We See a Wider Moat for Plains
The dominant position in the Permian can't be replicated.
After taking a deeper dive into the Plains entities, we have upgraded our economic moat rating for Plains All American Pipeline (PAA) and its general partner, Plains GP Holdings (PAGP), to wide from narrow.
Our fair value estimate moves to $26 from $24 for both entities as a result of extending our period of excess returns over a longer time frame. We see both entities as about 20% undervalued; in our view, this reflects a lack of appreciation for growth in Permian volumes over the next few years, a recovery in supply and logistics margins to normalized levels from today’s trough levels, and improved utilization of Plains’ assets in general across the business as a result of the expiration of minimum volume commitment contracts that have distorted pipeline flows.
Producers have been forced to acquire incremental barrels to meet overly aggressive pipeline commitments for acreage that is no longer economic or capital is not available to produce. These incremental barrels are often being acquired at a loss to reduce the cost of the firm origination or reservation fees the shipper has committed to pay and also to meet refinery crude quality specifications, affecting Plains’ supply and logistics margins and flows.
We view Plains All American’s moat as wide because of a strong efficient scale moat source. We have upgraded the moat rating from narrow for a few reasons. First, we believe Plains’ shipping and logistics segment has always been a no-moat business on a stand-alone basis, but its high-profile collapse over the past few years to near break-even levels of profitability in 2017 from nearly $900 million in EBITDA in 2013 (roughly 40% of Plains’ EBITDA) has obscured the wide-moat nature of Plains’ core network of oil pipelines, led by its dominance in the Permian Basin, where about 60% of its 4.9 million barrels per day of oil are sourced.
We do not believe the attractiveness of the underlying asset profile at Plains’ transportation and facilities segments has changed over the past few years, while the business mix has returned to more normalized levels, given the unusual industry environment in 2012-14, and is now roughly 96% fee-based (88% at our midcycle estimates), with the supply and logistics margin-based business regulated to a fraction of the business.
Second, from an asset quality perspective, Plains’ position in the Permian Basin--currently producing 2.6 million bpd of oil--makes up about 60% of Plains’ volumes (about 2.8 million bpd of its 4.9 million bpd of oil throughput) and is dominant and cannot be replicated: Plains has 4,600 pipeline miles, which is about 2 million bpd of gathering capacity, 1.7 million bpd of intrabasin capacity, 1 million bpd of long-haul capacity, and other related assets. It’s not much of a stretch to state that Plains has a high probability of touching every barrel of oil the Permian produces in some fashion and earning a fee, if not multiple fees. Given the basin’s growth prospects, we expect Permian volumes to make up about 70% of crude oil volumes by 2021 compared with about 60% today.
We believe the Alpha Crude Connector, acquired for $1.2 billion in January, is a reasonably good example of Plains’ ability to build on its Permian position. The pipeline runs more than 500 miles through New Mexico, which is environmentally sensitive, and is adjacent to many existing Plains assets with connections to Plains takeaway capacity as well as third-party takeaway pipelines (Enterprise, Sunoco), two major refineries in the region (HollyFrontier and Western Refining), and rail access. The excellent location of the asset means that Plains’ planned increase to around 350,000 bpd of capacity over the next few years from the current 70,000 bpd is very reasonable. In addition, the pipeline offers considerable and unusual levels of flexibility after obtaining Federal Energy Regulatory Commission approval for shippers that are used to dealing with fixed rates for oil pipelines. The acreage dedication contracts for the pipeline provide for substantial discounts for a larger amount of acreage dedicated to the pipeline. There are also FERC-approved market-based storage rates (versus fixed rates) and a gravity bank, a first for the basin and a break-even effort for Plains, which takes the penalties that pipelines charge shippers for supplying heavy crude and passes them on as a credit to shippers that provide lighter-gravity crude, a growing area of production for the Permian. The advantage for Plains is that it obtains more valuable light crude, on which it can earn additional fees by segregating it via its network to locations where the crude is most valuable.
We view the Permian as the lowest-cost U.S. shale basin on the cost curve, with ample production growth ahead of it, so we think the sustainability of Plains’ returns here remains very strong and will take place over decades. It’s very difficult for us to imagine a stronger asset base for an oil-focused midstream entity. For those concerned about the Permian’s very long-term production outlook, we note that it has been a key oil-producing region in the United States for over 100 years, and being able to use and repurpose this existing infrastructure is also an important contributor to the basin’s emergence. The Permian Basin is unique among major U.S. oil basins in terms of reservoir quality and Tier 1 acreage available and yet to be drilled. While more developed basins (Eagle Ford, Williston) are shifting to infill drilling, indicating that Tier 1 acreage is largely drilled up, the Permian (particularly Midland) is only beginning to emerge, and wells drilled are around 3 per square mile, while we estimate the basin could support 25-30 wells per square mile, far higher than the typical oil basin at around 6 wells per square mile. The geology of the reservoir suggests a pay zone of around 4,000 feet compared with 40 feet in the Bakken and 150 feet in the Eagle Ford. Overall, these factors imply 20-30 years of drilling potential for the Permian, and exploration and production companies in the region have 30-plus years of Tier 1 inventory to work through. For our explicit forecast period of five years, Permian production volumes should more than double, given the low-cost position of around $25-$30 per barrel to develop.
Third, despite the industry upheaval over the past few years and the cyclical and structural pressures for Plains’ supply and logistics business, which have consumed management and investor attention, the company still generates economic value supported entirely by the strength of Plains’ integrated oil transportation and facilities network, with zero contributions now from supply and logistics. We expect similar returns going forward, assuming reduced contributions from supply and logistics. Given the substantial spread between our forecast return on invested capital of 11.5% on average over the next five years and our weighted average cost of capital of 8.4%, we believe Plains fits in the wide-moat category.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.