Gas Giant on the Prairie
The Permian Basin is one of the nation’s oldest oil-producing regions. The area has been pumping crude since 1921. According to the Texas Railroad Commission, the Permian has already produced more than 29 billion barrels of oil and 75 trillion cubic feet of natural gas. For perspective, the U.S. consumed 6.9 billion barrels of oil and 27 trillion cubic feet of natural gas in 2014.
The Permian Basin has commercial deposits of oil and gas in stacked layers, at depths ranging from 1,000 feet to more than 25,000 feet. One horizontal shale play within the Permian called Wolfcamp is estimated to contain 2 to 4 times the estimated oil reserves of the Eagle Ford or the Bakken. And there are multiple commercially viable layers of oil and gas above and below Wolfcamp.
Thanks to those stacked layers, the Permian is one of the most prolific and cost-effective oil plays in the U.S. Last week I visited to see things first hand.
In my day job I serve as director of alternative fuels technology for a small Arizona technology company. One of our core technologies is aimed at reducing natural gas flaring in oil fields. As shale oil production in the U.S. boomed, so did the volumes of associated natural gas. But there was often no infrastructure to process it. As a result, that natural gas was often flared.
Why would you flare something of value? As I heard one producer explain it, “The associated gas on my site has a market value of $600,000, but it will take at least $1.5 million in infrastructure to move it to market. So I flare it.”
Governments have sought to restrict the practice to protect the environment, even as they worry about curbing the tax receipts from oil production. Amid a worldwide clampdown on flaring, oil producers already suffering from the energy slump face the high cost of complying with the new restrictions.
That’s where we come in. We have developed a unit that conditions flared gas to efficiently fuel a generator. If a site is using diesel for power — as many are — our solution can cut the flaring while reducing or eliminating diesel consumption. We deployed our first demonstration unit to the Eagle Ford in Texas last year. The second unit went to the Bakken, and I reported on a visit there in Addressing the World’s Flare Gas Problem. Our third unit is deployed in the Permian Basin in West Texas, and last week I made a visit to see it:
Me at a well site in the Permian Basin, south of Pecos, Texas on Jan. 26.
Yes, that is snow on the ground and in my hair. Our target is that flare behind me.
Trips to the key oil and gas regions of the U.S. give me a chance to talk not only with the men and women who extract oil and gas but also with people up and down the supply chain: oilfield services providers, midstream companies, etc. I even sat down with officials from the Bureau of Land Management in Carlsbad, New Mexico to get their take on the current oil and gas markets — especially as it relates to the Permian Basin.
One of the things I do on these trips is to note the companies most actively engaged in a region. The Permian probably has the most developed infrastructure of any major U.S. oil basin, but in the past few years drilling has pushed into many new areas. As a result, there was abundant evidence of new infrastructure in the process of being built. As we drove around the Permian, I saw a number of midstream companies in operation, including Plains All American Pipeline (NYSE: PAA), Energy Transfer Partners (NYSE: ETP), Enterprise Products Partners (NYSE: EPD) and Targa Resources Partners (NYSE: NGLS).
A Fixture in the Permian
But at least in the regions I drove through, the midstream company with the most visible presence was DCP Midstream Partners (NYSE: DPM). Its general partner, DCP Midstream (DCP), is a 50/50 joint venture of Phillips 66 (NYSE: PSX) and Spectra Energy (NYSE: SE). In aggregate with DPM, DCP Midstream is the largest producer of natural gas liquids (NGLs) in the U.S., as well as the largest natural gas processor. DPM gathers or processes about 12% of the U.S. gas supply.
Source: DCP Midstream Annual Report
DCP Midstream has 18,610 miles of natural gas and NGL gathering lines and transmission systems just in the Permian. It also has 19 processing plants in the basin with an aggregate capacity of 1.5 billion cubic feet per day of natural gas and 115,000 barrels per day of NGL production.
Source: Phillips 66
DPM didn’t escaped the carnage in the MLP space over the past year, its unit price dropping nearly 50% over the past year. But the underlying performance of the business has been good. Despite weak NGL prices, DPM managed to increase production while reducing costs in 2015. This meant the company generated enough cash to fund its distribution with a coverage ratio for the past year of 1.13x (and 1.21x in Q3).
My colleague Igor Greenwald wrote last March in a note to subscribers:
“Unless NGL prices recover significantly, either DPM or its general partner may still need a capital infusion from (most likely) Phillips 66, which can afford it and is unlikely to devalue its stake in the venture by leaving it ailing. What’s not in doubt is DPM’s staying power. It should be able to at least maintain the current distribution if NGL prices don’t drop much further.”
Of course DPM did maintain its distribution, and another note to subscribers in September reported on the the capital infusion:
“On another tough day for energy equities, at least one was granted a reprieve. DCP Midstream Partners (NYSE: DPM) units appreciated more than 6% Wednesday. Business didn’t improve, because the energy prices on which it depends sagged once again. But at least DPM’s indirect corporate parents finally came through with a long awaited aid infusion.
The DPM publicly listed partnership is now almost fully shielded from commodity price risk for the balance of this year and mostly protected (locking in 80% or so of its cash flow) for 2016. But its general partner, a 50/50 joint venture between Conservative Portfolio recommendation Spectra Energy (NYSE: SE) and Phillips 66 (NYSE: PSX), is much more exposed. It lost its investment-grade credit rating earlier this year as a result, casting doubt on DPM’s growth prospects.
The infusion of $1.5 billion in cash from Phillips and one-third stakes in two natural gas liquids pipelines from Spectra will keep DCP Midstream on the good side of its credit line covenants and more than cover its expected cash outflows over the next year.”
The Permian Basin has been producing oil since the 1920s, and nearly 100 years later it is producing at near record levels. High oil prices in recent years resulted in a new oil boom in the Permian, and that has been accompanied by large investments in infrastructure. On my recent trip there I noticed a lot of pipeline construction to connect newer oil and gas wells to existing infrastructure. One of the companies most active in the region is DCP Midstream, which is one we have covered here in the past. To receive our current advice on DCM, please join us at MLP Profits.
Collateral Damage for CPLP
Very high yields don’t come without very high risk; the trick is finding those that will decline by means of capital appreciation rather than a distribution cut.
We think we have one of those in #7 Best Buy Capital Products Partners (NASDAQ: CPLP), the owner of refined product and crude tankers, as well as containerships and a bulker. The strong tanker markets have allowed CPLP to gradually increase its charter rates and distributable cash flow, a trend that continued in the fourth quarter reported by the partnership last week.
Cash flow coverage improved to 1.10x on a distribution that was kept level with the prior quarter, in a departure from the prior plan to grow it by 2-3% annually. Management cited recent market volatility, which has dropped the unit price 31% year-to-date and 48% over the last three months.
Coverage will improve further now that CPLP has chartered its two idle containerships at deeply discounted (but so far undisclosed) rates for the next year, and will again when the partnership takes delivery of the last containership it’s contracted to buy from its sponsor later this month. That vessel has already been chartered at an attractive rate for the next five years.
So why is the annualized yield back up to 25%, now that units have given up the better part of their 30% relief rally over the last two weeks of January?
One obvious reason is that the equity went ex-dividend on Feb. 3 ahead of a quarterly distribution of nearly 24 cents per unit payable Feb. 12.
Less helpfully, Navios Maritime Partners (NYSE: NMM) eliminated its recently reduced dividend entirely on Wednesday. While NMM operates bulkers and containerships and has none of the tanker exposure shielding CPLP from the current shipping slump, it too is a maritime master limited partnership.
Even less helpfully, the creditors of Hyundai Merchant Marine (HMM) reportedly demanded it negotiate cuts of 20-30% to its charter before they refinance debt maturing this year. The corporate parent of the heavily leveraged shipping line, South Korea’s second largest, has been restructuring for the last two years.
This matters to CPLP because HMM containership charters account for 22% of its current revenue (dropping to 20% or so by the second quarter.). A 30% reduction on those rates wouldn’t even use up all of CPLP’s most recent cash flow surplus. But there’s no guarantee that HMM will remain solvent this year, in 2017 or in any other year before its CPLP charters are scheduled to expire in 2025. And in the slumping container market’s current state the bulk of the revenue from those charters could not be replaced if they were broken.
If we were to write this revenue off entirely as the market seems to have done, as well as CPLP’s containership and bulker charters with far less troubled operators, we would be down to the tankers currently accounting for 60% of revenue and an effective 15% yield based on the current unit price.
So there is plenty of value apparent here even in a plausible worst-case scenario. But there are two additional risks to consider.
One is that the recently strong tanker rates could certainly head lower, as they’ve done so often in the past. There is still plenty of speculative money chasing hulls in the few still healthy shipping sectors, so that excess supply of ships remains a risk in 2017 and beyond.
A more insidious potential threat is that the management and the sponsor could, like those at Navios, simply decide that their current limited partners are not a useful source of capital any longer.
That seems to have transpired at NMM, which only three months ago said it had set a newly reduced payout at a level it could honor for the next five years. But as the unit price continued to go down, that tune changed to today’s complete elimination of the dividend despite plenty of excess coverage, so that management can pursue unspecified growth opportunities.
I don’t believe CPLP is on this path. Its balance sheet is in much better shape, and the sponsor has more of an incentive to preserve the partnership’s value and reputation.
But anyone dumbfounded that an investment with such risks can yield 25% in a market like this simply hasn’t been paying attention.
CPLP remains an Aggressive Portfolio buy below $5.50.
— Igor Greenwald