Description

We are in the middle innings of a global energy crisis that will push oil prices higher until an adequate supply response emerges.  While US oil producers have been disciplined thus far, I believe there is room for higher production once a more transparent political backdrop emerges. The catalyst behind this will be Republicans taking control of the Senate in the upcoming Midterms.  As the most prolific US basin, the Permian has already regained record production levels in 4Q21 and, based on my forecast, I project will run out of effective takeaway capacity by YE24.  With almost one-half of its EBITDA derived from Permian pipelines, PAA is the ideal way to play this theme.  Importantly, this excludes any contribution from its S&L business, a direct beneficiary of Permian crude differentials that currently is just breaking-even.  Assuming a return to normalized differentials, my FY22/23/24 EBITDA estimates are 4%/15%/32% above Street, respectively.  Most importantly, this return to mid-cycle profitability could pave the way for a ’24 distribution of $2.40/share, ~200% above current levels.  A ~7% yield target results in a $33 PT (220% upside).  While I believe common units are obviously extremely attractive, deep OTM call options screen as being materially mispriced.  As an example, Jan ‘24 $20/share calls are just trading at $.20, implying a ~60x return potential based on my PT.  It will be time to sell once PAA and other energy MLPs are trending on WSB and Robinhood...we're not quite there yet.

Macro Outlook

Massive covid-driven fiscal stimulus has collided head-on with E&P austerity, creating a global energy shortage.  As shown below, global liquids product stockpiles have just breached 5-year lows. Particularly disturbing are US crude stockpiles:

While Biden’s recent drastic SPR release will serve to quell near-term oil prices, the rest of the crude curve has shifted up as those inventories will eventually need to be replenished.  This is a particularly favorable backdrop for energy equities, as a higher long-term oil prices will be supportive of multiple expansion. 

The cure for high prices is even higher prices; however, despite prices surging back to pre-2014 OPEC price war levels, the US oil rig count remains below pre-covid levels.  

While E&Ps have transformed into a more shareholder friendly (i.e., FCF-generative) business model, there is plenty of cash available for higher-returning incremental drilling opportunities under strip pricing.  So why aren’t they drilling?  I believe the largest impediment to a proper US supply response has been policy uncertainty.  This was just evidenced by Biden’s decision to reduce the SPR to levels last seen in 1984.  Senators Sanders and Warren have also been supportive of a return to a windfall profit tax.  Under this backdrop, it is hardly a surprise that E&P companies are hesitant to increase drilling.

I believe the catalyst to change this behavior will be the November ’22 Midterm elections.  As shown below, Republicans hold a high probability of regaining control of the Senate for Biden’s remaining two years.  With a more balanced Congress, I believe that E&P operators will have more confidence in increasing production.  The primary beneficiaries of this will be US midstream and oilfield service companies.

Investment Thesis

As a primarily crude-exposed US midstream energy company (“MLP”), PAA is one of the best ways to play a resurgence in US oil production.  This is due to the fact nearly half of PAA’s current EBITDA is derived from Permian pipelines (see below), the area which I project to see the fastest production growth within the US given its low-cost nature.  

As shown below, Permian production just recently surpassed its pre-covid highs and now accounts for 44% of total US oil production.  While the majority of the PAA’s Permian exposure is derived via contracted pipelines, I believe the market is underestimating the upside leverage to its S&L business via tighter Permian S/D takeaway balances.

The following analysis juxtaposes my basin-specific US production forecast with a snapshot of Permian takeaway capacity.  As shown, I project mid-’24 Permian production of ~6.9Mn bpd, implying a lack of takeaway capacity by the end of the year.  This will have the obvious impact of increasing inland oil differentials, the biggest driver behind PAA’s S&L segment.

The historical relationship between S&L profitability and various crude benchmarks confirms this relationship.  As shown below, a multivariate regression between EBITDA vs. differentials, contango structure and weekly vol provides a .85 R2 (with differentials having the greatest significance by far).  

What is the upside from normalized differentials?  The following graph provides a snapshot of S&L segment ROIC based on historical / projected differential assumptions.  As shown, I believe Permian diffs will significantly accelerate in 2024 as effective capacity becomes limited again.  Based on my regression, I believe S&L ROIC will approach decade highs.  Importantly, with shares trading at just 8x trailing EBITDA even after assuming no contribution from S&L, I believe that current investors are getting a free call option on S&L’s return to midcycle profitability. 

In summary, the most important driver behind S&L profitability is US crude oil production: higher production increases both the likelihood that takeaway capacity becomes tight and crude structure flipping to contango.  This was confirmed on the latest 4Q21 earnings call by management:

Jeremy Goebel, EVP: “Thanks for the question, Michael. So it's a little bit more nuanced than that. The first 600,000. I think over the next 18 to 24 months on a long-haul basis is that's going to fill MVCs and the ramps on Wink-to-Webster and others. So there is a leverage on the gathering system, which is somewhat market share at the existing tariffs that we have is its largely dedicated barrels. So there is that one such barrel, but anything we can do on the marketing side with quality segregations, pump-overs, that type of business. There is a throughput component and then there is a tariff component, but as we get to leverage, let's say, it's another two years of growth consistent with last year, then you start to get leverage on increasing spreads to the Gulf Coast into markets outside and there is also a volume component to that spot volume. So it's not linear there, it's going to have a certain impact this year and next year, which we view to be a competitive market, but then it gets materially higher as we go through this volume, this tariff, and it's not single touch, it's multiple touch barrels”

EBITDA Bridge

While the major earnings driver will be expanding Permian volumes and differentials, there are several other tailwinds that I believe are supportive of EBITDA upside vs. consensus.  The following analysis provides an EBITDA bridge for my estimates vs. Street.  As shown, while I believe there is slight upside to near-term estimates, this upside “hockey sticks” closer to 2024 as my theme of expanding Permian basis fully plays out.  As a result, my ’24 EBITDA estimate is 30% above Street (+$800Mn).  

I believe the biggest reason why sell-side analysts are assuming minimal EBITDA growth over the next few years is the black box element of the S&L segment (my ’24 EBITDA estimate is ~$800Mn above Street, which is identical to the $764Mn S&L EBITDA improvement I’m forecasting vs. 2021’s break-even levels).  While I do acknowledge the opaqueness of this business, I’m comforted in my above-consensus forecast for two reasons: 

•  After years of declines, EBITDA estimates appear to have finally bottomed in early 2021:

• In addition to increasing the distribution this quarter for the first time since 4Q15, PAA is now repurchasing shares for the first time in its history.  Given the near-death experience the industry experienced over the past few years, I do not believe they would take such a decision lightly:
  

Valuation

In order to normalize for PAA’s high payout ratio, the following table displays PAA’s key valuation metrics assuming no distribution.  As shown, shares are currently trading for an extremely attractive 16% ’22 FCF yield.  To re-emphasize, S&L is still projected to be massively underearning during this period.  Thus, as S&L normalized to mid-cycle profitability, the FCF yield expands to 30%.  On an EBITDA multiple basis, shares trade at just ~7.3x ’22 EBITDA.  For perspective, HAL (a lower quality oilfield service business) is currently trading at 12x run-rate EBITDA.  Simply put, I would expect considerable multiple expansion once the market gains comfort that PAA’s earnings have stabilized.  

While management has maintained a lower distribution payout ratio in recent years to support debt-paydown, I believe the return to a normalized operating environment will pave the way for a distribution in-line with its historical 130-150% coverage ratio guidance.  As shown below, I believe this is supportive of a $2.40 annualized distribution, 175% above current levels.  While this does seem like a substantial increase, note that the distribution was as high as $2.80 in 2016.  A 7.3% yield target (in-line with recent history) results in a YE23 PT of $33/share (220% upside).

Catalyst

Management continuing to increase shareholder return via distribution increases / share repurchases

Republican's regaining control of Senate in '22 Midterms to provide a clearer path for a US oil production response

Positive EBITDA guidance revisions (management already raised FY22 in the 1st quarter)