Description

I recommend a long position in Plains All American Pipeline (“PAA”). This idea is based on two assumptions.

1.       Global crude oil demand will continue to grow through 2030+ and after peaking will decline slowly thereafter.

2.       The Permian basin’s position on the global cost curve is low enough that crude prices will incentivize some level of Permian basin growth for several years to come.

PAA offers a compelling investment opportunity right now for three reasons that are not being properly discounted.

1.       Permian Franchise: PAA has the strongest Permian basin franchise of any company in the space. This Permian exposure is currently viewed by the market as a liability due to fierce competition creating an EBITDA “cliff” for long haul recontracting. However, this cliff represents a one time EBITDA hit, while PAA’s full value chain participation and scale in the Permian is an asset that will create value for shareholders for years to come.

2.       2020 Funding Gap: 2020 will be a “rebuilding year” with meaningful capital spend for projects that do not come online until 2021. However, management has the balance sheet in great shape and project returns will likely surprise to the high side as they predominantly consist of joint ventures with customers who are participating in project returns.

3.       Management’s Newfound Discipline: After back to back distribution cuts, the market has no faith in PAA management. However, over the past two and a half years management rediscovered financial discipline as leverage has fallen precipitously and fee based returns on incremental capital invested have increased dramatically.

Permian Franchise

PAA woke up at the beginning of the shale revolution with a significant asset base in the Permian basin, and they leveraged that existing asset base into an unparalleled franchise. A few key points:

1.       >2 million acres are dedicated to PAA’s system under multi year agreements (many life of lease) meaning all production from that acreage will flow through PAA’s pipes, and upon renewal, PAA will have a competitive advantage with steel in the ground to recontract that acreage.

2.       PAA’s Permian system runs from wellhead to market providing “full value chain” economics. In other words, PAA earns multiple tariffs on each barrel on its system. This is a key competitive advantage allowing PAA to “win” projects will still meeting return thresholders. PAA can charge lower gathering fees to earn an acreage dedication because they will also earn an intra-basin fee, a long haul fee, and potentially a terminal fee on those barrels that their competitors will not.

3.       PAA is the first purchaser of 725kb/d in the Permian (and another 400kb/d in other basins). These volumes form the foundation of PAA’s Supply and Logistics segment (“S&L”). The S&L segment has gotten a bad reputation over the past few years due to the unpredictability of the cash flows. However, to focus on S&L EBITDA is missing the point. While S&L generates great cash flow ($5.4bn cumulative over the past 10 years), it is also a strategic weapon in competing for fee based volume. The producer relationships, market intel, and incremental margin opportunities are a large part of why PAA has been able to leverage is legacy Permian asset base into the leading franchise it is today. And it is why going forward, PAA will continue to be able to win projects and earn solid returns on capital, while others will struggle.  

The aforementioned advantages are currently being overshadowed by an alternative narrative: competition and pipeline overbuild are driving a race to the bottom on long haul fees. This alternative narrative, although overstated, has the advantage of being partially true. There is too much long haul pipeline capacity currently under construction. These new pipes are large and are underpinned by fees significantly lower than fees currently being charged. A reasonable rule of thumb is that the average EBITDA/bbl for existing long haul pipes out of the Permian to the USGC is ~$2/bbl. New pipes are being built with fees providing <=$1.25/bbl of EBITDA. As contracts roll off existing pipes, those volumes will either move to spare capacity on new pipelines with lower fees, or more likely, will demand a fee low enough to incentivize them to stay put. To see where this headed, we can look at what happened last time there was too much pipeline capacity out of the Permian. This was prior to the shale boom when Permian production was <1mmb/d and declining. The pipelines from that era (e.g. PAA’s Basin) competed fees down to ~90c/bbl which would generate ~75c/bbl of EBITDA.

So yes, there is an EBITDA cliff coming; however, my contention is that this is a quantifiable, one time event. The table below lays out how I see the sustainable earning power of PAA’s existing Permian business based on estimates of long term sustainable fees. I just explained my basis for the long haul EBITDA/bbl. Intra-Basin and Gathering EBITDA/bbl will vary widely from less than 25c/bbl to almost $1/bbl depending on specific circumstances. 25c/bbl is the low end of what I have heard anecdotally, and I feel comfortable leaning on those figures here.

Using the above calculated sustainable Permian based EBITDA, we can calculate an estimate of PAA’s Transportation EBITDA being generated by the combination of Permian Overearning and Other Basins. Below I have tried to break out a conservative estimate of Permian’s Overearning EBITDA. After taking into account the $85mm of EBITDA step down in 2020 due to a decrease in high margin spot long haul volume, I estimate another $400mm of Permian Overearning EBITDA that is at risk as contract start to roll off “several years” from now. This estimate assumes that the average fee/bbl for all of the estimated non-Basin long haul volume steps down by $1/bbl. In addition, I assume that 50% of the Q319 Intra Basin/Gathering volume steps down by 10c/bbl, an estimated 29% average fee reduction.

Other Transportation

The above estimates leave $622mm of Transportation EBITDA generated by Other Basins. This bucket includes a mix of long haul pipes such as Saddlehorn, White Cliffs (DJ Basin), Diamond, Red River, Canadian crude and NGL lines, Eagle Ford JV with EPD, among others. Many of these long haul pipes include upstream gathering assets and are supported by PAA’s marketing business. While there are standouts and laggards amongst the bunch, as a whole, this piece of EBITDA should represent a stable source of cash flow going forward with potentially low single digit base volume declines offset by accretive growth projects.

Facilities

Similar to the “Other Transportation” bucket I just described, this segment has some strong assets and some weaker assets. I would note that most of the pain to be felt in the segment, has already been incurred. There have been meaningful dropoffs in natural gas storage and crude by rail. In addition, since the 2015 downturn, several assets have been sold.

The three gems are Cushing, Patoka, St. James. The demise of Cushing has been greatly exaggerated over the years. Local refinery demand and connectivity to multiple basins and demand centers ensures that this asset will be well utilized for years to come. Furthermore, PAA’s position at the Cushing hub is unique in its scale and connectivity. If storage utilization ever did start to drop, PAA’s tanks would be the last ones full. St. James is a burgeoning export hub and will benefit from Capline reversal coming online in 2021. Storage capacity has increased by almost almost 4x over the past 10 years. Capline serves as a supply source for the Midwest refinery base and a way station for Canadian crude imports. I estimate these three terminals account for >30% of the Facilities segment EBITDA.

In addition, the Facilities segment houses meaningful Canadian NGL EBITDA. Plains Midstream Canada is a large competitor of PPL and KEY in the Canadian NGL value chain. The positive industry fundamentals for Canadian NGLs is illustrated by the double digit EBITDA multiples those companies command.

Supply and Logistics

This segment has generated huge amounts of cash flow over the past 10+ years. 2020 will be a lean year as basis differentials collapse due to new pipelines coming in service. However, in addition to the strategic value described earlier, this segment provides a material but somewhat unpredictable cash flow stream. In my valuation I have taken an average the past four years EBITDA and applied a 5 to 6x multiple to get a total valuation of $1.6bn to $1.9bn. From 2008 to 2019, this segment will have generated $5.3bn of EBITDA. The near term outlook is poor, but there will be undoubtedly be opportunities for this segment to monetize in the future, and I suspect that this is one area where my valuation is over conservative.

2020 Funding Gap

In 2020, PAA has a $1.65bn expansion capital program to fund and will only retain ~$500mm of cash flow after distributions. Mgmt has indicated an expected $100mm in divestitures leaving a ~$1.0bn funding gap. Prior to 2015, this would have been par for the course. But with the equity markets closed, and investors focused on leverage ratios, this is a big number. Fortunately, mgmt. has made significant progress on the balance sheet due to a combination of two dividend cuts, material asset sales, and S&L segment outperformance. Current total debt / EBITDA is ~3.2x. This is down from 5.5x at the end of 2016. In other words, there is room on the balance sheet to fund this gap with debt. If they choose to do so, leverage would creep up a full turn to 4.2x by YE 2020 before decreasing to 3.6x by YE 2021. My expectation is that if able to, mgmt. will tap the preferred equity market at an all in cost of capital of 6% to 9% to fund a large part of this funding gap. Typically preferred’s receive 50% equity credit from the rating agencies. Under this methodology, PAA’s current leverage ratio is 3.6x and would increase to 4.5x at YE 2020. These are manageable metrics and assume minimal EBITDA contribution from S&L.

Management

Prior to the bursting of the midstream bubble in late 2015, PAA traded with a management premium. After two distribution cuts and a failure to predict the evaporation of the S&L segment EBITDA that had previously surprised only in one direction (up), the market has reversed this management premium to a discount. However, over the past few years, PAA management has quietly righted the ship and put it back on a sustainable path to value creation.

1.       Leverage ratios have decreased dramatically from 5- 6x down to 3-4x.

2.       Distribution coverage ratios have increased materially

a.       Not just DCF coverage, but GAAP earnings now cover distributions

3.       Returns on incremental capital invested have been historically strong.

a.       These strong returns have been enhanced by high multiple divestitures

b.       In addition, management has been deliberate in partnering with customers and competitors on new growth projects with the explicit purpose of enhancing returns. The chart below lays out partnership by project.

Sustainable Free Cash Flow

Per management, post 2020 expansion capital will step down materially. At the current distribution level, PAA will be able to reinvest $900mm into expansion capital projects funded by retained cash flow (2021E D&A ~ $700mm). At a 7.0x multiple, that would generate $129mm of cash flow to offset up to a 5% base decline in 2021E fee based EBITDA. I don’t expect such a high base decline as I believe that continued Permian organic growth will more than offset any declining assets; however, that optionality provides a material margin of safety for the current distribution yield.

Valuation

The tables below lay out my valuation assumptions. I am applying a NTM EBITDA multiple to a forecasted 2021E EBITDA broken out into the buckets I identified and estimated earlier. Note that this total EBITDA figure for 2021 is meant to reflect the current consensus estimate, and I believe it to be conservative. As such I expect my Permian Growth/Other bucket to be understated.

For the Permian Sustainable base business and the Permian/Other Growth EBITDA, I assume an 11x to 13x EBITDA multiple. These buckets of EBITDA are fully risked and will benefit from continued Permian volume growth in the years to come. I apply a 9x to 11x multiple to Other Basins Transportation and Facilities buckets as these will likely be flattish for the foreseeable future but have a high free cash flow conversion ratio. S&L receives an undemanding 5-6x EBITDA multiple on the last 4 year average EBITDA. I expect this segment to generate significantly more cash over the next 10 years than the valuation I am placing on it, but I don’t expect the market to believe that any time soon. Permian Overearning receives a 4-5x multiple as I most of the cash flow could disappear by 2025.

These multiple assumptions get to a weighted average of 8.6x to 10.3x, which implies a fair value unit price of $21.80 or +25% for my “base” case and $15.21 or -13% for my downside case. With a current yield of 8.2%, room for error on the balance sheet, and a conservative distribution policy, good things can happen over the next few years.

Risks

1.       A key risk is a high level of competition for barrels than I am taking into account. I believe that a $400mm EBITDA cliff on top of the $85mm step down in 2020 is very conservative. However, I will be watching for extreme irrational competitive behavior by market participants.

2.       Market turmoil causing capital markets to close prior to securing funding for the 2020 capital program is a real risk. However, PAA has $3.0bn of committed liquidity attenuating this risk.

3.       A prolonged global recession crushing oil demand to the point where Permian volume growth is not required for an extended period of time.

4.       Permian tier 1 acreage exhaustion and parent child interference issues move the entire basin higher in the global cost curve to the point where basin wide volume enters terminal decline. Despite the headlines, I believe that with wider spacing, there are still several years of Permian basin production growth ahead of us. Supermajor behavior and messaging support this notion.

5.       Capital markets have completely closed for independent E&Ps. As rigs continue to roll off, true capital discipline may be on the horizon for the first time in history, decreasing the Permian production outlook.

6.       A democratic president may outlaw fracking on federal lands. This would undoubtedly materially affect PAA’s Delaware basin (NM) volume outlook. Partially attenuating this risk, is that a ban on fracking on federal lands would likely benefit PAA’s assets outside of NM through higher oil prices and rig activity.

Historicals, Forecast, Capital Efficiency, and Leverage

Catalyst

2021 projects in service

Continued finanicial discipline and capital efficiency