Magellan Midstream: Adapt Or Die In The New Energy Economy
Summary
- Magellan Midstream has been one of the highest quality oil midstream companies for many years.
- The energy environment is changing in ways that threaten the midstream oil MLP growth model.
- How will a new company strategy fare in an environment where there is low or no growth.
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Magellan's Impressive Success
Success for oil midstream MLPs has always been predicated on growth. Steady investment in new projects generates higher revenue, cash flow, and distributions. Magellan has an excellent record of turning growth capital into increasing value for investors:
Source: MMP investor presentation
And this chart:
Source: MMP investor presentation
A major key to their success is their insistence on a minimum ROIC of 15% for any growth capital. As this chart shows, their discipline in this regard over 20 years has been amazing.
Source: MMP investor presentation
The New Energy Environment
What happens when growth slows, in the short and long term? Specifically, what happens when the demand for the products that MMP transports and stores stops growing? Make no mistake, this is what is happening in the fossil fuel world, and how Magellan addresses these questions is key to the company's future. Magellan is a very US-centric company, and the data presented here focuses on the US energy economy. Global oil markets may change Magellan's business around the edges, but the US is its operating environment.
Changes in the US energy economy are unmistakable and can no longer be discounted or ignored. First, US crude production is projected to peak in the next few years and then start a slow decline for the next 25 years.
Source: AEO 2021 Petroleum (eia.gov)
Gasoline consumption, along with diesel responsible for 71% of MMP operating margin, has already peaked.
Source: AEO 2021 Petroleum (eia.gov)
New signs of the new energy economy appear on a regular basis. Some recent examples, out of many:
- The oil & gas industry will deliver its worst exploration year since 1946, according to data compiled by Rystad Energy.
- Most majors declined to bid on top tier Brazilian offshore assets, even greatly improved terms for bidders after a failed auction in 2019.
- Production budgets are not returning to pre-Covid levels, and probably never will, for companies like Exxon Mobil (XOM), Chevron (CVX), Conoco (COP), and Pioneer (PXD).
- Two hundred countries at the November UN Climate Change Conference reached an agreement that reinforces global efforts to reduce emissions, with fossil fuels by far the largest target.
- In a case against Shell in the Netherlands, a court for the first time made a company legally obligated to align its policies with the Paris climate accords. Shortly after, Shell announced it is moving its global headquarters out of the Netherlands to the United Kingdom (there are more reasons for the move, but it's hardly a coincidence).
In transportation, the biggest end-user or MMP's services, major trends will permanently lower the use of oil-consuming vehicles.
This 12-month-old EIA Outlook is already outdated. Vehicle manufacturers have been pulling forward their future EV production plans all year long.
Toyota now plans to generate half of its sales from EVs by 2025, five years than earlier estimates. Volkswagen will spend $30 billion on EV development through 2023 and have a 40% EVs in their mix by 2030. Ford will have 40 electric vehicles in their lineup next year. Every manufacturer is planning for an electric future. Each Tesla, Ford Lightning, or other EV that gets sold is several hundred gallons of gas a year that will not be pumped through MMP pipelines.
On top of all this, the Biden administration has just increased the fleet mileage requirement for auto manufacturers from 40 to 55 mpg by 2026.
Magellan's Response to the New Energy Environment
MMP is already planning for a future of flat or declining oil use in the US. As the following table shows, MMP is winding up its existing capital projects and does not have plans for new ones.
2017 | 2018 | 2019 | 2020 | 2021 (est.) | 2022 (est.) | |
Capital exp. ($ millions) | 482 | 640 | 990 | 355 | 75 | 80 |
MMP is not entirely foregoing expansion capex. There are proposals for up to six potential projects in the $10-20 million range. Additionally, there is a base level for maintenance capex of about $80-100 million (which is not part of DCF).
As CEO Mike Mears stated in December 2020,
...we envision ourselves in a relatively low capital environment through the foreseeable future.
Source: Magellan Midstream Partners' (NYSE:MMP) CEO Mike Mears Presents at Barclays CEO Energy-Power Conference Transcript | Seeking Alpha
Excess Distributable Cash Flow
Fortunately, MMP throws off a lot of cash in excess of what's needed for distributions.
2016 | 2017 | 2018 | 2019 | 2020 | 2021 (est.) | |
DCF (millions) | 948 | 1020 | 1110 | 1298 | 1045 | 1100 |
Distributions | 739 | 803 | 865 | 922 | 927 | 906 |
Excess DCF | 209 | 217 | 245 | 376 | 118 | 194 |
Source: MMP quarterly reports
What to do with all that cash? In the words of Mike Mears again,
So if we – our expectation is, if we have a stable, slightly growing EBIDA stream and we're using our available cash for equity buybacks, which is our preferred return of capital method at this point, then we can be growing our cash flow per unit, which I think in the long-term is what investors want.
Source: Magellan Midstream Partners' (MMP) CEO Mike Mears Presents at Barclays CEO Energy-Power Conference Transcript | Seeking Alpha
And why not? Every unit bought back is an immediate 9.18% return as the distribution for that unit no longer must be paid. At the same time, when there are fewer units outstanding the cash flow per unit increases.
Buybacks
This strategy will have meaningful benefits for investors. MMP just completed a $750 million buyback and has announced an additional $750 million buyback plan. With large amounts of cash available after distributions and no heavy capital needs, this is very doable over several years – the last buyback took only two years and $467 million was used for repurchases this year. At the current unit price of $45, $750 million will buy back 16.67 million shares out of the 225.5 million float, or 7.4%. This will save $69 million annually in distributions, and distributions will be allocated to 7.4% fewer shares. This will be a substantial tailwind for both cash flow per unit and the unit price. Investors should be pleased.
Longer term, there is more uncertainty. Corporations don't stand still – they are either growing or declining. MMP will continue to adjust its business in the face of declining domestic demand and longer term declining domestic oil production. On the positive side, successful corporations constantly adapt to changing conditions. If a new growth strategy makes itself known MMP can take advantage. For the foreseeable future, however, investors can expect a strategy of lower business growth and more direct return of capital.
MMP vs. the Field
Other large midstream MLPs like Enterprise Products Partners (EPD) and Energy Transfer (ET), are still in growth mode. An important difference between them and MMP is that a major part of their business is natural gas, which has a much more robust outlook than the domestic oil that MMP specializes in. Still, in terms of stock performance, MMP has held its own. This chart shows that, like MMP, many midstream companies have not fully recovered since the 2020 correction. MMPs' performance is between gas/oil combo companies EPD and ET, but better than oil-centric Plains All American Pipeline (PAA) and Phillips 66 Partners (PSXP). Midstream companies that have fully recovered, such as Williams (WMB) and Marathon (MPLX), have a large natural gas business for the most part.
Source: Yahoo Finance
The MMP stock price is still 28% below its pre-2020 correction level.
Summary and Recommendations
Magellan is a solid choice for investors who see a reliable 9% annual yield as an acceptable return. There is enough distributable cash flow to support the distribution and the company expects a comfortable 1.2x distribution coverage. Those expecting outsized capital gains, however, may be disappointed. The growth projects that drove performance in the past are not there, according to the company. Holders such as me, who bought around 60, won't get back to breakeven any time soon. The company's plan is for a more gradual increase through buybacks through reducing the number of units outstanding. I will continue to hold and reinvest distributions, as there are not many opportunities to get a solid 9% yield with a good potential for some capital growth regardless of general market conditions.
MMP investors are fortunate that management is disciplined, transparent, and puts a high priority on treating its unitholders well. Personally, finding shareholder-friendly companies has been a key to my own investment success. Growth has been the key driver for midstream MLPs for a long time, but Magellan is frank about the lack of growth projects for the foreseeable future. This is consistent with developments in the domestic oil industry where demand for MMP transportation and storage services is in a secular decline.
The strategy of small growth projects and using cash to reduce units is a sound approach to increasing shareholder value, but that will be a gradual process and how it compares to the previous high growth strategy remains to be seen. The lack of growth opportunities makes the out years more uncertain, particularly for an MLP so reliant on the US oil economy. We can't discount the resilience of corporations and their ability to adapt to changing circumstances, and MMP must be given credit for adapting to a new paradigm earlier than much of the industry. Adaptation and change will be the key to Magellan's future in an environment where growth will need to be found in different ways than in the past.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of MMP, EPD either through stock ownership, options, or other derivatives. 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.
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