Gray Oak Pipeline Addresses Permian Weakness: Exit Capacity

Summary

• Pipeline could transport up to 1 million bpd from the Permian to the Gulf Coast.
• Meantime, WTI in Midland was recently trading about $9/bbl below Gulf Coast crude.
• First open season was heavily subscribed and there will now be a second binding open season.
• The pipeline will terminate at multiple Gulf Coast markets, including a marine terminal connection in Corpus Christi for the export market.

Last week Phillips 66 Partners (PSXP) announced the open season for its proposed Gray Oak pipeline had received enough volume commitments to proceed with a second open season. The ultimate capacity of the pipeline is dependent on the outcome of the second open season. If fully subscribed, the pipeline's capacity could ultimately be expanded to 1 million bpd.

Source: PSXP Q1 Presentation

The Gray Oak Pipeline is a joint venture: 75% owned by Phillips 66 Partners and 25% by Andeavor (ANDV) which is likely to merge with Marathon Petroleum (MPC). Enbridge (ENB) has an option to acquire up to a 32.75% interest in the joint venture. If all options are exercised, which is likely considering ENB's very important Line 3 challenges in Minnesota, Phillips 66 Partners’ ownership would be 42.25% and Andeavor’s ownership would remain 25%.

It is no coincidence Marathon's offer for Andeavor came after the announcement of Gray Oak's second open season and the same day announcement by Buckeye Partners (NYSE:BPL) to develop a new deep water marine terminal at the mouth of Corpus Christi Bay. The terminal will be operated by Buckeye and will initially have 3.4 million barrels of storage. Most importantly, the terminal will have two deepwater ports capable of servicing very large crude carriers, or VLCC's, for the global export market. BPL owns 50% of the terminal and be the operator. Phillips 66 Partners and Andeavor will each own a 25% stake.

Marathon was increasingly watching the Permian crude oil market from the cheap seats. That problem will be solved with the Andeavor merger and the acquisition of ANDV's stakes in the Gray Oak pipeline and Corpus terminal. The merger also increased Marathon's refining footprint to the West Coast from, primarily, the mid-continent.

For Phillips 66 (NYSE:PSX), Gray Oak is another investment - this time through its MLP - in a world-class pipeline. The company already owns JV interests in the Dakota Access Pipeline ("DAPL"), the Sand Hills & Southern Hills NGLs pipelines, as well as the Explorer refined products pipeline - just to name a few:

Source: Phillips 66 February Presentation

Phillips 66's refining and midstream presence on the Gulf Coast is ideally located to fully integrate its refining and chemicals assets with its growing midstream business.

The Permian's Desperate Need For More Pipelines

Permian basin oil producers are in desperate need for the increased exit capacity that Gray Oak will provide. As RBN Energy recently reported, as of Friday (April 27), WTI in Midland was trading about $9/bbl below the price of equivalent-quality crude on the Gulf Coast (according to Bloomberg). And on the Q1 conference call, PSX explained why there really was no other alternative to new pipelines:

As we look at alternative route options, trucking is one. That's kind of a $12 a barrel movement at this point although that's not going to be a steady number. A typical truck can haul about 180 barrels of crude, it's roughly a 500-mile haul from the Permian to the Gulf Coast, it's a day -- 2-day round trip, so you need 100 trucks to move 10,000 barrels a day. It's not really realistic to expect to move 100,000 barrels a day or 200,000 barrels a day, it's just not really practical.

In addition, management explained that there are not a lot of rail facilities in the Permian. Most of those that do exist are designed for frac sand and not crude movement. So rail is not a great option. The current $9/bbl differential was closer to $3/bbl when there was adequate pipeline exit capacity. This is the strong motivation behind Gray Oak, which I predict will see strong demand and ultimately will be built out to full capacity supported by strong long-term contracts with investment grade producers.

Since Gray Oak is not expected to go into service until the second half of 2019, investors owning shares in Permian producers should take special note of their companies' current access to adequate crude oil pipeline exit capacity. With WTI currently around $67/bbl, a $9 discount still achieves a realized price of ~$58/bbl at Midland. Many Permian producers can be quite profitable at $58. However, with natural gas prices in the Permian already weak and continuing to fall (for the same reason - a lack of adequate exit capacity), a drop in WTI of $10/bbl would have a big impact on many Permian producers as a result of the heavily discounted local price.

How To Play Gray Oak

While Phillips 66 Partners is a very solid investment:

• Current yield of 5.6%.
• An investment grade credit rating.
• A 1.4x distribution coverage ratio for Q1.
• A recent 5.3% increase in the quarterly distribution (to $0.714 per unit).
• An annual EBITDA run-rate of ~$1 billion.
• A 30% CAGR in the distribution.

The truth is MLPs are contending for the most unloved sector in the entire stock market, perhaps trailing only the Canadian energy sector - which has a worse crude and natural gas exit capacity crisis than does the Permian.

The better way to play the Gray Oak pipeline is through PSXP's general partner: Phillips 66. Phillips 66 beat Q1 estimates by $0.15/share and it is shaping up to be another great year for the company. Shares are currently changing hands at around $110/share. That's up about $17/share since the big deal to buy back 35 million shares from Berkshire Hathaway (BRK.A) (BRK.B). I said at the time that Buffett's sale made no sense to me (see Discussing The Buffett/Phillips 66 $3.5 Billion Stock Transaction).

I rate PSXP as a hold and PSX as a buy with a year-end price target of $120. PSX currently yields 2.5% and I expect a dividend increase announcement any day now. Last year, the company announced an 11% increase in the dividend on May 3.

Analyst’s Disclosure: I am/we are long PSX PSXP ENB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I am an engineer, not a qualified investment advisor. While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. Therefore, I cannot guarantee its accuracy. I advise investors conduct their own research and/or consult a qualified investment advisor. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles. Thanks for reading and I wish you much success with your investments.