A version of this article was originally published on November 16.
The Keystone XL pipeline has been perhaps the most talked about issue surrounding midstream operators in recent years. The rejection of the proposed pipeline by the US government has brought increased attention and bravado to pipeline opponents, while also highlighting the increased risks associated with midstream entities.
Specifically, pipeline opponents are now turning their attention to Kinder Morgan’s (KMI) Trans Mountain pipeline in southern Canada. Environmental advocates are pushing for a similar result that was realized along the northern Pacific coast of Canada, where the Canadian government will ban crude oil tankers, effectively ending the usefulness of Enbridge’s (ENB) Northern Gateway pipeline. These developments are both damaging to pipeline operators immediately and in the future, as these types of situations will make future pipeline expansion increasingly difficult.
However, there are far more risks associated with pipeline operators than simply the rejection of expansion projects. The underperforming equity prices of MLPs across the midstream space have brought the issues of capital market access and the cost of capital much greater attention, and rightfully so. According to Fitch Ratings in August,
Equity prices remain suppressed and the ability and willingness to fund capital spending with equity is becoming a more prominent concern for midstream issuers. Access to capital markets remains intact despite the rising cost of capital. We believe access to markets could deteriorate as commodity and equity prices continue to languish and potential interest rate increases from the U.S. Federal Reserve loom.
This situation is one that we have been warning about for some time now, and it continues to gain momentum as commodity prices are not expected to rebound in 2016 and regulatory risks increase.
MLP and pipeline operator Plains All American (PAA) has seen its share price nearly halved since early May, just before the first of two high-profile pipeline failures that occurred under the firm’s watch. The company has become a poster-child of sorts for the turmoil that is currently taking place across its industry. It has been affected by falling crude oil prices, failing infrastructure, supplier bankruptcy risk, and, inevitably, the potential of interest rate increases.
In the third quarter of 2015, Plains All American reported revenue being nearly cut in half, diluted net income per limited partner unit more than halved, and EBITDA fell 8% from the year-ago period. The oil price slump, production cutbacks, and shutdowns from the pipeline ruptures earlier this year were key contributors to the weak quarterly results. Further, the company does not expect Line 901, the California pipeline that ruptured, to be back in operating condition in 2015. Excluding the loss of revenue, Plains All American estimates the total costs from the incident to be ~$257 million. The Pipeline and Hazardous Materials Safety Administration (PHMSA) has also called for the company to fully close and purge nearby Line 903, which has been almost fully closed since May but has remained full of oil. PHMSA has claimed “similar corrosion characteristics” to Line 901. If these two lines in such a small radius are both in such poor condition, how many others are in similar shape across the nation?
Bringing further risk to Plains All American, and more importantly to midstream entities in general, is the increased risk of bankruptcy of upstream operators. Pipeline operators will not be spared from the carnage in the supply chain due to the sharp drop in commodity prices. A prime example of this is the rapid cash-burn situation taking place at Chesapeake Energy (CHK). Sales from Chesapeake Energy to Plains All American accounted for 11% of Chesapeake’s total revenue, or just over $2.3 billion. The fact that one of the largest oil and gas producers in the US is in such dire straits only further emphasizes the inherent risks developing in energy markets in general. Midstream pipeline operators are not immune to falling crude oil prices. We’ve said it before, and we’re saying it again.
After reporting poor third-quarter results, Plains All American announced it expects that “2016 will be a challenging year.” The company plans to cut its 2016 capital spending program and may sell some assets to counter the challenging operating environment that is expected to continue through the end of 2016; it is cash hungry. The 2015 capital budget of $2.2 billion–which is the same amount as its adjusted EBITDA guidance for the year–is expected to be cut by up to 30% in 2016. A more precise number will be released once the firm gains a better understanding of how upstream capital spending will pan out in the coming year.
Nevertheless, the firm increased its distribution in the quarter, albeit by a marginal amount. This comes after management indicated that distribution growth was at risk in 2016 due to falling volumes and margins. The company’s goal is to maintain 105% distribution coverage, but if the originally planned distribution growth trajectory is maintained, it would result in a continued period–distribution coverage is expected to come in at 94% for the full-year 2015–of subpar distribution coverage. Management stated it was not prepared to comment on the distribution for 2016 in its third-quarter earnings call. A sustainable rebound in crude oil prices is not expected before the end of 2016, and management’s dedication to its distribution will certainly be tested.
At current levels, Plains All American’s raw, unadjusted Dividend Cushion ratio–which does not take into account the capital-market assistance that many MLPs are accustomed to having–see an in-depth explanation here—is well below 1. Given the company’s outlook for 2016, we would not be surprised to see a distribution cut. Management will have to take a significant amount of cost saving measures while maintaining business in order to drive the cash flow needed to properly support the distribution it wishes to pay to shareholders. Considering the risks specific to the entity coupled with those prevalent across the industry, we find this increasingly more unlikely.
Even if cost savings may delay what we consider to be immediate trouble, they may be futile in saving the distribution at present levels if the potential for more costly regulations–which we highlighted months ago here—become reality. What actually counts as maintenance for pipelines is quite a political issue. For example, we don’t consider fixing a pipeline after failure maintenance, no more than we would consider swapping out a combustion engine after it fails as maintenance. Changing the oil prior to combustion engine failure is what we call maintenance, the equivalent of which seems to be lacking across much of the pipeline industry when it comes to maintaining infrastructure, given the number of well-publicized ruptures. In any case, the oil and gas pipeline industry continues to lobby against recent proposals for increased standards of maintenance. Though we use Plains All American as a specific example, the risks highlighted by the firm’s situation are not unique to the company; they are rampant across the midstream space.
All things considered, the mounting risks across the midstream and MLP space are far too great to draw our interest. We continue to emphasize the risks related to distribution cuts as a result of the tremendous pressure on participant’s operations, and we point to Plains All American as next in line. We prefer to err on the side of conservatism. Income investors beware.
Pipelines – Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, PAA, SE, SEP, WES