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Weekender 100518 - Plaguing Midstream.pdf
1. Please see page 7 for rating definitions, important disclosures and
required analyst certifications. All estimates/forecasts are as of 10/05/18
unless otherwise stated. 10/04/18 17:20:49 ET
Wells Fargo Securities, LLC does and seeks to do business with companies covered
in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of the report and
investors should consider this report as only a single factor in making their
investment decision.
October 5, 2018 | Equity Research
Weekender: What's Plaguing Midstream?
What's Plaguing Midstream Now? Besides questions on NGL
fundamentals, the most popular question we receive from investors
goes something like this. “Fundamentals for midstream are better than
anytime I can remember in my career, so why is this not translating
into stock performance?” As if you need reminding, the AMZ is up only
1.6% for the year, compared to 8.5% for the S&P 500, 17.1% for the
S&P E&P index, and 1.6% for the OSX. So what exactly is plaguing
midstream performance?
Our Take On Continued Lagging Performance. There’s still an
overall lack of rotation among generalist investors to energy. When you
have large-cap tech stocks growing at 20%+ CAGRs, it becomes more
difficult to rotate into a sector that (despite very strong fundamentals)
is “only” growing at a 5-10% rate. As a reminder, only 6% of the S&P
500 is made up of energy. Once we see broader rotation into energy,
we think midstream should follow. Other reasons for the lackluster
performance include overhang from the Colorado ballot initiative, higher
interest rates, more simplifications (investors are waiting for these to
be over). Lastly, there’s a concern among some investors that
midstream will ultimately not show capital discipline. (More on these
items below).
Our Outlook. To be clear, we’re bullish midstream as we believe
fundamentals will ultimately rule the day. We view current EV/EBITDA
multiples for the sector as, by and large, fair so we are not arguing for
multiple expansion per se. Instead, we believe fundamentals will drive
earnings beats and EBITDA forecasts will be revised higher. The other
path to outperformance is a reversion to a more yield-based valuation,
which could occur if retail returns to the sector and/or once yields
stabilize (i.e. distribution cuts cease via simplification, etc.). We’d also
note that once fund flows to the sector pick up, this should propel
valuations higher as equity issuance in the space has significantly
diminished. For example, we forecast total midstream sector equity
issuance of $4.7B and $2.8B for 2019 and 2020, respectively,
compared to an average of $36.7B per year for 2014-2018. This
suggests it could take much less fund flows to drive higher price
performance than in the past. See Exhibit 1.
Continued inside.
Midstream/MLPs
Michael Blum
Senior Analyst|212-214-5037
michael.j.blum@wellsfargo.com
Praneeth Satish
Senior Analyst|212-214-8056
praneeth.satish@wellsfargo.com
Sharon Lui, CPA
Senior Analyst|212-214-5035
sharon.lui@wellsfargo.com
Ned Baramov, CFA
Senior Analyst|212-214-8021
ned.baramov@wellsfargo.com
Eric Shiu
Associate Analyst|212-214-5038
eric.shiu@wellsfargo.com
Mac Hanson
Associate Analyst|212-214-8012
mac.hanson@wellsfargo.com
2. Midstream/MLPs Equity Research
2 | Wells Fargo Securities, LLC
Blame It On Interest Rates? Some investors have blamed recent lackluster performance on rising
interest rates. Since 12/31/17, the ten year treasury yield has increased by 75 basis points to 3.16%
from 2.41%. Perhaps. In the past, all the correlation data we’ve run over time suggests that the
relationship between interest rates and MLPs is just not that strong. Please see Exhibit 2. However, we
note that the correlation with interest rates has strengthened this year (i.e. -0.65 YTD vs. -0.05 over
the past three and five years. Year to date, there has been three fed funds rate hikes (i.e. 75 basis
points to a target range of 2.0-2.25%) and the market expects more increases this year. Relative to
previous years, the pace of rate hikes has certainly picked up in 2018, which may be a factor impacting
midstream performance.
The Cleanup Continues. In the past few weeks, ENB announced revised terms to acquire SEP, EEP
and EEQ. D announced plans to acquire DM. AMID announced an offer from sponsor ArcLight to be
taken private. StoneMor Partners (STON) announced plans to convert to c-corp. The march towards a
simpler, more consolidated midstream space continues. We’re still waiting on simplification from
AM/AMGP, ENLK/ENLC, EQGP/EQM and WGP/WES. Other cleanup trades include: MPLX merging with
ANDX, TRP possibly acquiring TCP, and BPL cutting its distribution. Finally, some GP IDR elimination
deals are likely in the mix: DCP, PSXP, SHLX and VLP among others. The sooner, the better for all of
these, is our opinion. The faster we can get to a streamlined, simplified sector, the better the chance
for outperformance, in our view.
The Other Cleanup. Assuming all the aforementioned transactions occur, the sector would be much
improved. But we’d still be left with a significant number of small cap MLPs that don’t seem to have a
place in institutional investor portfolios. Specifically, we count 10 small cap MLPs that sport double digit
yields. For most all of these companies, distributions seem secure, balance sheets are in decent shape,
business fundamentals are fine; in other words, they are not trading at high yields due to structural or
fundamental concerns. Rather, the market is pricing their equity at what we would consider untenable
levels with cost of capitals that are simply too high. What happens to these stocks? If we argue that
the issue is merely one of size and liquidity, this would argue for consolidation. But that’s much easier
said than done. Another option (suggested by a client) is for these MLPs to voluntary reduce their
distributions (as the market is clearly not properly valuing the cash flow) and re-direct that cash flow
towards stock buy backs. Interesting idea, but that only exacerbates the size and liquidity issue.
Perhaps what this is really arguing for, is more take private deals since slowly buying back your market
cap every year is basically slowly taking the company private. Food for thought.
Capital Discipline Is A Worry Point. One risk investors consistently point to is capital discipline.
Midstream companies have been more disciplined of late, both in terms of selling non-core assets,
minimizing or eliminating equity issuance, and only doing growth projects with contractual
commitments and adequate returns on investment. But will this last? And will companies learn to live
within cash flow? The more time that passes with midstream companies executing on this strategy, the
more comfortable investors will feel.
Colorado Feedback. Our note (“Midstream: CO Elections A Pot'l Setback?” dated 9/24/18)
highlighting the potential risk to Colorado-exposed companies elicited some strong feedback. To
summarize, the main points of pushback were: (1) The note was unnecessarily alarmist and
overblown; (2) A 50% probability weighting was too high; (3) We didn’t highlight offsetting factors
(like lower Colorado production could drive higher commodity prices and some companies could divert
rigs to other basins [like the Permian], which would offset a potential decline in volumes); (4) We
didn’t differentiate Colorado exposure between the DJ and the Piceance, the latter being in a more
rural area and thus, potentially less impacted by a change in legislation.
Our Approach To Colorado. Points 3 & 4 seem valid and could have been included in our original
note – though we’d note that the Permian is constrained across multiple commodities/frac capacity and
so increasing growth in that basin in the near-term seems challenging. As for points 1 & 2, we simply
did not want to be complacent heading into November 6. Much of the industry (including us) was
complacent heading into the FERC ruling earlier this year. November 6 is the election vote – since we
have no edge on the outcome here- we assumed 50/50. The polls range from 40-60% on both sides. If
Proposition 112 passes, we think CO-exposed stocks could fall to the valuation targets that we
calculated under our low case scenario. There is a gap of at least two months between when the
election takes place and the CO legislature comes into session (Jan 4th
). Therefore, if Prop 112 goes
through, the CO-stocks are going to discount the worst case initially due to the uncertainty. Once the
general assembly convenes in January, we think there’s a good chance Prop 112 would be softened,
but it’s unclear how Prop 112 would be changed and the timing of any changes. Assuming Prop 112 is
3. Weekender: What's Plaguing Midstream? Equity Research
Wells Fargo Securities, LLC | 3
softened, we agree that CO-stocks could potentially rally off the lows. But it should be shoot first and
ask questions later. We realize not all investors agree with our approach but we very much value the
feedback and thought it was the prudent path.
Investor Topics
Continued ETE underperformance post simplification announcement
TRP Coastal GasLink announcement
DCP preferred offering
Prop 112 and Colorado-exposed names
Outlook on propane MLPs (e.g. margin given higher propane prices, market share commentary on
FGP’s earnings call)
Model Requests
APU
DCP
ENLC
ENLK
EPD
EQGP
EQM
ETP
KMI
NBLX
PAA
SHLX
SPH
Exhibit 1. Historical And Projected Equity Capital Issuance
$5.3
$9.2
$12.0
$5.9 $4.9
$14.1
$18.1
$31.4
$37.7
$40.5
$31.7
$22.3
$33.2
$16.4
$2.2 $2.3 $2.0 $2.2 $2.3
$0.4
$0.2
$2.7
$3.1
$2.8
$1.2
$1.3
$3.0
$6.4 $2.0
$9.2
$12.0
$9.6
$6.7
$2.4
$0.5 $0.0 $0.0 $0.0
$5.7
$9.4
$14.7
$9.1
$7.6
$15.3
$19.4
$34.4
$44.1
$42.6
$40.9
$34.3
$42.8
$23.1
$4.7
$2.8
$2.0 $2.2 $2.3
$0
$10
$20
$30
$40
$50
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018E 2019E 2020E 2021E 2022E 2023E
$
in
Billions
MLP Equity Issuance C-Corp Equity Issuance
Source: Partnership reports and Wells Fargo Securities, LLC estimates
6. Midstream/MLPs Equity Research
6 | Wells Fargo Securities, LLC
MLP Glossary Of Terms
Available Cash Flow: Available cash flow is the cash flow available to
the common unitholders and the general partner.
Backwardation: A market condition in which future commodity prices
are lower than spot prices. A backwardated market usually occurs when
demand exceeds supply.
Contango: A market condition in which future commodity prices are
greater than spot prices. The higher future price is often due to the cost
associated with storing and insuring the underlying commodity.
British Thermal Unit (Btu): A unit of measurement for energy
representing the amount of heat required to raise the temperature of
one pound of water one degree Fahrenheit.
Current Yield: The current yield is calculated by taking the current
declared quarterly distribution annualized and dividing it by current stock
price.
Dekatherm: A dekatherm is a measurement of energy content. One
dekatherm is the approximate energy content of 1,000 cubic feet of
natural gas (or 1 Mcf).
Distributable Cash Flow (DCF): DCF is the cash flow available to be
paid to common unitholders after payments to the general partner.
Distribution (Dividend) Discount Model (DDM): DDM is an equity
valuation tool used to estimate the present value of a stock based on the
expected distributions (or dividends/future cash flow) received from the
company.
Distribution: In a typical partnership agreement, the MLP is required to
distribute all of its “available cash.” MLPs typically distribute all available
cash flow (i.e. cash flow from operations less maintenance capex) to
unitholders in the form of distributions (similar to dividends). However,
management typically has some discretion in how much cash flow they
choose to pay out.
Distribution Coverage Ratio: The coverage ratio indicates the cash
available for distribution for every dollar to be distributed. The ratio is
calculated by dividing available cash flow by distributions paid. Investors
typically associate the coverage ratio as the “cushion” a partnership has
in paying its cash distribution. In this context, the higher the ratio, the
greater the safety of the distribution.
Dropdown: A dropdown is the sale of an asset from the parent
company (or sponsor company) to the underlying partnership.
Dropdowns can also be defined as a transaction between two affiliated
companies.
Earnings Before Interest, Taxes, Depreciation and Amortization
(EBITDA): EBITDA is a non-GAAP measure used to provide an
approximation of a company’s profitability. This measure excludes the
potential distortion that accounting and financing rules may have on a
company’s earnings; therefore, EBITDA is a useful tool when comparing
companies that incur large amounts of depreciation expense because it
excludes these non-cash items which could understate the company’s
true performance.
Earnings Per Unit (EPU): An MLPs’ EPU is synonymous with a C corp.’s
earnings per share (EPS). EPU is calculated by dividing net income
allocated to the limited partners divided by the weighted average units
outstanding at the end of the period.
EBITDA Multiple: An EBITDA multiple is the expected return an
acquisition or organic growth project is estimated to generate. For
example, a $100 million investment at an 8x EBITDA multiple, would be
expected to generate approximately $12.5 million of EBITDA on an
annual basis (or a 12.5% return).
Excess Cash Flow: Excess cash flow is the cash flow that remains after
distributions have been paid to common and subordinated unitholders
and general partner.
Fractionation: Fractionation is the process that involves the separation
of the NGLs into discrete NGL purity products (i.e. ethane, propane,
normal butane, iso-butane, and natural gasoline).
Frac Spread (also known as “Processing Margin”): The processing
margin is the difference between the price of natural gas and a
composite price for NGLs on a BTU-equivalent basis.
General Partner (GP): The GP (1) manages the day-to-day
operations of the partnership, (2) generally has a 2% ownership stake
in the partnership, and (3) is eligible to receive an incentive distribution
(through the ownership of the MLPs’ incentive distribution rights).
Incentive Distribution Rights (IDRs): IDRs allow the holder
(typically the general partner) to receive an increasing percentage of
quarterly distributions after the MQD and target distribution thresholds
have been achieved. In most partnerships, IDRs can reach a tier
wherein the GP is receiving 50% of every incremental dollar paid to the
LP unitholders. This is known as the 50/50 or “high splits” tier.
Limited Partner (LP): The LP (1) provides capital, (2) has no role in
the MLPs’ operations or management, and (3) receives cash
distributions.
Liquid Petroleum Gases (LPGs): LPGs are created (as a byproduct)
during the refining of crude oil or from natural gas production. LPGs are
typically a mixed form of propane and butane.
Maintenance Capital Expenditures (Capex): Maintenance capex is
the investment required to maintain the partnership’s existing assets.
Natural Gas Liquids (NGLs): NGLs are extracted from the raw
natural gas stream into a liquid mix (consisting of ethane, propane,
butane, iso-butane, and natural gasoline). The NGLs are then typically
transported via pipelines to fractionation facilities.
Organic Growth Capital Expenditures (Capex): Organic growth
capex is investments used to expand a company’s operating capacity or
operating income over the long-term.
Processing: Natural gas processing involves the separation of raw
natural gas into “pipeline quality” gas and natural gas liquids.
Tax Deferral Rate: A percentage of the cash distribution to the
unitholder that is tax deferred until the security is sold. The tax deferral
rate on distributions ranges from 40-90%. The tax deferral rate is an
approximation provided by the partnership and is only effective for a
certain period of time.
Energy Industry Abbreviations
Bbls: Barrels
Bcf/d: One billion cubic feet per day
MBtu: One thousand Btus.
Mcf: One thousand cubic feet of natural gas.
MBbls: One thousand barrels.
MBbls/d: One thousand barrels per day.
MM: In millions.
MMBbls: One million barrels.
MMBbls/d: One million barrels per day.
MMBtu: One million Btus.
MMBtu/d: One million Btus per day.
MMcf: One million cubic feet of natural gas.
MMcf/d: One million cubic feet of natural gas per day.
Tcf: One trillion cubic feet of gas.
7. Weekender: What's Plaguing Midstream? Equity Research
Wells Fargo Securities, LLC | 7
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Research are rated Underperform.
Wells Fargo Securities, LLC has provided investment banking
services for 19% of its Equity Research Underperform-rated
companies.
8. Midstream/MLPs Equity Research
8 | Wells Fargo Securities, LLC
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![Midstream/MLPs Equity Research
2 | Wells Fargo Securities, LLC
Blame It On Interest Rates? Some investors have blamed recent lackluster performance on rising
interest rates. Since 12/31/17, the ten year treasury yield has increased by 75 basis points to 3.16%
from 2.41%. Perhaps. In the past, all the correlation data we’ve run over time suggests that the
relationship between interest rates and MLPs is just not that strong. Please see Exhibit 2. However, we
note that the correlation with interest rates has strengthened this year (i.e. -0.65 YTD vs. -0.05 over
the past three and five years. Year to date, there has been three fed funds rate hikes (i.e. 75 basis
points to a target range of 2.0-2.25%) and the market expects more increases this year. Relative to
previous years, the pace of rate hikes has certainly picked up in 2018, which may be a factor impacting
midstream performance.
The Cleanup Continues. In the past few weeks, ENB announced revised terms to acquire SEP, EEP
and EEQ. D announced plans to acquire DM. AMID announced an offer from sponsor ArcLight to be
taken private. StoneMor Partners (STON) announced plans to convert to c-corp. The march towards a
simpler, more consolidated midstream space continues. We’re still waiting on simplification from
AM/AMGP, ENLK/ENLC, EQGP/EQM and WGP/WES. Other cleanup trades include: MPLX merging with
ANDX, TRP possibly acquiring TCP, and BPL cutting its distribution. Finally, some GP IDR elimination
deals are likely in the mix: DCP, PSXP, SHLX and VLP among others. The sooner, the better for all of
these, is our opinion. The faster we can get to a streamlined, simplified sector, the better the chance
for outperformance, in our view.
The Other Cleanup. Assuming all the aforementioned transactions occur, the sector would be much
improved. But we’d still be left with a significant number of small cap MLPs that don’t seem to have a
place in institutional investor portfolios. Specifically, we count 10 small cap MLPs that sport double digit
yields. For most all of these companies, distributions seem secure, balance sheets are in decent shape,
business fundamentals are fine; in other words, they are not trading at high yields due to structural or
fundamental concerns. Rather, the market is pricing their equity at what we would consider untenable
levels with cost of capitals that are simply too high. What happens to these stocks? If we argue that
the issue is merely one of size and liquidity, this would argue for consolidation. But that’s much easier
said than done. Another option (suggested by a client) is for these MLPs to voluntary reduce their
distributions (as the market is clearly not properly valuing the cash flow) and re-direct that cash flow
towards stock buy backs. Interesting idea, but that only exacerbates the size and liquidity issue.
Perhaps what this is really arguing for, is more take private deals since slowly buying back your market
cap every year is basically slowly taking the company private. Food for thought.
Capital Discipline Is A Worry Point. One risk investors consistently point to is capital discipline.
Midstream companies have been more disciplined of late, both in terms of selling non-core assets,
minimizing or eliminating equity issuance, and only doing growth projects with contractual
commitments and adequate returns on investment. But will this last? And will companies learn to live
within cash flow? The more time that passes with midstream companies executing on this strategy, the
more comfortable investors will feel.
Colorado Feedback. Our note (“Midstream: CO Elections A Pot'l Setback?” dated 9/24/18)
highlighting the potential risk to Colorado-exposed companies elicited some strong feedback. To
summarize, the main points of pushback were: (1) The note was unnecessarily alarmist and
overblown; (2) A 50% probability weighting was too high; (3) We didn’t highlight offsetting factors
(like lower Colorado production could drive higher commodity prices and some companies could divert
rigs to other basins [like the Permian], which would offset a potential decline in volumes); (4) We
didn’t differentiate Colorado exposure between the DJ and the Piceance, the latter being in a more
rural area and thus, potentially less impacted by a change in legislation.
Our Approach To Colorado. Points 3 & 4 seem valid and could have been included in our original
note – though we’d note that the Permian is constrained across multiple commodities/frac capacity and
so increasing growth in that basin in the near-term seems challenging. As for points 1 & 2, we simply
did not want to be complacent heading into November 6. Much of the industry (including us) was
complacent heading into the FERC ruling earlier this year. November 6 is the election vote – since we
have no edge on the outcome here- we assumed 50/50. The polls range from 40-60% on both sides. If
Proposition 112 passes, we think CO-exposed stocks could fall to the valuation targets that we
calculated under our low case scenario. There is a gap of at least two months between when the
election takes place and the CO legislature comes into session (Jan 4th
). Therefore, if Prop 112 goes
through, the CO-stocks are going to discount the worst case initially due to the uncertainty. Once the
general assembly convenes in January, we think there’s a good chance Prop 112 would be softened,
but it’s unclear how Prop 112 would be changed and the timing of any changes. Assuming Prop 112 is](data:image/gif;base64,R0lGODlhAQABAIAAAAAAAP///yH5BAEAAAAALAAAAAABAAEAAAIBRAA7)