With natural gas prices expected to remain depressed for some time, companies engaged in US energy production, transportation and storage are increasingly diversifying their resource mix in favor of crude oil. The latest example of this trend is last week’s announcement that Targa Resources Partners LP (NYSE: NGLS) will acquire Saddle Butte Pipeline LLC’s midstream and storage assets in the oil-rich Bakken Shale for $950 million.
As part of the deal, the midstream master limited partnership (MLP), whose orientation toward natural gas and natural gas liquids (NGL) is readily apparent from its choice of ticker symbol, will be adding 155 miles of crude oil pipeline to its asset portfolio.
This marks Targa’s initial foray into North Dakota’s Bakken, as the majority of its portfolio is situated in Texas in the Permian Basin and Barnett Shale, as well as in proximity to Louisiana’s Henry Hub, the largest natural gas distribution point in the US. The MLP also has significant assets located near Mont Belvieu, Texas, which is the primary hub for the NGL market.
In its most recent quarter, Targa was able to boost its distribution 3 percent sequentially and 14 percent from a year ago, but weakness in natural gas prices still weighed on its results. Targa’s distributable cash flow (DCF) increased 18 percent from a year ago to $77.2 million, however, its coverage ratio ticked down from 1.1 to 1. The LP’s long-term average for this ratio is 1.3, and it’s targeting an average of 1.2 going forward.
Meanwhile, revenue fell nearly 14 percent to $4.4 billion during the first nine months of 2012 versus the prior-year period. Management largely attributed this drop to lower prices for natural gas and NGLs, though Hurricane Isaac was also a factor.
The energy industry’s overinvestment in natural gas production in the prolific US shale plays resulted in a glut of supply that caused prices to crater to a decade low of $1.91 per million British thermal units (MMBtu) back in late April. Since then, the price of natural gas has jumped 101 percent to $3.84 per MMBtu, as producers sharply curtailed production. NGL prices have also averaged roughly 25 percent below what Targa’s management had forecast a year ago.
Nowhere is that pullback from production more evident than in the nearly perfect inversion in the most recent rig count when compared to those same numbers back in 2008. That year, nearly 77 percent of all rigs, or just over 1,400, were deployed for natural gas drilling versus just over 22 percent, or 390, in the latest week. And that erosion has quickened this year, as the natural gas rig count at the end of 2011 has more than halved year to date.
At the same time, the supply-demand balance for natural gas could finally be tightening. While natural gas inventories remain 4.4 percent above their five-year average, they’ve dropped 78 percent to 3.9 trillion cubic feet since the beginning of April. And NGL prices could soon see a further rebound from a resurging petrochemicals industry.
So while these commodities have likely bottomed, it’s still a shrewd move for Targa to expand its footprint to ensure that it’s less dependent on the “boom and bust” cycle of any one resource. Of course, the MLP routinely hedges much of its exposure to volatile commodities prices. For instance, it has already hedged 45 percent to 55 percent of natural gas and NGL volumes for 2013, though given the already low prices for these commodities, it’s not hedging as aggressively as it has in the past.
More important, Targa has a sufficiently strong balance sheet to continue expanding existing assets and acquiring new ones. With each acquisition, the MLP can further mitigate its exposure to commodity prices by focusing on deals that increase its proportion of fee-based revenue. Prior to this latest deal, Targa already had $1.6 billion in growth expenditures underway through 2014, with roughly half of these projects expected to be accretive to cash flow by the end of 2013. And nearly two-thirds of these projects will generate fee-based revenue.
Fee-based assets bolster the sustainability of the distribution, while also increasing the potential for growth in the payout. Indeed, management forecasts a further 10 percent to 12 percent rise in the MLP’s distribution during 2013.
At the end of the third quarter, Targa had almost $89 million in cash on its balance sheet, with just $1.7 billion in long-term debt. Additionally, it had $280 million in borrowings from its credit revolver, with another $773 million available from this line of credit. Its earliest maturities for both forms of debt don’t come due until 2017.
Management has approached financing in a disciplined manner. It’s adhered to its long-term leverage target, with a debt-to-ebitda (earnings before interest, taxation, depreciation, and amortization) ratio of 3.1, which is toward the bottom of its targeted range of 3 to 4 times ebitda.
This latest deal, which is slated to close by the end of the fourth quarter, is expected to be accretive to DCF by 2014. Targa is financing the acquisition with an equity offering of 9.5 million common units, with the balance funded via borrowings from its credit revolver.
In addition to the crude oil pipeline, the deal includes two crude oil terminals, 95 miles of natural gas gathering pipeline and a natural gas processing plant. Even better, almost all of the assets are under long-term, fee-based contracts. That improves management’s forecast of fee-based operating margin over the next several years to a range of 55 percent to 65 percent versus its earlier projection of 40 percent to 55 percent.
With total production from the Bakken expected to rise 60 percent over the next five years, Targa will likely look to expand upon its toehold there. And that should hopefully help it achieve double-digit distribution growth for years to come.
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