Wednesday, November 3, 2021

Pipeline Earnings - Q3 2021 ($MMP $EPD)

[See previously Hydrocarbon Royalties and Pipelines and Magellan Midstream Partners, L.P. (MMP).]

Two of our pipeline companies, Enterprise Products Partners and Magellan Midstream, reported their Q3 earnings (EPD, MMP) yesterday.

Current market capitalization is $11.3 billion and enterprise value is $16.7 billion. For the first nine months of 2021, Magellan earned $738 million, had $1 billion of EBITDA, and $821 million of "distributable" cash flow after "maintenance" capital expenditures. They have paid $685 million of distributions and have repurchased $473 million of LP units for a total of $1.16 billion returned to shareholders year to date.

So, Magellan's past nine month's annualized earnings ($984 million, current guidance is for $975 million) would be an 8.7% earnings yield on the current market cap. Magellan shares trade at the same price that they did in 2013 ($50). What is interesting is that TTM net income then was only $580 million, about 60% of what it should be this year, and the dividend then was a third of what it is now. Which meant that the dividend yield then was around 3% vs over 8% today.

This snippet, in response to a question, was what I thought was most interesting from the Q3 earnings call:

But if you look at the rest of our system, in particular, in Texas, if there is demand growth in Texas, which happens to be especially the Dallas Fort Worth area, one of the fastest-growing areas in the country, we have plenty of capacity to accommodate that without -- well speaking about Dallas, without really any capital investment. And when you think about West Texas and access to Mexico and Arizona, markets are further west. We have opportunities there to expand capacity also. So there are upsides around our system. The other thing I mentioned, I've mentioned this before that as we go through an energy transition cycle over the next five or 10-years, it's reasonable to assume that you have more refinery rationalization. And typically speaking for a pipeline company that is a net positive, because it creates incremental transportation opportunities basically to fill the hole that if a refinery closure is creating. And we have a system that's ideally situated for that since we're connected to half the refining capacity in the country. And so, we're not supply constrained in any way. So if we have a refinery close in a certain market, we've got plenty of sufficient supply. And in most cases, sufficient capacity to fill that hole with barrels removed over a longer haul, which is typically a higher tariff. So, I think we do have operating leverage going forward around our refined product system.

I was most glad to see that net income for the first nine months of 2021 has exceeded the first nine months of 2019 ($738 million vs $734 million). We like when our "dying businesses" have growing earnings. (Of course, the bond market never agrees that these businesses are dying. Magellan's debt due 2050 yields only 3.5%.)

Magellan shipped 142 million barrels of refined products in Q3 2021 versus 136 million in Q3 2019. Even though aviation fuel fell from 11 million barrels to 8.4 million, gasoline rose from 75 million to 80 million and distillates rose from 47 million to 53 million. Revenue per barrel of refined product rose from $1.62 to $1.72 per barrel.

Their crude oil pipelines are operating below capacity, with shipping on their 100% owned pipelines falling from 79 million barrels in Q3 2019 (at 94 cents per barrel) to 40 million in Q3 2021 (at 80 cents per barrel). Their BridgeTex pipeline volume has fallen from 41 million barrels (Q3 2019) to 29 million (Q3 2021).

So it's interesting that the refined products pipelines have carried the company back to 2019 earnings even with crude oil volumes lagging. (Refined products made $240 million operating income in Q3 2019 vs $272 million in Q3 2021. Crude oil made $154 operating income in Q3 2019 vs $112 million in Q3 2021.) Magellan should make a lot more money if and when production in the Permian basin increases.

Current market capitalization is $50 billion and enterprise value is $78 billion. For the first nine months of 2021, Enterprise earned $3.6 billion, had $6.3 billion of EBITDA, and $4.9 billion of distributable cash flow.

So, Enterprise's past nine month's annualized earnings ($4.8 billion) would be an 9.6% earnings yield on the current market cap. Magellan shares trade at the same price that they did in early 2014 ($22). At that time, the TTM net income had been only $2.6 billion, about 53% of what it should be this year, and the dividend then was about half of what it is now. Which meant that the dividend yield then was just under 4% vs almost 8% today.

Here is the most interesting snippet from the Q3 earnings call:

Our businesses continued to perform extremely well during the third quarter. We reported $2 billion of EBITDA even though we were impacted by $30 million of headwinds due to hurricane Ida. Cash flow from operations was a record $2.4 billion, which more than fully funded both our capital expenditures and our distributions. Year-to-date distributable cash flow is almost $5 billion, which has provided coverage of 1.7x and $2 billion in retained cash year-to-date. As we head into the final quarter of the year, while we don't take anything for granted, it looks like our businesses are going to finish with another strong year in 2021. Our results reflect the ongoing recovery in demand for crude, NGLs, primary petrochemicals and refined products as the global economy continues to recover. For 2022, most experts agree on continued strong demand and economic growth worldwide. We believe that economic backdrop plus the need to restock virtually everything will continue to provide strong demand growth for oil and gas, natural gas liquids and plastics. In addition to the record cash flow from operations, we had record profits from our propylene business, which contributed to the record gross operating income for our petrochemical and refined product service sector. Our PDH and splitters complement one another in our value chain, and we were able to take advantage of strong propylene spreads. Long term, petrochemical fundamentals are very strong and U.S. petrochemicals have multiple competitive advantages compared to almost all of their global peers. And likewise, Enterprise remains strongly positioned to provide the petrochemicals midstream services, including feedstock, storage, distribution and exports. It's a footprint that's not easily copied. Our liquids pipelines have substantially recovered to near pre-pandemic levels at 6.3 million barrels a day with gas processing volumes benefiting from higher prices for NGLs. Enterprise's natural gas pipeline and transportation for the third quarter exceeded pre-pandemic 2019 levels at a record 14.6 Bcf a day.

As at Magellan, Enterprise's net income for the first nine months of 2021 has exceeded the first nine months of 2019 ($3.6 billion vs $3.5 billion). Gross operating margin for the NGL Pipelines & Services segment (the largest) are up slightly vs 2019, Crude Oil Pipelines & Services and Natural Gas Pipelines & Services are both down somewhat, and then the Petrochemical & Refined Products Services segment earnings are up 42% since 2019, bringing overall gross operating margin to $2.08 billion for the quarter vs $2.05 billion two years ago.

People are unhappy with Enterprise for refusing to buy back units and for spending money on growth capex when units are trading so cheap.

Convexity Idea
It is really interesting that these pipelines yield so much more than they did in 2014, especially with interest rates lower. Magellan yielded 2.9% when the ten year bond yielded 2.4%. Now the ten year yield is 1.6% and Magellan yields 8%. The story with Enterprise is basically the same.

What if these pipelines re-valued? Suppose that gasoline consumption and vehicle miles traveled hit new all time highs next year. Even without growing earnings, if Magellan traded to a 5% dividend yield (where it was in 2017-2018), that would be 60% upside to the current share price, or $80. A $60 call for Jan 2024 last traded for $1.30. If the stock revalues between now and then, that's 15x upside. [An ATM $50 call has IV of only 13% and trades for $4. That would be 7.5x upside with breakeven at $54 - MMP traded at $53.5 in June.]

What's interesting about these calls is that they have upside to improving fundamentals and lower dividend yields but they are also an option on inflation. How much might the currency devalue between now and January 2024? Is 13% implied volatility the right price? 

Note the last two comments on our Rethinking Inflation post, recent quotes from the two smartest options traders that we know: the "distribution of future inflation has a fat right tail" and "Implied Volatility is way too low since the range of outcomes is now much wider."

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