Seeking Alpha

The Compression Sector Is On Fire

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Includes: AROC, CCLP, ET, USAC, XES
by: Darren McCammon
Summary

The three publicly traded compression companies – USAC, AROC, and CCLP – all had very strong Q4’s.

They benefit from high demand in the sector, demand that may be more secular than cyclical.

If this in fact proves true, growth should continue while multiples also expand, the two combining to further padding investor pocketbooks.

Overview

Publicly traded compression companies – Archrock (AROC), USA Compression Partners (USAC) and CSI Compressco (CCLP) – lease natural gas compression engines to E&P firms, pipelines, and other companies.

Source: Archrock website

These companies have been doing very well, achieving record orders, revenue, EBITDA and cash flows thanks to strong demand in the sector. When you hear about things like bottlenecks preventing natural gas from getting out of the Permian, and Marcellus shale sourced LNG ending up heating homes in Beijing, understand these guys are part of the solution for how natural gas gets from production to where it is demanded. Compressors are part of the backbone that gets natural gas from here to there.

The current market for compression services is stronger than we've seen in quite a while, due in part to increasing domestic gas production and the continued supply tightness for equipment to serve this growing production.

- Eric Long, USAC CEO 2-19-2019

2018 has been a great success and we are looking forward towards continuing to improve the business in 2019 as the compression market remains very strong across all of our business lines.

- Owen Serjeant, CCLP President 2-27-2019

The increase in natural gas production and demand for compression is not just a part of the oil and gas commodity price cycle, but rather part of a structural change necessitating significant investment in additional natural gas production infrastructure of which compression is a critical part.

- Brad Chiders, AROC CEO 2-20-2019

Obviously, as evidenced by the quotes above, the compression sector is doing quite well. The debate about whether this growth is short lived or longer term in nature, however, is not as clear.

Cyclical or Secular?

The answer to this question is neither academic, nor inconsequential. The stock market typically assigns infrastructure assets such as pipelines, bridges, and airports a significantly higher multiple on profits than it does more cyclical oilfield service stocks. This is because investors can count more on those profits one year to the next. If natural gas compressor stocks such as AROC or CCLP for instance traded at the same EV/EBITDA that multiple natural gas pipeline stocks such as Targa (TRGP) or Oneok (OKE) do, their stock prices would be 2 to 3 times higher.

Additionally, how one should think about investing in the sector is highly dependent on the cyclical vs. secular debate. When a sector is undergoing temporary or cyclical growth, one is usually best served taking a trading approach. You try to invest during low points, typically when the past looks horrible, and individual investor comments are telling authors they are idiots for investing in the stock. That trader then tries to harvest these investments after a subsequent recovery when everything looks wonderful, and comments are agreeing what a fabulous investment it is. In addition to oilfield services, semiconductor capital equipment, and most types of shipping are examples of notoriously cyclical sectors.

However, when a sector isn’t cyclical but instead is undergoing secular growth, the best time to invest is frequently yesterday. The best time to harvest sometimes ends up being never, or at least not until that secular growth slows down and/or gets fully priced in to the multiple being paid. Infrastructure investors tend to be longer term buy and hold investors looking for long-term steady growth and willing to pay a higher multiple for it.

Secular vs. cyclical is thus an important distinction that leads to widely different opinions on the appropriate fair market multiple. Get this question answered correctly for the compression sector, and you could be looking at 200% to 300% returns in the next couple years.

I think natural gas volumes being transported, and therefore compressor demand, is getting more secular.

Current increases in natural gas demand are partially dependent on price and spreads between points of production (e.g. the Permian) and points of usage (e.g. China). Current production of natural gas is also partly dependent on price for not just natural gas but also oil (drilling for oil produces ancillary gas). These are cyclical influences.

However, the demand for cleaner-burning alternatives to coal and oil is a long-term trend (secular) driven by the desire to reduce pollution levels and global warming.

Source: Golar LNG, Investor Presentation

Likewise, the ability to access natural gas at ever cheaper prices thanks to advancements in fracking technology also appears to be an ongoing trend - a trend that already makes natural gas and liquified natural gas 'LNG' cheaper than oil.

Source: Golar LNG Presentation

Important logistical changes, the ability for the Permian to fill Chinese demand, for instance, is also structural in nature. Multi-billion-dollar LNG export plants don’t turn off liquefaction and stop shipping LNG because prices change 20%, or even 50%. Launch of the next train expansion or export facility expansion may pause, but any existing trains already operating continue to produce LNG and ship under long term contracts (LNG export lines are referred to as trains).

Likewise, pipelines to Mexico, growing state sponsored LNG truck fleets in China, electricity plants switching from coal to natural gas, India's moves to double its natural gas usage in the next decade, new high use natural gas chemical, and fertilizer plants coming online in the US, etc., these are also all long-term structural changes. They are clearly secular in nature and creating a long-term secular uptrend in the volume of natural gas demanded and transported.

This secular trend results in long-term compressor demand more closely resembling the picture on the right below rather than the purely cyclical picture on the left.

Source: Author; HP = Compression Horsepower

Investment, Cyclical vs. Secular

That in turn creates an interesting situation which the more prescient investor can occasionally take advantage of. Historically, compression sector stocks are held in cyclical oil service sector funds such as the S&P Oil & Gas Equipment and Services ETF (XES). This means the price of compression stocks tends to go up and down as investors buy and sell the ETF, and other similar funds, in conjunction with energy price changes. The stock prices go up and down, even though the companies actual underlying cash flows end up being much more stable. As an extreme example, AROC saw a 90% drop in its stock price during the time of the oil price crash highlighted red in the graph below.

Source: US EIA data

Yet, natural gas volumes transported hardly dropped at all. Compressors are typically leased for a year at a fixed monthly rate, and the amount of compression demanded to move natural gas is a function of volume needing to be transported (blue line) not the price of natural gas (or oil). In other words, any cash flow tie to energy prices is tenuous at best. Looking again at the blue line in the graph, ask yourself would you even have noticed the slight dip in natural gas volume during the oil crash if I hadn’t highlighted the applicable area in red? Indeed, the graph as a whole looks an awful lot more like it depicts secular growth, which has recently been accelerating, rather than cyclical supply and demand.

Understanding this dichotomy is an edge Cash Flow Kingdom members have been taking advantage of for more than a year now. Namely, one can potentially buy compressor firms much cheaper whenever energy prices have fallen significantly, secure in the knowledge their underlying cash flows were unlikely to be affected.

This greater understanding however may also be about to change. EQT Infrastructure just purchased Kodiak, the fifth largest compressor company, for its Infrastructure III fund. I suspect the smart people at EQT have noticed the compression sector is becoming more of a secular growth story. They likely also think the price currently being assigned is much too low if that secular growth theme plays out. Note also that EQT bought Kodiak for a stable infrastructure fund, NOT a cyclical energy services fund. That in itself is tacit acknowledgement that at least in their mind compression is becoming more secular than cyclical, more basic infrastructure than services oriented.

Yet for now, most of the market continues to price these firms as if they were cyclical companies tied to the price of oil (and/or for their dividend payout). When energy prices fluctuate, yet underlying cash flows for these firms just keep powering ahead with strong, ongoing demand, it’s a potentially lucrative situation the investor can take advantage of.

Macro

North America drilling rig counts are roughly flat at 1,275. This is pretty good considering both the Permian Basin and Canada are still having significant problems getting product to market.

https://static.seekingalpha.com/uploads/2019/2/379412_15506939044193_rId12.png

Source: Baker Hughes Drill Counts

In the Permian in particular E&P firms are still drilling wells in anticipation of logistics problems being solved relatively soon; for now they just aren’t completing them.

If you think about this, you’ll realize it’s a strong indicator for ongoing compressor demand. Compression assets are absolutely necessary to get natural gas to market. They are a part of the solution, so once completed all these wells will need gas lift and gathering systems with compressors to get natural gas to the pipelines. As soon as offtake becomes available, Permian E&Ps are going to be able to quickly complete those wells and get it in the pipes. In fact, over the last few years natural gas production volume has continued to rise regardless of price and despite Permian logistical issues (see graph on left below).

https://static.seekingalpha.com/uploads/2019/2/379412_15506939044193_rId13_thumb.jpg

Source: US Energy Information Administration

Furthermore, this natural gas is enjoying strong demand from both the US and for export to foreign countries (via LNG & LPG carriers as well as pipelines to Mexico). The US Energy Information Administration forecasts export takeaway capacity to continue to rise to 8.2 billion cubic feet per day in 2020 (in the graph on the right above, -8.2 means 8.2 billion cubic feet exported).

Individual Firms

There are three notable publicly traded firms in the natural gas compression industry that I am aware of. All benefit significantly from the ongoing growth in volumes being transported.

Data Powered by Intrinio.com

  • USA Compression Partners (USAC) is probably the firm most individual investors are first attracted to due to it high dividend payout - 13.1% at current prices. This is probably also why it trades at the highest multiple of the three. Because of this high payout, however, USAC doesn’t retain much cash to purchase additional compressors, and must rely on borrowing or share issuance in order to provide funds for capex and other uses. This makes the stock inherently riskier. Additionally, investors should be aware that USAC’s parent, Energy Transfer (ET), has a history of folding its children back into the parent via “simplification” transactions. These transactions typically end up reducing the distribution. I personally don’t think USAC is the best choice in the sector; however, others disagree. Here’s a more positive take from Double Dividend Stocks, and another from Rida Morwa, two respected authors at Seeking Alpha. I suggest you read them and do your own further due diligence before taking a position.
  • Archrock (AROC) is more a DGI stock than a high dividend equity. It “only” pays a 5.4% yield on current price because it retained roughly 2/3 of its cash flow last quarter for compressor purchases. This means over time Archrock is going to continue to enjoy a cost of capital advantage over USAC, a lower leverage ratio, and be more resilience to any setbacks. It will also almost certainly have greater distribution growth (currently guided at 10 – 15% per year). I’ve written a lot about Archrock, most recently in “Archrock: A DGI Darling.”
  • CSI Compressco (CCLP) is a distant third in total compressor horsepower deployed. Until recently I recommended readers stay away from it due to poisonous variable weighted average price ‘VWAP’ convertible preferred. A type of preferred which can be highly dilutive to the stock. That, however, all changed at the end of last year when new management cut the distribution to a token 1¢ in order to use excess funds to redeem the convertibles. Importantly, they also then personally bought shares on the open market. CCLP is the stock with the most total return potential among these three, and is trading at the lowest multiple; however, it is also probably has the highest risk. I wrote in more depth about CCLP recently in “187% Price Upside Inherent In CSI Compressco Distributable Cash Flows” Once again, I suggest you read these articles if you are considering a position and then do your own further due diligence.

Conclusion

I consider AROC and CCLP excellent investments. AROC is the lowest risk of the bunch with a good dividend and significant upside prospects. CCLP is more a high risk / high reward choice, but based on projections it is quite a potential reward for the risk being taken. CCLP has the potential to triple over the next 18 months, IF things go as planned.

USAC investors will also benefit from the strength in the sector while collecting the highest distribution. However, in my opinion they are giving up a lot in return for that high distribution. They are unlikely to do much better than just collecting that distribution.

The compression sector is firing on all cylinders, as they say. If indeed this growth is more secular than cyclical, these stocks are remarkably cheap and an investment in any of the three should do well.

Disclosure: I am/we are long AROC, CCLP. 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.

Additional disclosure: The article discusses a risky investments in the natural gas compression sector. I do not know your goals, risk tolerance, or particular situation; therefore, I cannot recommend any specific investment to you. Please do your own additional due diligence.