The ongoing uncertainty over Dakota Access Pipeline’s future continues to be the spotlight at Phillips 66 Partners L.P. (NYSE: PSXP), which holds a 25% equity interest in the pipeline alongside joint venturers: Energy Transfer (NYSE: ET; operator of the Dakota Access Pipeline), Enbridge (NYSE: ENB), and Marathon Petroleum (NYSE: MPC). Following the Biden Administration’s decision to scrap the Keystone XL pipeline in January and the latest calls to toughen up the environmental review process, it is more likely than not that DAPL will become the next victim. The fate of DAPL has also received ample media coverage in the past month due to recent status hearings and the fast-approaching court decision on whether the pipeline could continue operations during the environmental review process.
We believe the market has already priced in the worst-case scenario in PSXP’s recent share price, which has dropped 24% from its 5-year average price of $47.55 per unit, and 45% from its 5-year peak price of $64.78. Based on the closing price of $35.93 on April 29th, PSXP’s quarterly distributions declared for Q1 at $0.875 per common unit ($3.50 per common unit on an annualized basis) is equivalent to almost-10% annual yield. Our analysis of PSXP’s financials also indicates that the company has been resilient despite a challenging year for the oil and gas industry, with an ability to generate robust cash flows and maintain low leverage. We believe PSXP is positioned for high growth potential despite impacts from DAPL, and is a value stock to hold close to in the long run.
Company Overview
PSXP is a midstream MLP created by Phillips 66 in 2013. PSXP currently owns and operates a portfolio of transportation pipelines, terminals, processing and fractionation plants, and storage facilities throughout the U.S., with the majority of its operating capacity backed by long-term contracts with parent company Phillips 66 and other third parties.
Some of the company’s recent major developments include the following:
- Gray Oak Pipeline: operations went online in the second quarter of 2020; the pipeline connects Permian and Eagle Ford to Texas Gulf Coast destinations with a capacity of 900,000 BPD.
- Clemens Caverns expansion: Added 7.5 million barrels of capacity to the Clemens Caverns storage facility. Total capacity at the storage facility is now 16.5 million barrels, which comes just in time for the heightened demand for storage due to the oversupply of crude observed in 2020.
- Sweeny to Pasadena Pipeline expansion: The project added 80,000 BPD of pipeline capacity to aid transportation of product from the Sweeny refinery and adjacent NGL fractionators to their Pasadena terminal. The expansion also added 300,000 barrels of storage capacity at the Pasadena terminal to accommodate the anticipated increase in volumes transported post-expansion.
- Construction of C2G Pipeline: Construction of the newest pipeline is well underway, with completion expected in mid-2021. The 16-inch ethane pipeline will transport product from the Clemens Caverns storage facility to the petrochemical facilities in Gregory, Texas upon completion.
- Liberty Pipeline Exit: The Liberty Pipeline joint venture that was put on hold in March 2020 following market uncertainties has been officially called off based on an 8K filing released on April 5th. The Company has recorded a $195 million impairment charge related to the project.
About the DAPL Debacle
As mentioned above, PSXP owns 25% effective interest in DAPL through a joint venture with ET, ENB and MPC. DAPL is a critical underground oil pipeline that connects the Bakken shale oil fields in North Dakota through to Patoka, Illinois. The 30-inch pipeline has become one of the most efficient sources of product transport since coming online in 2017 with transport capacity of 570,000 BPD, which has effectively alleviated the previous production bottleneck caused by costly transportation alternatives (e.g. rail, truck and other smaller connecting pipelines). Currently, the fate of DAPL remains uncertain, and PSXP has not provided any concrete information on what the monetized impact of DAPL’s potential shutdown on PSXP's books would be.
DAPL Protest Timeline
The below is a brief timeline on the ongoing DAPL protest and litigation for those who are not familiar with what the recent news is about:
Source: Author, with data from reuters.com
With the latest cancellation of the Keystone XL project in January, the market has expressed concerns over the future of DAPL under Biden’s administration, which has continuously advocated for stricter environmental reviews on energy projects. The odds of shutting down the pipeline, at least temporarily, are high given pressure from environmental groups, the Sioux Tribe, and the environmental agenda under Biden’s administration.
Financial Analysis & Valuation
We have performed an analysis on PSXP's earnings outlook and valuation under two scenarios to better support our classification of PSXP as a value stock: 1) DAPL shuts down, and 2) DAPL continues its operations.
Case #1: DAPL Shuts Down
In the event that DAPL is ordered to shut down, we are projecting total revenues (inclusive of related party and third-party operating revenues, and earnings from affiliates) to grow at a CAGR of approximately 4% from 2021 to 2030. For FY 2021, we are forecasting revenues of $1,551 million (2020: $1,618 million); the projection is based on full commercial operation of the Gray Oak Pipeline and the C2G Pipeline, offset by lost revenues from affiliate earnings at DAPL in the second half of the year. We are also anticipating a lower net income of $548 million (2020: $791 million) due to the impairment charge recorded on the Liberty Pipeline. Earnings in the next three to five years will continue to experience the repercussions of DAPL’s shut down due to PSXP’s potential requirement to pay interest expenses equivalent to approximately $25 million annually on the $2.5 billion of senior notes issued and outstanding at DAPL if the affiliate can no longer fund these ongoing expenses. PSXP also has a contingent requirement to make equity contributions totaling $631 million under the Contingent Equity Contribution Undertaking (“CECU”), which is a guarantee on DAPL’s outstanding borrowings in the event that DAPL defaults post shut down.
Source: Author, with data from our forecasted Statement of Operating Income
Our valuation of PSXP in the case that DAPL is ordered to shut down results in an equity value of approximately $8.8 billion, which is equivalent to $36 to $38 per common unit. PSXP is currently trading at $35.93 (April 29th closing price). Given the proximity of our estimated value of PSXP’s units and its current share price, we believe the closure of DAPL has already been priced in by the market, making PSXP a reasonably priced stock pick at the moment.
Source: Author, with data from phillips66partners.com
Source: Author, with data from our valuation model
Case #2: DAPL Continues Operations
In the unlikely scenario that DAPL is granted an easement to operate the pipeline under Lake Oahe, we are projecting total revenue of $1,685 million (2020: $1,618 million) for FY 2021; the projection is based on full commercial operation of the Gray Oak Pipeline and the C2G Pipeline, with continuing growth in the rate-based portion of revenues due to an anticipated increase in oil and gas demand according to the International Energy Agency (“IEA”). Forecasted net income is expected to land at $707 million (2020: $791 million), which is lower than the prior year due to the impairment charge related to the Liberty Pipeline as mentioned above. However, we are anticipating continued growth in earnings over a 10-year discrete period until 2030 on the basis of increasing oil and gas demands (the IEA estimates global demand to grow by 3.2% year-over-year) and return on capital investments from future growth projects.
Source: Author, with data from our forecasted Statement of Operating Income
Our valuation of PSXP in the case that DAPL is granted an easement to continue operations results in an equity value of approximately $10.9 billion, which is equivalent to $45 to $48 per common unit. This represents an upside potential of approximately 25% to 34% based on the current share price.
Source: Author, with data from phillips66partners.com
Source: Author, with data from our valuation model
PSXP's Overall Financial Strength
With concerns over DAPL aside, our analysis of PSXP’s latest annual report and first quarter earnings release shows that the company has continued to demonstrate strong cash flows despite a challenging year due to the volatility of the oil market, weather impacts, as well as other COVID-related business disruptions. Although the first quarter reported losses due to impairment of the Liberty Pipeline project, PSXP recorded distributable cash flows of $233 million, which are comparable to those in prior periods thanks to the heavily contracted nature of the business. Most of PSXP’s operations are backed by long-term fee-based agreements, whereby counterparties commit to provide PSXP with minimum volumes and/or minimum monthly service fees regardless of capacity used; counterparties are also charged a “deficiency payment” if minimum contracted volume commitments are not met, providing PSXP with guaranteed fixed cash inflow.
PSXP is also a low-leverage midstream company, with a leverage ratio of only 2.9x while the current industry average is approximately 4.0x. The low leverage nature of PSXP provides the company with sufficient capital to engage in capacity expansion opportunities when oil demands increase, and sufficient liquidity to maintain operational flexibility during a challenging economy.
To further corroborate PSXP’s strong fundamentals, we have also considered PSXP’s performance in comparison to its industry peers of similar market cap, namely Magellan Midstream Partners L.P. (NYSE: MMP) and Shell Midstream Partners L.P. (NYSE: SHLX). Based on the diagram below, PSXP is adequately positioned between its comparables with a similar P/E ratio while offering high dividend yield of close to 10% and robust year-to-date performance.
Source: Finviz - The size of the bubbles represent the company's market cap, while opacity of the colour represents strength of performance in the past 12 months.
Source: Author, with data from phillips66partners.com
Conclusion
Based on our analysis above, we believe PSXP is a winning pick for value investors to hold near and dear to right now. Despite the high likelihood of its joint venture in DAPL facing shut down in the near future, we believe the expectation has already been priced into the company’s current share price based on our valuation estimates, and does not come across as a surprise to market participants; in other words, the stock is reasonably priced at the moment with a generous annual distribution yield of almost 10%. On the contrary, if DAPL is granted an easement to continue its operations, PSXP's share price could reach an upside potential of 25% to 34%. Either way, PSXP seems to be exhibiting a buy-opportunity at the moment.
With the midstream industry poised to benefit from the reopening of the economy and increasing global demand for oil and gas, PSXP’s track record in generating strong cash flows and ability to maintain low leverage levels also allows the company to take advantage of growth opportunities in the long-run. We have a conviction that PSXP is equipped to deliver attractive upside potential once they overcome the situation at DAPL, which we will know more about following the court ruling on May 3rd.
