Description

Summary

The thesis for EPD is simple. 

1. Regulation and ESG mandates have made the economics and political viability of new, large-scale pipeline buildouts questionable at best. It is unlikely there is a deluge of new pipeline supply coming online in the near future.

2. Inflation makes assets in the ground more valuable, as new-build capex has to be done with inflated dollars and a higher cost of capital.

3. This makes these assets more valuable, and operators can charge higher prices for their services. Many pipeline companies operate specialized assets that ship refined product to a variety of destinations, giving their customers flexibility to ship to end markets with the best price.

4. The industry has rationalized since last decade, and capital expenditure in the industry is collapsing (other than maintenance capex) for reasons mentioned. 

5. The Russian invasion of Ukraine has caused a significant spike in the price of hydrocarbons, and US producers will likely drive incremental volume from here.

6. All this adds up to more free cash flow and dividends per share: little to no additional pipeline supply, inflation increasing hurdle rates for new pipelines, the ability to raise prices, a strong network effect, and increasing throughput volumes. 

Thesis

Pipelines are undergoing a renaissance today, but it’s not the one you think. The previous renaissance of shale oil and natural gas development was anything but a good outcome for this industry. Capital-intensive industries, contrary to common opinion, don’t benefit from increased demand for their product. Increased demand attracts competition. In capital-intensive businesses it is very difficult to increase your capacity just a little. These industries don’t work that way, and here is why: Larger investments bring lower costs on a per-unit basis. But when everyone does this it also brings lower prices (revenues) per unit.

To make things more complicated, the pipeline industry is structured as master limited partnerships (MLPs). MLPs are mostly owned by retail investors who hold them to get one shiny object – yield. These companies generate enormous cash flows, while maintenance capital expenditures – basically, the expenses of maintaining their pipelines – are relatively small (10-20% or so of their cash flows).

To grow cash flows, once a company has an established pipeline network, it can do any number of things: It can raise prices for transporting products in its pipelines. It can make small investments to improve the interconnectivity of its pipelines, thus increasing the value of the pipelines to its customers, which also brings higher prices. It can send more products through its pipelines (of course, they are limited by capacity). There are probably a few other small things it can do, and we are sure these companies did them. A company can also do big things – build new pipelines, for instance. Improvements in oil and natural gas extraction technologies brought an enormous amount of petrochemicals to the surface, and they need to be transported.

Here is the problem. Since their investors were attracted to dividends, these companies would pay out most of their cash flows in that form, and whatever cash flows were left they’d put into new projects; but those cash flows were not enough, so… yes, they’d borrow a lot of money. But even borrowing was not enough, so they would pay large dividends and then issue shares (MLP units). They’d pay 6% dividends and then turn around and issue 3% of new shares. Retail investors were delighted to collect 6%, ignoring the fact that the pie now needed to be shared with 3% more shareholders.

From 2008 to 2014 none of those things mattered. Investors infatuated with high and rising dividends drove prices of these companies higher in a straight line. This party ended in 2014, when lower oil prices exposed overcapacity in the industry.

That is not the renaissance we are referring to.

The renaissance of today is one of cash generation. The pandemic and low commodity prices increased uncertainty in the industry, and pipeline companies stopped investing in new projects and have thus been generating enormous cash flows. In our conversations with these companies we learned that this trend did not start in 2020 but a few years back, as their shareholder base changed from retail to institutional investors. They generate cash flows and then decide what is the best use for the cash, after they pay a reasonable dividend. We’ll come back to how the war in Ukraine impacts these businesses. 

We spent a lot of time analyzing pipelines in January 2020. Two companies stood out back then: Magellan Midstream (MMP) and Enterprise Products (EPD). However, at the time we decided to do nothing – they were not cheap enough. Today, they are.

This writeup will focus on EPD.

Enterprise Products (EPD) is the largest pipeline company in the US. Its main focus is on natural gas (predominantly NGLs). Size is important in this industry. Pipelines are networks that connect producers with refineries and transportation hubs. As prices vary at various points, flexibility of this network allows producers to send their commodities to the points where they’ll get paid the most. Also, 89% of EPD’s revenue is from fees for services (take or pay contracts). We like EPD’s exposure to natural gas and natural gas liquids, because most of these products are used in manufacturing (plastics) and the generation of electricity.

EPD was not shy about spending money on new pipelines over the last five years, but neither was it shy about issuing new units (this was another reason for our initial hesitation about the company in early 2020). 

EPD recently announced that it is slashing its capital expenditures to $1.85 billion from $4.5 billion in 2019. EPD’s free cash flow  per share (operating cash flow less capital expenditures) is due to increase from about $1 in 2020 to as much as $2.75 around 2024.

As MLPs, the vast majority of this cash will come back to us in the form of dividends. But there’s more good news: the unit growth has reversed, as EPD has put a $2 billion buyback in place, roughly a quarter of which has been deployed as of March 31, 2022. 

Is EPD funding all this free cash flow with debt? Far from it. EPD management has made a conscious effort at becoming fully self-funding, in the sense that they can fund all their liabilities, including capex, dividends, and debt service from operational cash flow. If EPD has around $5 billion of run rate free cash flow (conservatively speaking), they’ll be able to pay off debt maturities with free cash from now until 2077 (at which point we admittedly start to become worried). See chart from Capital IQ below.

Overall, we believe that the war in Ukraine, while tragic, will ultimately be accretive to pipeline companies like EPD. The war has taken a substantial amount of oil out of circulation, at least to the vast majority of Western markets. The resulting price spike in hydrocarbons, as well as energy security and independence concerns, will drive American E&P companies to “drill baby drill”. Furthermore, natural gas (and its derivatives) have become a mature product of their own. All this will be accretive to EPD as they help their customers send product to refining and consumption markets across the country.

Our confidence in EPD is boosted by the fact that a third of EPD units are owned by the Duncan family (Dan Duncan, EPD’s founder, died in 2010). The Duncans have been a significant buyer of EPD stock lately, and it’s not in their interest to be overly diluted. 

Over the next four years we’ll collect around $8 per share or more in dividends. The stock should be trading at 15 times free cash flows, or about $40. Add dividends, and over four years EPD is worth $48 to us, give or take. 

At a current price of $24, the stock is attractive.

Catalyst

Energy inflation

Higher cost of capital

Low new build capex from competitors