Midstream Liquidity Concerns Overblown
Operational results will worsen, but most companies should muddle through.
Our analysis of midstream oil and gas companies’ liquidity and investor payouts suggests a few areas for concern, but broadly, we think the industry can muddle through. Wide-moat companies such as Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP), Plains All American Pipeline (PAA), Cheniere Energy (LNG), and Cheniere Energy Partners (CQP) remain well positioned. Gas-focused names such as Energy Transfer (ET) and Kinder Morgan (KMI) should also do well. Williams (WMB) will need to proactively address its maturity issues, given its lack of excess cash flow, but the resilience of its operations should provide a buffer.
On the negative side, we think some entities, including MPLX (MPLX), DCP Midstream (DCP), Energy Transfer, and Oneok (OKE), are under substantial pressure by investors to reduce payouts to more aggressively address high leverage or other business priorities. To be clear, we think the payouts are financially supportable, given our expectations for business results and the entities’ balance sheets, but this environment is potentially offering management sharply higher returns elsewhere, particularly around repurchasing highly discounted debt. We think MPLX, Oneok, and Williams could prioritize upcoming maturities over their payouts, given their lack of near-term excess cash flow generation if further culling near-term capital spending plans is not feasible. For DCP and Energy Transfer, we think the focus on preserving liquidity during a period when near-term results will be more challenging than at any time in the energy markets over the last few decades could force a reckoning.
Not Many Areas of Safety as Focus Shifts to Balance Sheet
Oil prices have crashed as a result of the demand shock from COVID-19 along with the supply shock due to the failure of OPEC+ to reach a new production cut agreement. In response to these events, oil prices initially fell more than 60% and reached the low $20s. We project that 2020 oil demand will fall 2.8 million barrels a day (2.8%), the largest single-year drop in nearly 40 years. Because oil producers cannot adjust overnight, global oil markets are likely to be oversupplied on the order of 3.3 mmb/d in 2020, which dwarfs the excess seen in the 2014-16 downturn.
What does this environment mean for midstream? Ultimately, a focus on protecting the balance sheet and generating excess cash flow (operating cash flow minus distributions/dividends minus capital spending). The focus on liquidity is important because we now expect Permian oil supply to decline following a wave of rig releases by exploration and production companies. While fee-based instead of commodity-based contracts are now the norm, they are exposed to volume declines. We also expect a focus on the balance sheet, since most of our coverage has leverage above 4 times, exposing the space to higher debt costs and liquidity challenges for the weakest players.
Addressing balance sheet and liquidity issues while dealing with struggling customers, where E&P bankruptcies are likely to occur, is a challenge. In response, the midstream industry has cut billions of dollars in capital spending in the past few weeks and in some cases (Targa (TRGP) and DCP) cut distributions and dividends. We expect some creativity on the part of E&Ps to extend contracts for some short-term relief. We see this as more likely for long-haul pipelines in more established basins with less-than-ideal basin economics. In contrast, we think gathering and processing agreements are more likely to be paid, as it is crucial to moving the hydrocarbons to market, with the rather large caveat that the underlying acreage has to be economic to drill. Offsetting these negatives are some positives. Three key areas are significant E&P hedges, minimum-volume contracts that protect near-term volumes, and storage.
Reviewing Dividend and Distribution Security
Broadly, before the collapse in oil prices and the COVID-19 pandemic, we didn’t expect much distribution or dividend growth, given the already extremely high yields across the space. We believe investors want better capital allocation from midstream management teams, which includes restraining payouts and favoring debt reduction, unit buybacks, and more thoughtfulness around growth capital spending. After the oil price collapse, we think the pressure on management teams has only increased, with some entities under more pressure than others to improve outcomes for their investors.
We think the majority of our coverage’s payouts are safe for a variety of reasons. First, looking at excess cash flow and the overall resilience of the business, the payout can be funded with few issues. This would be the case for Kinder Morgan, Energy Transfer, Williams, and Cheniere Energy Partners. Second, in some cases, such as for Magellan and Enterprise Products Partners, the payout has been consistent for decades, and management teams have protected it through several boom/bust cycles. Third, Phillips 66 Partners (PSXP) and MPLX have large corporate parents planning on the cash flows received from each child.
We do see a group that is at risk of cuts, which includes Oneok and DCP Midstream (for a second time). Financially, we believe this group can support current payouts, as project deferments will ease pressure on the claims on the cash the business generates. However, with the yields for the stocks so high, we believe management is under substantial pressure from investors to reallocate cash toward higher-returning areas of the business, such as repurchasing debt or stock/units or ensuring that the business is protected when customers are struggling. These companies have also cut payouts sharply in the past few years, so there is less commitment by management over time to sustaining and increasing payouts. We would characterize the decision to maintain the payout as more of a capital-allocation decision by management as opposed to a financial inability to support it.
Excess Cash Flow and Liquidity Important in Near Term
Most of the companies we cover are generating excess cash flow. Further capital-spending reductions could increase the amount of cash available to devote elsewhere. Alternatively, if conditions worsen and the core business weakens beyond our current estimates, we see a margin of safety before excess cash turns negative. For companies with negative excess cash flow, our forecast implies that some debt refinancing or additional debt will be needed to fund ongoing operations in order to bring accretive projects on line. Midstream entities that are generating substantial excess cash flow in 2020 include Enterprise Products Partners, Plains, Cheniere, Cheniere Partners, Targa, and DCP. Kinder Morgan and Energy Transfer are generating modest excess cash flow in 2020, but this should increase rapidly in 2021 and beyond. While our confidence regarding our near-term estimates varies for some, as Targa and DCP have extreme fair value uncertainty ratings and are at the highest risk of breaching covenants, we think most of this group is well positioned.
Our liquidity analysis, which considers expected cash and credit facility availability and maturities until the end of 2021, does not suggest that any of our midstream coverage will enter financial distress, but some companies need to be more proactive than others. Focusing on our weakest companies, MPLX has a $2 billion maturity in 2021 that could present issues if its credit facility capacity of $3.5 billion were sharply reduced and thus required a payout cut. Oneok has a $1.25 billion maturity in 2021 but over $3 billion in liquidity to address it, though it will be sapped somewhat by its $2.2 billion in cash outflows over the same time frame, requiring it to consider other options, include reducing payouts or spending. Similarly, Williams will need to proactively address its $3 billion in near-term maturities, even considering its $4.9 billion in liquidity, given its nearly $800 million in expected cash burn over the same time frame. Equitrans (ETRN), DCP, and Targa do not have material maturities, in our view.
European Storage Is Key for the More Defensive Gas Names
We view the more defensive midstream gas companies as Energy Transfer, Kinder Morgan, Williams, and the Cheniere entities. Falling oil prices will put substantial near-term pressure on Permian producers to curtail oil production, and the recent drop in active rigs shows producers are already responding. With Permian oil volumes at risk, a substantial decline in associated gas production from the Permian is likely, as Permian oil producers are indifferent to gas prices because they do not drive well economics. However, this supply shock is being met with a virus-driven LNG demand shock.
With Asian and European liquefied natural gas prices reaching multidecade lows, the market is clearly struggling with oversupply. We think the key area to watch in the near term is European storage levels. China is beginning to take U.S. LNG cargoes now that it has allowed for tariff exemptions, but it remains unclear if Chinese demand can pick up enough to offset weaker European demand in the short run. With European power demand down 15%-20% across a number of countries, we expect storage levels to increase in the near term as U.S. gas will flow, given the nature of U.S. LNG contracts. U.S. LNG feedstock demand has been essentially unchanged at 9.4 billion cubic feet per day in recent weeks.
In a scenario where European storage is full, we would expect several market developments. First, the end customers are likely to cancel cargoes ahead of the 60-day notice period and still pay Cheniere fees, given the physical storage limitations. Second, while Cheniere has long-term supply contracts with multiple producers to ensure a steady supply of gas to its terminals, we would expect to see discussions about deferring or shutting in gas production on a short-term basis. We think producers would be open to these discussions to rightsize the market quicker and obtain better gas prices when European LNG demand recovers, especially if storage logistics constraints arise. We could see some kind of shared economics on a temporary basis for canceled cargoes between the producer and Cheniere’s marketing arm, particularly given the multidecade relationships already contracted in place. We still do not expect to see successful force majeure declarations by LNG customers, given the technical requirements associated with this effort.
Storage Is a Key Winner; Plains the Biggest Beneficiary
One important area that will benefit in this difficult environment is Cushing oil storage, as West Texas Intermediate crude is now in contango. Current prices allow storage traders to buy crude at about $22/barrel in May and potentially offload it in June 2021 for closer to $36/barrel. This situation means that oil storage is incredibly valuable in this environment, particularly the 76 million barrels of working storage at Cushing. At the end of February, oil in storage at Cushing was just 37 million barrels, less than 50% utilization. Just over 2 million barrels of oil have been added to storage since then, and we expect that to increase sharply. In turn, storage rates at Cushing have more than doubled to $0.50/barrel from $0.20 over the same time frame. Even at those rates, traders could clear at least $7/barrel profit, as storage costs would be $7/barrel to capture a $14 spread.
The largest owners of storage at Cushing are Plains All American (about 25 million barrels), Enbridge (20 million barrels), and Magellan (12 million barrels), which make up the majority of capacity. Enterprise Products Partners also owns 37 million barrels of storage, though we believe only a fraction (about 3 million barrels) is at Cushing, so it should benefit as well. In total, Plains owns about 79 million barrels of storage, and Magellan has about 20 million barrels of contract storage. We estimate the upside opportunity assuming similar rates across all storage options would mean an incremental $284 million in EBITDA for Plains, $133 million for Enterprise Products Partners, and $72 million for Magellan.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.