it may make more sense for investors to value Enterprise at a higher valuation, especially if it finds ways to profitably add hydrogen and renewables projects. The petrochemical returns seem attractive enough at 15% unleveraged, according to Enterprise management’s expectations. Notably, the vast majority of the petrochemical business is fee-based, with Enterprise highlighting that its propane dehydrogenation contracts are usually longer than 10 years. If investors start to value Enterprise’s petrochemical business more in line with a chemical company’s valuation, and Enterprise reaches its $1.3 billion goal, our $25.50 fair value estimate could increase by about $5 per unit.

Better Growth Prospects Than Hydrocarbons

Petrochemicals offer an attractive growth opportunity as Enterprise Products Partners avoids long-term demand headwinds for U.S. oil and gas. Historical growth for ethylene and propylene has been about 3.3% annually compared with global GDP growth of 3%, well above oil’s 1.3% growth. Setting aside long-term concerns, petrochemicals also offers a growth avenue free of overcapacity pipeline concerns around the Permian or permitting headwinds for natural gas pipeline projects.

For Enterprise, the opportunity is to leverage its existing logistics expertise in moving molecules across the United States but also exporting, as much of the growth from ethylene and propylene is overseas. Enterprise has the opportunity to build assets to produce, transport, store, and export propylene and use existing assets to obtain ethane to crack into ethylene. In the U.S., much of this infrastructure is private, undersized, and lacks connectivity. Enterprise sees an opportunity to better link demand and supply centers across the Gulf Coast and create new markets overseas.

End uses are numerous and include food packaging, insulation, paints, single-use medical supplies and personal protective equipment, and wind turbine and solar panel parts. Key demand centers include China, India, and the United Kingdom; China in particular is an aggressive importer of U.S. products as it seeks to move away from coal. Liquefied petroleum gas is important as a heating source but also as a cooking fuel, as India is encouraging LPG use instead of firewood and kerosene. China’s shift away from coal also offers significant carbon emission savings.

About two thirds of Enterprise’s capital spending planned for 2021-23 is devoted to petrochemicals, which accounted for only 9% of its 2020 gross operating margin. To some extent this reflects the difficult environment in oil and gas, but it also illustrates the relatively attractive nature of petrochemical investments as a countercyclical investment versus only being able to pursue material oil and gas investments when oil and gas prices may reach unsustainable levels. Enterprise recently completed ethylene export tank expansion and related pipelines as well as an expansion of its deisobutanizer operations at Mont Belvieu.

The largest capital investment project over the next few years is Enterprise’s second propane dehydrogenation facility. When completed, Enterprise will have 11 billion pounds per year of polymer-grade propylene capacity. However, Enterprise’s control over the propylene value chain extends elsewhere, with 1 billion pounds of storage, 3.5 billion pounds per year of export capacity, and over 350 miles of gathering pipelines.

While the extensive control over the value chain is impressive, it does not dramatically extend the efficient scale advantage at the heart of Enterprise’s wide economic moat, as it merely diversifies the business in a fairly profitable fashion. Enterprise faces competition from other producers, including Dow.

New ESG Risks Come With Shift to Petrochemicals

A shift toward petrochemicals by Enterprise Products Partners offers an attractive growth path but requires careful management of ESG risks, in our view. Analysis by Sustainalytics points to a large ESG risk-management gap between Enterprise and chemical peer Dow. We believe Enterprise must improve its ESG risk-management approach, particularly around employee and operational safety as well as carbon emissions management.

The chemical industry and Dow have put robust health and safety management programs in place, and their risk scores are considered strong on a relative basis. In contrast, Enterprise’s management of its existing level of reduced ESG risks across its oil and gas portfolio is considered average. As a result, we believe Enterprise will need to pursue more aggressive management of its health and safety, plus be wary of new exposure to potential new chemical-related legal liabilities. Major material ESG issues for Dow include health and safety, the environmental and social effects of its products, and carbon emissions, similar to Enterprise’s.

Polymer-grade propylene is considered highly flammable. A propylene gas explosion at a Houston business in January 2020 killed two employees, damaged over 450 structures, and eventually caused Watson Grinding to file for bankruptcy. On the chemical side, risks tend to include environmental damage from chemical waste that typically occurs around a manufacturing site. This typically results in remediation and litigation expenses that can range from the tens of millions of dollars to over $1 billion, depending on the extent of the damage.

That said, two significant components of Dow’s strong ESG risk-management score are related to its greenhouse gas emissions program and its renewable energy program. These are obvious areas of interest for Enterprise Products Partners as well, given the significant considerations for its oil and gas businesses. Enterprise is already evaluating renewables investments and plans to source 25% of its internal power needs from renewable sources by 2025.

Hydrogen Business Could Drive Even More Upside

Hydrogen is particularly promising as an avenue to decarbonize economies and enable storage of renewable power. The European Union announced in summer 2020 that it planned to spend potentially $500 billion or more on hydrogen investments, including up to 40 gigawatts of hydrogen power generation by 2030. Hydrogen is attractive as a zero-carbon fuel and a substitute for hydrocarbons to produce electricity via hydrogen-compatible turbines, as well as hydrogen fuel cells, vehicles, and building heating. Nearly all hydrogen produced in the U.S. today is “gray hydrogen,” generated from natural gas. Our own analysis places natural gas usage for hydrogen production at around 4.3 billion cubic feet per day--about 5% of U.S. gas production. Still, costs measured by the levelized cost of hydrogen need to fall significantly to drive further adoption.

We think the potential for most gas pipeline companies is somewhat limited and likely highly specific for individual pipelines that will be able to blend some hydrogen (10%-15%) on an existing gas long-haul pipeline, given that most of the development will be for regional or city hubs for hydrogen and likely more utility-focused. However, all could benefit from adopting renewable hydrogen as a power source for their own operations.

Enterprise Products Partners already produces hydrogen for industrial use and plans to almost double its associated gross operating margin to a midpoint of $1.3 billion in the next few years. Given its extensive assets across every part of the value chain and in all key portions of U.S. energy infrastructure, we think Enterprise could have opportunities to participate in hydrogen marketing and also contribute to local industrial hydrogen clusters. Today, this business is buried in the petrochemical segment, but it could evolve into a significant and distinct component of gross operating margin.