Description

This will likely be a somewhat controversial write-up. Over the past several months there have been several good write-ups touting interesting long opportunities in the midstream MLP space. While there are idiosyncratic characteristics that might make individual names attractive, we are bearish on the sector as a whole. This is a relatively brief write-up the outlines our high-level thesis as well as our thesis on a single name, Plains All American (“PAA”). We will post additional analysis on this thesis and this name in subsequent postings in the comments section of this write-up.

Industry Thesis

Energy infrastructure, particularly crude focused infrastructure, is massively oversupplied. Years of rampant spending to accommodate the needs of growing liquids production in the US has resulted in a massive build out of pipelines, storage, gathering and processing, rail and other forms of crude infrastructure. Despite the large drop in commodity prices, the large cuts to E&P capex budgets and the current trend in US liquids production, midstream MLPs are still spending significant amounts on new infrastructure. To an extent this trend makes sense as the inherent lead-time in brining online new infrastructure has meant capital decisions made in early 2014 (when everyone thought the US would be growing 1mmbpd per year forever) are still being put into service today (when clearly the trajectory of crude production growth has changed). Put simply, US crude oil production growth and US crude oil infrastructure growth are heading in different directions. It is widely acknowledged that there is already an oversupply of pipeline capacity in some of the most prolific basins in the US. The graphic below is from a recent Morgan Stanley report showing pipeline take-away capacity versus historical and projected production for each of the 4 major shale oil producing basins in the US. Almost every other analysis we have seen from the sell side shows similar figures.

The buildout in pipeline capacity over the past several years has been staggering. As an example, as recently as 2012 there were no large diameter liquids pipelines for moving crude from the Permian Basin to demand centers on the Gulf Coast. Today there are 7 active or under construction pipelines with the ability to carry in excess of 2mmbpd to the Gulf Coast. Keep in mind this capacity has come online in a relatively short span of time. Furthermore, many of these pipelines have the ability to be quickly expanded, potentially adding another 400kbpd+ of take-away capacity.

Of course this is not just about looking at capacity added, but how capacity growth has compared with production growth. As many of you will likely know, production growth in the Permian has been strong as the basin has some of the best economics in the country. Still, take-away capacity has grown faster than production and it seems with projects currently under development, the basin will be well supplied until at least 2020.

Over the long-run this dynamic should impact midstream MLP cash flows through lower volumes, decreasing utilization and falling margins. We believe the market is significantly underestimating the potential long-term downside the midstream MLPs face as a result of these variables because 1) the midstream MLP space has never really gone through a real down-cycle since growing from infancy 15 years ago (making it hard for analysts for forecast given the lack of precedent) and 2) because many midstream MLPs are protected through medium and long-term take-or-pay contracts (i.e. cash flows won’t decline immediately). Midstream MLPs should also be impacted by lower growth, as the enormous build-out in infrastructure would suggest less growth/spending is needed going forward. As many names in the industry trade at 10x+ EBITDA multiples, when it typically costs 5x-8x to build new infrastructure, a decrease in the growth profile should have a dramatic impact on valuation.

Plains All American

Amongst the universe of midstream MLPs, we believe that Plains All American LP (“PAA”) is uniquely exposed to this thesis. PAA is primarily a crude oil exposed midstream company (~75% of EBITDA relates to crude infrastructure) with pipeline, storage and other infrastructure assets throughout the US and Canada. PAA’s segments are divided between Transportation (50% of EBITDA, primarily fee-based pipelines), Facilities (25% of EBITDA, primarily crude storage, natural gas storage, rail terminals, gas processing plants, NGL fractionators, etc.) and Supply and Logistics (25% of EBITDA, described in more detail below).

PAA is an attractive way of expressing this thesis for several reasons. Unlike some of its peers, PAA lacks significant minimum volume coverage in the form of “take-or-pay” or “minimum volume” (“MVCs”) contracts and thus will come under increasing pressure as new pipeline capacity is added. Based on our conversations with management, we believe only about 1/4th to 1/3rd of Transportation volumes are covered by MVCs. This compares to other crude exposed names such has Sunoco Logistics (SXL) at ~60% and Enbridge Energy Partners (EEP) at ~50%. As the oversupply in crude take-away further manifests, we would expect shippers with volume commitments on competing pipelines to take volume off of PAA pipes. PAA has already admitted this trend is occurring and was likely part of the reason the Company has been missing volume guidance for each of the past 4 quarters. We believe this dynamic will also have an impact on pipeline margins as midstream companies now appear to be more willing to compete on price in order to keep volumes on their own pipelines. We have already heard this dynamic is occurring through our conversations with senior management of Enterprise Product Partners and other crude focused MLPs. Furthermore, PAA’s adjusted margin per barrel has been falling, further suggesting that this dynamic is real and occurring.

PAA also derives a material portion of its earnings from its Supply & Logistics ("S&L") segment, which essentially utilizes PAA's pipeline and storage asset base to profit from regional crude price differentials and storage contango. The graphic below highlights how we believe PAA’s S&L segment makes its margin, as well as how it interacts to PAA’s other business segments.

PAA's business model is uniquely leveraged to crude volumes as the Company's S&L segment is the largest customer of its pipeline and storage businesses. We have not encountered any other midstream company which internally leases up so much of its own pipeline and storage capacity. While this business structure was advantageous when pipeline capacity was tight and differentials wide, it is less attractive today. As margins fall in S&L, it could impact the amount of capacity that the segment leases from transportation and storage segments. We view PAA as having multiple layers of leverage to infrastructure oversupply as falling volumes and margin in S&L could result in falling volumes and margin in the pipeline and storage segments of the business.

With the build out of infrastructure, combined with a slowdown in production growth (or production declines), basis differentials have fallen and in some cases have totally reversed. Looking at the Midland to Cushing differential as an example (Permian to Cushing), differentials were as wide as $20/bbl in 2014 (Midland $20 discount to WTI Cushing), but have recently traded at a premium to Cushing. As PAA has a large pipeline moving crude from Midland to Cushing (the Basin Pipeline), its S&L division was likely able to capture this differential when it was wide. With the differential now at zero, PAA’s margin for this particular route has likely been eroded. Across the US we have seen differentials collapse as more infrastructure has been put in place.

When thinking about the appropriate margin for the S&L business, given the build out in infrastructure the US has seen we think its important to consider the long-term margin history of this business. In 2015 S&L earned an adjusted EBITDA margin of $1.14 per barrel whereas the longer-term average margin for this business (2000-2010) has been approximately $0.65 per barrel. Given the trajectory of differentials, we would expect S&Ls margins to fall more in-line with historical average (or lower).

PAA’s Deteriorating Capital Efficiency

Deterioration in PAA's business is already visible from the results of the past several quarters. Year over year margins are down across all of the Company’s business segments. In several of its operating areas, including the Bakken and the Mid-continent, PAA has been seeing volume declines for several quarters in the row. Capital efficiency appears to be declining dramatically. In the past 3 years PAA has spent over $7bn in expansion capex, significantly outstripping operating cash flow, yet Transportation and Facilities EBITDA has only grown $366 million. Put another way, PAA appears to be generating only ~5% returns on its growth capex. An alternative way of thinking about PAA’s capital efficiency is by assuming the Company earns 12.5% returns on its expansion capex (a number which the company has quoted multiple times, and supported by bottoms up analysis of growth projects). If PAA’s net expansion capex has actually been generating 12.5% returns, we can solve for the implied growth of the “base” business by looking at actual EBITDA growth. Using this methodology over the past 3 years PAA should have generated $886m of incremental EBITDA ($7.1bn of capex between 2013 to 2015 times 12.5% return). Instead, PAA generated fee based EBITDA growth of only $366m. If PAA’s expansion capex did deliver on expected returns, it would imply that the rest of the business fell by $520 million over this period ($886m minus $366m). Spread over 3 years, this works out to about 11.4% decline in “base” EBTIDA per year.

This analysis leads us to conclude that PAA’s base business has actually been declining quite dramatically and that this decline has likely been masked by the large amount of expansion capex they’ve been spending. Looking across PAA’s asset base its not surprising declines have occurred and will continue to occur in the base business. Prior to the drop in crude prices PAA spent heavily on rail terminals, rail cars, and NGL fractionators, all assets which have seen significant margin deterioration as a result of oversupply. PAA has also spent heavily (and continues to do so) on projects that cannibalize business from existing assets. For example, PAA’s new pipeline spending in the Permian has likely taken share from its legacy Basin pipeline. PAA is spending a significant amount of money on a new pipeline in the DJ Basin which will likely take share from its existing White Cliffs pipeline. We believe the extent of these base business declines will become more visible as the Company pulls back on expansion capex in 2017.

PAA’s Valuation

We will save a detailed discussion on PAA valuation for a later date as we could write many pages with our deeper thoughts on MLP valuation and appropriate treatment of capex (we think maintenance capex is understated across the industry). At a high level, in looking at recent trends in production and historical margin levels as well as the Company’s capital efficiency, we do not think it is unreasonable for PAA’s EBITDA to fall 40%, from $2.2 billion in 2015 to less than $1.3 billion over the next several years. This path in EBITDA would assume the Company stops growth capex spending beyond 2017 and as a result starts seeing meaningful declines across its fee-based businesses as a result of the factors described throughout this write-up (note we also believe storage appears to be increasingly overbuilt).

In this scenario, if PAA were to trade in-line with the best names in the industry (Enterprise Product Partners, Magellan Midstream), or about 15x EBITDA, we would see about 50% downside to the stock price. If it were to trade more in-line with peer average of about 10x EBITDA, we would see almost no equity value in the stock. Based on our view of lower growth going forward, we would think a lower multiple would be appropriate.

Catalyst

Over the next 12-24 months we see a number of catalysts to help push the stock towards what we view as being fair value. Most significantly, we believe PAA will soon undertake a transaction to eliminate its significant IDR burden (currently takes about 1/3rd of distributable cash flow). We believe that such a transaction will be accompanied by a significant dividend cut (PAA is overpaying its dividend even on trailing figures). We believe that such a transaction will ultimately be negative for the stock as 1) it will result in significant dilution for PAA unit holders and 2) we believe the Company may cut the dividend more significantly than the market expects. Additionally, we believe PAA’s guidance for FY2016 is very aggressive and we expect a guidance cut in the coming quarters. Looking beyond 2016, we believe the underlying deterioration that the business is experiencing will accelerate and become more clear to the market as the company finishes up its growth capex projects in 2017.