Energy Transfer: Crying The Pennsylvania Blues

Summary

• Energy Transfer recorded excellent 4Q 2018 and full-year results.
• However, the company is taking a beat-down in Pennsylvania. The Mariner East and Revolution franchises have been shut down or are limping along.
• What's going on, who's doing what to whom, and my views about how it will come out are the focus of this article.

Over the past several years, Energy Transfer (NYSE:ET) has embarked upon multiple pipeline projects centered around Pennsylvania. The largest of these include the Mariner East and Revolution franchises. Broadly, the systems are intended to gather, process, and transport NGLs from the Utica/Marcellus shale fields to Energy Transfer's Marcus Hook complex located on the Delaware River. From there, the materials are processed, stored and distributed to local, domestic and waterborne markets.

The construction work surrounding these projects has ranged from adequate to absolutely terrible.

This article focuses upon the current state, ongoing issues, path forward, and my opinion about lessons learned.

First, a brief overview of these projects is in order.

Mariner East Franchise

Mariner East is actually 3 pipelines. There's Mariner East 1, Mariner East 2, and Mariner East 2x.

Source: Energy Transfer UBS Midstream, MLP and Utilities Conference Presentation

Mariner East 1 is a 1930s vintage gasoline pipeline repurposed to move propane from west to east, terminating at Marcus Hook. New service began in 2014. In 2018, the line was temporarily shut down by the State of Pennsylvania after sinkholes were discovered along the pipeline right of way. More sinkholes were found in January 2019. The pipeline has been shut down since that time.

Mariner East 2 is a new pipeline designed to move NGLs from western PA to Marcus Hook. Since the project began in 2017, the State has halted construction at least twice for failure to adhere to permit requirements. Various issues have dogged activities, including the creation of sinkholes in residential neighborhoods, accidental pollutant releases, alleged groundwater contamination, extensive litigation by landowners/residents, and heavy environmental protests; vandalism of pipeline machinery has been reported.

In 2018, the State of Pennsylvania levied a $12.6 million fine against Sunoco Pipeline (an Energy Transfer affiliate) for a variety of permit violations.

Indeed, the current pipeline configuration is a workaround: it's a combination of the original and incomplete 20-inch Mariner East 2 pipeline, portions of the 16-inch Mariner 2X pipeline, and another older 12-inch pipeline. The media has referred to the project as "FrankenPipe." Nonetheless, on December 29, 2018, ME2 was placed into service. In early 2019, attempts by opponents to block its operation were rejected in court. The Pennsylvania PUC upheld the ruling. ME2 operates today.

Mariner East 2x is another new pipeline designed to parallel ME2 (in pipeline parlance, it's called a "looped" pipeline). It will move incremental NGLs from Ohio/PA Marcellus shale to the Marcus Hook industrial complex. The line is 99% complete, but further construction is now on hold. In February 2019, the State DEP (Department of Environmental Protection) suspended review of permit applications and other approvals, saying the company failed to comply with agency orders following a Revolution Pipeline explosion in Beaver County, Pennsylvania, last fall (See below). ME2x was caught up in the dragnet. Energy Transfer's management indicates the project will get tracked and be in service by year-end 2019.

Revolution System

The Revolution System includes 110 miles of gathering pipelines, a cryogenic processing plant, takeaway NGL pipelines, and a frac facility. The system is complete; however, operations were halted after the aforementioned pipeline rupture and explosion in Beaver County, PA.

What's Energy Transfer Management Got To Say?

During the February 21 earnings conference call, the management had quite a bit to say about these projects. Here are some excerpts:

From CFO Tom Long:

And on ME2X, 99% of the mainline construction is complete, and at this time, we continue to target having the pipeline in service by late 2019.

Lastly, just a quick update on Revolution. We are working together with the Pennsylvania DEP and have communicated to them that we are committed to bringing this project into full compliance with all environmental permits and applicable regulations. The operations of our in-service pipelines are not impacted by PA DEP's recent permit hold nor any areas of construction where permits have already been issued.

Later on the call, he added the following remarks after a question about ME2x:

It's a matter now of completing the HDDs and some open cut. There are roughly 20 permit modifications required to convert from HDDs to open cut. We're processing those - submitting in processing those with pay debt. And I think that we have adequate time in our schedule for the return of those to be able to execute this. And as I say, we're still committed to completing 2X by the end of 2019.

EVP Kevin Smith is the new Engineering and Construction lead. He offered this response to a question posed by analyst Keith Stanley:

Keith Stanley

Hi, good morning. Couple more questions on Pennsylvania. First is for the Pennsylvania DEP is restoration at the Revolution site the only thing they're asking of you guys right now to get the permits again. And just any sense at all on when you'd have permit authorization again?

Kevin Smith

Sure. This is Kevin Smith. We have four documents that are due to pay debt on Monday [February] 25, which is the date mutually agreed. We expect that they'll review and approve those documents within 30 days, which would allow us to commence the restoration effort. And yes, that is the only thing that's prohibiting us.

Indeed, CEO Kelcy Warren also weighed in on matters:

...yes, we've learned all kinds of lessons. And we've made mistakes and we are correcting those mistakes and we'll not make those mistakes again. So yes, we've learned a lot. Every place is not Texas.

….we've grown so much. We made some mistakes, and specifically now we'd like to talk about Pennsylvania and we're going to take our medicine and fix those mistakes and complete good projects from this point forward. Not insinuated that everything we've done has been bad. It's just we've made some mistakes we're not proud of. So you'll see that improve and when we don't make those mistakes again, that our costs are going to improve and the predictability of those cost are likewise going to improve.

We have - we've done a reorganization, Engineering and Construction now reports directly to me. Operations, which is we're so big and just got to be overwhelming here. We had so much growth, but Engineering and Operations under Matt Ramsey who reports to me. Kevin Smith runs Engineering and Operations. And Kevin has assembled pretty much a new team, pretty much and some new faces and some just moved over. But it's - I'm really pleased with organization and I'm really pleased with the approach that I'm seeing at this stage and it will continue to show improvement.

My Take

So what's to make of all of this?

Based upon a review of available data, my understanding of Energy Transfer's business, and other reliable sources, I offer the following observations. Some items listed below are "between the lines" commentary, meaning these represent my interpretation of the PA situation, and not hard facts:

The Mariner East franchise and Revolution project will be completed. It will take longer and be considerably more expensive than anticipated. However, I do not believe either project will be sidelined permanently.

Clearly, Energy Transfer has made serious, egregious errors on multiple occasions. The company and its contractors failed to follow permit requirements. While state regulators may be tough, they didn't get tough just before the Energy Transfer projects began. Management should have been well aware, as Kelcy Warren so aptly put it, "Every place is not Texas." In large measure, the company deserved to get its head handed to it.

Pennsylvania sub-surface geology presents unstable and challenging pipeline construction circumstances. This isn't a new revelation, either. Rugged terrain, washouts, sinkholes, numerous waterways, aquifers, frigid weather, and highly differentiated underground geology make pipeline construction difficult. Old mining and mineral excavations throughout the state compound the challenge. Energy Transfer's management appeared ill-prepared to deal with it, attempting to rush the projects versus circling up and getting it right.

Management underestimated the resistance of anti-fossil fuel opponents. After the DAPL (Dakota Access Pipeline) theatre, this was especially disappointing. The Left-Greens are determined to block or delay fossil-fuel energy projects. Groups are well-organized, well-financed, and recognize the courts and the media are tools to be leveraged. Recruiting grass-roots supporters in the northeast is easy. Many of the same groups (and one source suggested some of the same people) that protested DAPL appeared to have moved on to organize Pennsylvania opposition.

In many respects, the organizations have been highly successful. Construction and pipeline operations have been delayed for months (and even years). Contractor mobilization, demobilization, fines, and litigation costs materially crimped project investment economics. On the other hand, the Left-Greens very well increased the overall enterprise value of the assets. Once complete and in service, these pipelines will be nearly impossible to duplicate. I submit no pipeline operator will even attempt to do so. Therefore, the Energy Transfer assets will become highly important (and valuable) to the region's energy infrastructure. It is likely to become an "only game in town" asset.

A few aspects of the situation are not entirely management's fault. For example, it is likely Pennsylvania regulators encouraged HDD (Horizontal Directional Drilling) when issuing permits. Unquestionably, HDD preserves topography above the pipeline right-of-way; it's less disruptive to the landowners along the RoW. However, bentonite clay is a major component of the drilling mud used to bore the holes prior to pipeline installation. It is nearly impossible to avoid some of this non-toxic material finding its way to the surface, especially given the rocky, porous sub-surface geography found throughout much of the state. Yet such releases, especially post-migration to a natural waterway, are considered "accidental releases," "pollutants," and classified as "permit violations." Often, the media fails to make this clear.

On the February earnings conference call, Energy Transfer management indicated "...roughly 20 permit modifications are required to convert from HDDs to open cut." My take is most of these were likely initiated by regulators. The terrain, geology, and politics around originally permitted HDDs may have proven to be too difficult to manage. Therefore, laying remaining pipeline sections via "open cut" excavation was determined to be a superior, less-risky alternative. Of course, pipeline opponents are now howling about open cut construction; notwithstanding all work being within the Energy Transfer right-of-way and to be permitted by state regulators.

In addition, the management is outgunned, often unfairly, on the PR and media front. Readers familiar with pipeline construction and operations may recognize certain information reported by certain media outlets just isn't accurate. It may contain half-truths, or opinions stated in such a way to sound like facts, and be mixed in along with some facts. Other sources are simply anti-fossil fuel blogs disguised as media outlets. For example, it's true the ME2 pipeline project racked up over 80 permit violations. However, many of these involve releases of as little as 5 gallons of bentonite HDD drilling mud spills (non-toxic), contained and managed within the Energy Transfer right-of-way. Other violations include contractors failing to adequately dispose of trash and construction debris. These are reportable and may constitute permit violations.

Beating up on Energy Transfer is also good practice for some pols in the region (Let the reader understand).

For its part, Energy Transfer management appears to have got the message. Rather than make excuses, the team now "owns" its mistakes.

Certain construction contractors and inspectors have been discharged. Company inspection agents now have been instructed to go about their work with renewed rigor.

Management (albeit belatedly) reorganized itself to better focus upon construction management and HS&E (Health, Safety, and Environment) performance. I believe certain internal processes and procedures have been changed. Senior leadership is contrite, not defiant.

For years, Energy Transfer owned a premier pipeline construction division. It was noted for completing major projects on time and on budget. No more. The work in Pennsylvania changed that. Finally, after too much time, too much money, and not enough management attention, I contend the ship is turning.

Conclusion

Energy Transfer's management has learned a lesson the hard way. Inattention to HS&E, particularly when dealing with the public, and especially in the face of hostile Left-Green organizations, is a losing hand. In the energy business, it's always a losing hand. For years, major energy corporations have known this. Cutting corners on HS&E always comes back to bite. When dealing with a restive populace, even doing things right will be unrewarded.

Nonetheless, as ET has done so often, I believe the company will turn, right itself, and live to fight another day.

• Remember the Williams Pipeline fiasco?
• How about when the previous administration revoked a key permit required to complete the Dakota Access Pipeline project?
• Recall when Energy Transfer's solvency was in question?

In each case, Energy Transfer's management figured out a way to dodge a bullet.

One more time? I believe so.

Oh yes, and by the way: Energy Transfer's 4Q 2018 and full-year results were outstanding. Year-over-year adjusted EBITDA was up 30%. Distributable Cash Flow was up 31%, and DCF/unit rose 26%. Operating cash flow leapt 70%. Leverage, as defined by bank covenants, fell to 3.38x from nearly 4x a year earlier. The company requires no secondary common equity offerings to fund growth capex. 2018 cash distributions were well-covered as evidenced by a 1.74x DCF coverage ratio. Now it's time to go to button up PA construction.

Disclosure: I am/we are long ET. 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.