Tuesday, February 16, 2021

Hydrocarbon Royalties and Pipelines

I'm interested in mineral landowners (energy royalties, previously 1, 2) and pipelines as being possibly the best part of the hydrocarbon value chain.

They generate cash and distribute it to shareholders, which removes the reinvestment risk. The explorers and producers have trouble creating as much long term value for shareholders because management's incentives are bad. They get paid to grow asset size, and they only have the money to do that at the top of the cycle when properties are expensive.

Refiners have huge operating leverage and volatile capacity utilization. (Valero, for example, has single digit operating margins.) It is hard for them to make money unless their fragmented industry is at capacity. 

Like tobacco, there is the mistaken perception that the oil business is dying. And some fraction of investors even think it is morally questionable to invest in producing the energy that our civilization runs on.

Notice how much more consistent the net income of a pipeline company (MMP) or a royalty company (DMLP) is than an E&P company (DVN) or a refiner (VLO).

Pipelines and royalties seem like the superior part of the hydrocarbon value chain. They are more consistently profitable over time, have less reinvestment requirement, and so more consistently send cash to shareholders.

9 comments:

KJP said...

I think you are correct and note that both of the parts of the value chain you mention (mineral royalties and pipelines) benefit from one of the Achilles heels of the e&p part of the value chain: the large barrier to exit. The majority of the cost of a producing wells is incurred upfront; the operating/lifting costs of already producing wells are relatively low. The result is that wells that would be uneconomic to drill at current prices don't shut down; instead, the ownership of them shifts to creditors, who keep producing because price is above marginal cost.

The result of that pattern is that volumes don't collapse even when price collapses. And who benefits from volumes: royalty owners (variable cost of extraction taxes decrease with price declines) and pipelines. The latter can also have real competitive advantages due to government regulation making it impossible to build competing pipelines (e.g., Transco) and the service provided by the some pipelines being irreplaceable (for example, a pipeline is the only way to move natural gas from field to end user; you can't move it by truck or rail).

This framework would suggest that natural gas pipelines protected from competition via regulation are the best businesses of all because they have high barriers to entry and benefit from barriers to exit among their suppliers. There are no barriers to entry in the royalty ownership business, so my speculation is that it would be structurally less profitable than the best pipelines.

In theory, there is opportunity for skilled management of royalty companies to create value by buying low. I wonder whether that's actually true in practice. Perhaps you could compare the long-term returns of relatively passive royalty owners (TPL, DMLP) with the long-term returns of much more active royalty owners (e.g., Black Stone Minerals). It wouldn't surprise me if active ownership (and the overhead that goes with it) ultimately produces negative returns.

CP said...

Thanks KJP, excellent observations.

Do you have any natural gas candidates for us to consider?

JP said...

the Achilles heels of the e&p part of the value chain: the large barrier to exit. The majority of the cost of a producing wells is incurred upfront; the operating/lifting costs of already producing wells are relatively low. The result is that wells that would be uneconomic to drill at current prices don't shut down; instead, the ownership of them shifts to creditors, who keep producing because price is above marginal cost.

IMO this is much less true for shale wells vs traditional oil and gas because shale decline rates are so steep. US production staying high after oil prices declined in 2014-15 was more a result of the shale cos being run by idiots and stock promoters who were eager to drill no matter what. If the shale management teams cared about shareholder returns, they could treat their business like a call option on oil prices and quickly adjust capex (and with a short lag, production) as prices fluctuate.

KJP said...

The most "gassy" publicly traded royalty owner that I'm aware of is Black Stone Minerals (BSM). I have owned it for awhile, think it is fairly cheap right now, it's highly diversified across basins, and it has its leverage under control. But Black Stone has significant G&A overhead from actively managing its acreage. They claim this adds value in various ways, but that should be looked at carefully, e.g., I suspect their offices are quite nice. Also, as a much more short term issue, be sure to look at its 2021 hedge book when thinking about near-term cash flows.

As for natural gas pipelines, I don't have any idea better than Williams (Transco owner). It traded down to absurd levels in March. I believe a big part of that was large forced selling from levered MLP/midstream funds that were hit by falling equity prices across the board. It's now back to a slow-growing 7% yielder.

CP said...

It's hard to argue with the long term 'utility' of these assets:

https://www.williams.com/operating-area/transmission-and-gulf-of-mexico/

CP said...

The thing people don't get in the electric vehicle discussion is that gasoline is almost a waste product in the refining industry. Our civilization runs on diesel and JP-8 and asphalt. The logistics, farming, and mining systems run on this stuff and electrification is utterly impossible, and you can't run the equiment on gasoline either: the torque curve requirements necessitate higher octane fuels. There will never be an electric or gasoline combine harvester or freight train or barge or surface mining vehicle. Refining profits are made from diesel/jet fuel and asphaltenes for industrial applications. The refineries make gasoline out of the remaining stuff that cannot be profitably re-fractionated into higher octane products. So it really makes almost no sense to power personal vehicles with electricity from uranium/coal/natgas when we are going to have the gasoline anyway whether we really need it or not, as it's basically a way to get rid of the leftover crap. I see many city electrified light rail and diesel/natgas powered bus systems that I am almost sure would operate at a fraction of the cost if replaced by fleets of large gasoline powered vans. Just give them reserved lanes and optimize traffic light timing for them. People would actually *use* public van transit that showed up very often (every eight minutes) and zipped past traffic. SWPLs really need to get over their superstitions (oooh, monorail) and think about these things systematically.
http://www.creditbubblestocks.com/2019/09/september-9th-links.html

CP said...

Tortoise Energy Independence Fund, Inc. (“NDP” or the “Fund”) announced in November that its board of directors (the “Board”) has recommended merging NDP shares into the Tortoise Pipeline & Energy Fund, Inc. (“TTP”), another of Tortoise’s closed-end fund vehicles focused on the energy space, and then changing the strategy to begin investing into renewable and power infrastructure companies.

We are writing as fellow shareholders to express our dissatisfaction with the Fund’s managers and the Board, and to announce that we have determined to vote “NO” on this merger. In our view, management’s inability to create value for shareholders has been clearly demonstrated over the past seven years, and we view this proposed merger as a last-ditch effort to buy more time to run a risky strategy that has dramatically underperformed peer funds and the index. Instead of pursuing this merger, we urge the Board to convert to an open-end fund or liquidate the assets, which we believe would provide substantial value realization to shareholders, by eliminating the Fund’s deep discount to its net asset value (“NAV”). Were the Board to pursue this shareholder-friendly strategy, as of the writing of this letter, shareholders would see immediate gains of approximately 30%.


https://au.news.yahoo.com/aristides-capital-issues-open-letter-120000218.html

CP said...

MMP Q1 2021 results:

Management is increasing its annual DCF guidance by $50 million to $1.07 billion for 2021. The higher guidance is a result of Magellan’s strong financial performance during the first quarter and a more favorable commodity pricing environment for the partnership’s gas liquids blending activities, partially offset by lower distributions from its Pasadena marine terminal joint venture due to the recently-announced sale of nearly half of Magellan’s interest in the venture.

Guidance assumes total refined products shipments will be generally in-line with initial estimates for the year, with an overall increase of 13% still expected versus 2020 as incremental volumes associated with recent expansion projects within the state of Texas are expected to more than offset the lingering impact of COVID-19 and still-recovering drilling activity. These estimates now include 13% higher gasoline, 10% higher distillate and 25% higher aviation fuel shipments, based on general trends so far this year and expected continuing recovery in travel, economic and drilling activity throughout the year. For reference, total 2021 refined products shipments are still expected to increase approximately 3% versus 2019, which is more representative of historical demand, as additional gasoline and distillate volumes from expansion projects are partially offset by lower aviation fuel.

As previously announced, Magellan intends to maintain its quarterly cash distribution at the current level of $1.0275 per unit for the remainder of 2021. Based on the current distribution amount and the current number of units outstanding, distribution coverage for 2021 is expected to be 1.17 times the amount necessary to pay cash distributions for the year.

Free cash flow (FCF), a non-GAAP financial measure that represents the amount of cash available for distributions, unit repurchases, debt reduction, additional investments or other partnership uses, is projected to be nearly $1.27 billion for full-year 2021, or $350 million after distributions, including the proceeds from the recent sale of a partial interest in the Pasadena marine terminal joint venture.

https://www.sec.gov/Archives/edgar/data/1126975/000112697521000070/exhibit991q21.htm

CP said...

EPD Q1 2021 results:

Enterprise reported net income attributable to common unitholders of $1.3 billion, or $0.61 per unit on a fully diluted basis, for the first quarter of 2021, compared to $1.4 billion, or $0.61 per unit on a fully diluted basis, for the first quarter of 2020. Net income for the first quarter of 2021 was reduced by non-cash, asset impairment charges of approximately $66 million, or $0.03 per fully diluted unit. The impairment charges include $43 million related to our coal bed natural gas gathering system and Val Verde treating facility in the San Juan Basin that was held-for-sale at March 31, 2021. Net income for the first quarter of 2020 included an aggregate $187 million, or $0.08 per fully diluted unit, of deferred income tax benefits associated with the settlement of the Liquidity Option Agreement on March 5, 2020, and the subsequent accounting for the related deferred tax liability.

Net cash flow provided by operating activities, or cash flow from operations (“CFFO”), was $2.0 billion for both the first quarters of 2021 and 2020. Distributions declared with respect to the first quarter of 2021 increased 1.1 percent to $0.45 per unit, or $1.80 per unit annualized, compared to distributions declared for the first quarter of 2020. Enterprise’s payout ratio to common unitholders of distributions and partnership unit buybacks for the twelve months ended March 31, 2021 was 68% of CFFO. For the twelve months ended March 31, 2021, Free Cash Flow (CFFO less capital investments, or “FCF”) was $3.1 billion compared to $3.4 billion for the twelve months ended March 31, 2020.

Distributable Cash Flow (“DCF”) was $1.7 billion for the first quarter of 2021 compared to $1.6 billion for the first quarter of 2020. DCF for the first quarter of 2021 included $81 million of cash proceeds from the monetization of interest rate hedging instruments and asset sales. Excluding these non-operating amounts, DCF provided 1.7 times coverage of the distribution declared with respect to the first quarter of 2021. Enterprise retained $746 million of DCF for the first quarter of 2021, and $2.7 billion for the twelve months ended March 31, 2021.


https://www.sec.gov/Archives/edgar/data/1061219/000114036121015411/exhibit99_1.htm