The Permian Has a Pipeline Problem Already

Production in the Permian is a bit too high for current pipeline infrastructure to support, and it's only going to increase by the end of this year.

In this week's episode of Industry Focus: Energy, Motley Fool analysts Sean O'Reilly and Taylor Muckerman look at why more producers probably should have seen this coming, and how pipeline companies are responding to the overproduction. Also, the hosts dive into one Canadian pipeline company that energy investors might want to take a look at, why so many oil company CEOs are lining their pockets while their companies are failing, what it means for the industry that Libya's Sharara field is back online, and more.

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, April 27, 2017, so we're talking about energy, materials, and industrials. I'm your host, Sean O'Reilly, and to my left is Motley Fool Premium analyst and the Butch Cassidy to my Sundance Kid, Taylor Muckerman. What's up, Taylor?

Taylor Muckerman: I hope we don't get tracked down by some Indians. I want to make it out alive on this show.

O'Reilly: What's the line that he says when they're about to run out?

Muckerman: I have no idea.

O'Reilly: I need to watch it now.

Muckerman: Old-school movie.

O'Reilly: I shouldn't make references like that if I don't know the climactic line. It's probably been 10 years since I've seen that.

Muckerman: I'll YouTube it while you talk, how about that?

O'Reilly: That actually would be a great solution. Would you mind? Today, we're going to rap about energy executives essentially thriving while their companies slog through Chapter 11 bankruptcy court. Lack of pipeline capacity, we had a listener tweet in, we have to talk about that. And I found a great article about how they were not going to have this problem, but apparently they're running out of pipelines in the Permian Basin to get oil out of there. I don't know. Do you like it? I wonder how the Delaware Basin within the Permian is doing.

Muckerman: They're certainly producing a lot of oil there. That's the hottest place to be right now, apparently.

O'Reilly: That's where the party is.

Muckerman: It seems like they might have caught some people off guard. Not good for anybody, really, though. It's good for the pipelines because they're maxed out, but it's not good because they didn't plan properly. Then, for the oil producers, it's not good because they can't get their oil and natural gas taken to the market.

O'Reilly: It's great for the pipelines, and I have the list of the companies.

Muckerman: Oh, you do?

O'Reilly: Yeah, I have a list. But first, before we do that, we have to talk about Libya really quick, because it's crashing oil right now. It's very sad. Oil is down 2% at the time of this reporting. The field that was shut down, Libya's Sharara oil field, is back in business -- 330,000 barrels per day of daily oil production. This happens all the time, Taylor.

Muckerman: Yeah. Apparently the oil markets thought Libya was never going to produce oil again.

O'Reilly: I remember, was it 2010 or 2011, when oil was going up a ton, that's when it completely shut down for a while. But, yeah, they're back. I don't know, it's just, ho-hum.

Muckerman: Ho-hum.

O'Reilly: Has it been a month since it shut down?

Muckerman: I don't remember when it did. Maybe a month. But, yeah, at the same time, this is good. It shows that the markets are responding to things like this, rather than when you had shutdowns and uprisings in 2014 and oil markets stayed on the same trajectory. At least you now have some immediate reaction to supply and-demand disruption. Maybe we're tightening the balance a little bit here.

O'Reilly: Markets are becoming more efficient.

Muckerman: How about that?

O'Reilly: Moving on here -- we had a listener tweet into our @TMFEnergy Twitter handle. Peter F Smith, @PSUPete, tweets at us and says, "When are you guys going to do a deep dive into Pembina?" Nailed it. You told me to say it like a Canadian.

Muckerman: Yeah. Well, it's even quicker in the YouTube videos, Pembina.

O'Reilly: Why do they drop the "B"?

Muckerman: I don't know; it's just the way it sounds. I don't know if they're dropping it or not.

O'Reilly: To all of our wonderful Canadian listeners, our neighbors to the north, please tell us why the "B" is dropped.

Muckerman: It sounds like you can kind of hear a "B," but you can't really hear the "B." Pembina.

O'Reilly: You can't really hear the "B." Stop.

Muckerman: Pembina Pipelines (PBA 1.72%).

O'Reilly: Nailed it. This guy says, "I would love Taylor's insights." Taylor, what do you think about Pembina?

Muckerman: There's a lot of pressure. It's a Canadian company, so shout out to the folks I work with on Motley Fool Canada services. Pipelines, so not necessarily having the same constraints as the Permian, because they're dealing with the oil sands, crude oil, oil sands, and natural gas liquids, out of the Western Canadian sedimentary basin, and ethane from North Dakota and Saskatchewan. 

O'Reilly: Is this oil sands?

Muckerman: Not all of it. It still does regular crude oil and natural gas liquids. But then you have ethane singled out as one of the natural gas liquids. So pretty well diversified in terms of the natural resources that they're funneling through their pipelines. Seems to be growing pretty rapidly, about $1.2 billion in projects completed last year, trying to complete $4.3 billion in projects this year. Most of it should be done by the middle of 2017, with a few stragglers coming in toward the end. Definitely upping their capacity, trying to be Canada's largest gas processor. And if you think about the need for the fractionation of natural gas liquids into all their base, like ethane and butane and everything, and also just natural gas processing in general, the use of it for energy and input, it seems to be a smart idea.

O'Reilly: If you haven't heard of the company, these guys are not small.

Muckerman: No, they're not small at all.

O'Reilly: They're a $12.9 billion market cap, dividend yield of 4.8%. Is this common? They're one of those guys that pay a monthly dividend.

Muckerman: It is fairly common in Canada.

O'Reilly: I like my monthly, check, eh? [laughs] 

Muckerman: Yeah. It's not like 50% of the market does it, but yeah, there's certainly significantly more companies doing it up there than in the United States. Speaking of their dividend, very consistent dividend growth. They just raised their annual dividend by 6.25%. Not yield-wise, but payment-wise.

O'Reilly: That's $0.16 to $0.17 a month, something like that?

Muckerman: I don't remember exactly what the exact cents work out to on a monthly basis, but the overall payment for an annual basis raised by 6.25%, April 3. And it's not just a one-time thing. They've been raising their dividends pretty consistently over the last decade or so, and improving margins, improving their cash flow. Certainly seems to be operating at a very high level. Eighty percent of their contracts and EBITDA come from fees for services, so pretty stable, consistent, you have good foresight into what kind of revenue they're going to be making on a year-in, year-out basis. And a very secure customer base, around 80% of their customers having investment-grade credit ratings or secured counterparties.

O'Reilly: Sounds like an interesting company.

Muckerman: Yeah. If the oil markets go bump again, they're at fairly low risk to have bankrupt customers that can't foot the bill. So yeah, seems like a good company. I hadn't really ever taken too deep of a dive in it. But I do love the midstream, the pipeline companies in the oil space, if you're going to get exposure to energy. And growing capacity, growing dividend, and sound balance sheets. Certainly worth looking at for anybody that wants access to the Canadian oil markets.

O'Reilly: There you have it. Two nights ago, you sent me a fun article here: "Permian growth overwhelms pipeline capacity." It's from WorldOil.com.

Muckerman: You sent me this. I sent you the CEO one. This is your bag right here, man.

O'Reilly: I'm sorry. All right. In fact, you know what? We'll talk about the executive, since you're so hot to talk about it, fine.

Muckerman: Whatever order you want to go in.

O'Reilly: I just can't believe this, because I found -- I'll get to it in a minute. More than a few oil and gas companies, producers, have gone belly up in the last couple years.

Muckerman: They went through some restructuring. They emerged.

O'Reilly: It's not quite belly up, because there's a difference between Chapter 7 bankruptcy, which is liquidation, and Chapter 11, which is restructuring, getting rid of some debt, converting it to equity, that kind of thing.

Muckerman: Selling some assets, yeah.

O'Reilly: Which, of course begs the question, what happens to the executives? It sounds like some good stuff.

Muckerman: Good stuff for whom?

O'Reilly: Them.

Muckerman: For them, there's a lot of good news. The Houston Chronicle recently put out an article showing that 10 companies with promises to management of between 5% and 10% of new equity rewards go ahead and reserve --

O'Reilly: Of the company.

Muckerman: Yeah, of the new restructured equity structure; 5% to 10% of those outstanding shares are just reserved for management.

O'Reilly: Why are the debtholders, the bondholders, OK with this? I mean, I know they don't want to run an oil company, but still.

Muckerman: A lot of people were saying, "Hey, these guys were able to build this company to begin with; we don't want them to be offered more money from somewhere else and jump ship, and then have to emerge ... "

O'Reilly: But their company went under, Taylor.

Muckerman: I know! I know. And they have to emerge from restructuring with a CEO that might not know as much about the company. I personally as a shareholder would not be too pleased. I mean, I'm fine with the same CEO being there.

O'Reilly: Well, if you're an original shareholder, you're gone, sorry.

Muckerman: I'm fine with the CEO remaining, but not with increased share structure. And it's just a bad incentive structure, when they can make even more money than they're being given. Floyd Wilson -- $24.1 million in annual comp coming out of Halcon [Resources'] bankruptcy restructuring. Up from an average of the previous few years of $3.4 million. So almost 8x.

O'Reilly: It's good to be the king.

Muckerman: Now, within that $24.1 million, it could be higher or lower in value, because some of it is options-based, some of it is restricted shares-based, so they divest over time. But the simple fact that the predominant amount of this compensation is share-based, you might have a situation where some of these CEOs just try to roll out as quickly as possible and get themselves into the same situation that led them to bankruptcy when the oil markets sold off. Linn Energy, one of your favorite oil companies of yesteryear, their CEO, Mark Ellis, received $16 million in restricted shares post-bankruptcy. That company actually set aside 7% of shares to reward management, which, at the time of the reservation, were worth $173 million. This is a company that was one of the biggest bankruptcies in the entire energy world over the last couple years, setting aside 7% of their shares for management rewards.

O'Reilly: No words.

Muckerman: Yeah, no words. And Goodrich Petroleum, Basic Energy, among the other two that were part of that 10 that they identified. To me, hooray for them, but the incentivization is all wrong, coming out of bankruptcy, giving them vested shares, options.

O'Reilly: I wonder what happened in the last big downdraft in the '90s in the oil sector, if something like this had happened.

Muckerman: Yeah, I don't know if there was a paper out there about that.

O'Reilly: Oh, well. Bottom line -- don't worry, the executives are just fine.

Muckerman: Yeah, they're doing all right. But if maybe you wanted to invest in a company that has just restructured thinking there might be an opportunity for some significant upside, bear in mind that --

O'Reilly: Seven percent of it is going to ... [laughs] 

Muckerman: They could be incentivized for rapid growth and long-term potential destruction, depending on the cyclicality of the industry.

O'Reilly: Beautiful. So. The big show, Permian over capacity. This is funny. As I mentioned, "Permian growth overwhelms pipeline capacity": "By the end of 2017, four new pipeline projects are expected to add over 800,000 barrels per day of capacity, and it is sorely needed. EIA [the Energy Information Administration] estimates production from the Permian Basin this year will grow 420,000 barrels per day." Apparently, WTI [West Texas intermediate] Midland prices relative to WTI Houston are all out of whack because of this. This is particularly funny because I found this article back from the Midland, the Midland Times, their newspaper. This is from March 2016, just a year ago. "Study finds Permian has four years of extra pipeline capacity ahead." What's going on here, guys? Did it really catch everybody that off guard?

Muckerman: I think, when you were talking about oil production and natural gas production several years ago, the United States was more diversified. Now, the Permian is the lowest cost, in some areas --

O'Reilly: It's kind of a bottleneck situation?

Muckerman: Yeah, so everyone has been rushing to the Permian, versus folks focusing a little bit more on the Williston, a little bit more on the Eagle Ford, a little bit more on the Niobrara. All the news has been about everyone rushing to the Permian, and really ramping up that region's production.

O'Reilly: I found a fun map with a list of all the pipelines in the Permian put together by Credit Suisse. Crude takeaway capacity in the Permian Basin -- and these are all the operating companies -- Plains All American Pipeline (PAA 1.41%) is a company.

Muckerman: I've heard of that one. 

O'Reilly: OXY [Occidental Petroleum], Sunoco [Logistics Partners] (NYSE: SXL), Kinder Morgan (KMI 3.46%), and of course, Magellan [Midstream Partners].

Muckerman: Some pretty big names in there.

O'Reilly: For sure. The biggest on the list is Plains, 450,000 barrels of capacity per day. Sunoco is 400,000, and then it tapers off from there to Magellan at 225,000. Kinder Morgan 120,000. OXY 75,000. This is 1.27 million barrels of daily production capacity we're talking about, to move it. There's more coming online mostly from Magellan, Plains, and Sunoco.

Muckerman: Yeah. Hopefully it's coming online because they're already been building it. If I were an investor, I wouldn't want to see companies running out to build crazy capacity just because there's a shortage, because it'll probably diffuse itself over time.

O'Reilly: Right. Apparently, the management of these companies have been pretty far-sighted. There's no way they rushed in there; they just built these.

Muckerman: Yeah, these take years. Maybe not years and years, but a year or more to throw these things together on the bigger scale of takeaway capacity.

O'Reilly: I'm surprise Kinder wasn't bigger in the Permian.

Muckerman: Yeah. You look at them, a lot of their business is natural gas.

O'Reilly: There's oil in them Permian hills.

Muckerman: Yeah, there's oil; there's some natural gas there, too. But a lot of Kinder's business is natural gas.

O'Reilly: Which of those pipelines do you like the most?

Muckerman: Read them off again?

O'Reilly: Plains, OXY, Sunoco, Kinder, and Magellan.

Muckerman: Hmm. That's a tough question. How about I give my answer on next week's show?

O'Reilly: You're killing me, man.

Muckerman: I mean, I don't have a favorite right off the top of my head. I own Sunoco.

O'Reilly: That's your favorite, then!

Muckerman: Yeah, but I don't know at the moment. I mean, I like it, so I'm holding it. But if I had to buy shares of one of those today, would it be Sunoco? I don't know.

O'Reilly: Deep.

Muckerman: I need to look at the other ones to make sure.

O'Reilly: Writing a check is important.

Muckerman: I'm being honest to our listeners. If I don't know enough about all of them, I'm not going to choose one over the other, because one of them that I don't know enough about might be better.

O'Reilly: Touche.

Muckerman: So, next week, I'll look at that list and I'll give you my No. 1 Permian-based pipeline company. 

O'Reilly: Oh, boy. We'll make a whole show about it.

Muckerman: No, we won't.

O'Reilly: We'll do DCF [discounted cash flow] analysis,;we'll do --

Muckerman: No.

O'Reilly: I'm kidding.

Muckerman: It'll just be, my favorite is, and then we'll talk about something less meaningful.

O'Reilly: Fine. What could be ... just kidding. Touche. I actually just wrote an article about Kinder. I like their turnaround.

Muckerman: You do. Yeah, out of that group, I know they definitely have some solid free cash flow generation, which isn't necessarily the norm.

O'Reilly: It's just the ratios, and they're on the line with paying out their dividend again. 

Muckerman: I do appreciate free cash flow with a pipeline company, because not all of them have it. Generally, your capex is way above your operating cash flow. 

O'Reilly: Yeah, Kinder Morgan has been just under $2 billion in free cash flow, even throughout all these. They're a little bit more leveraged than the average company. But just under $2 billion in free cash flow. I think I looked back three or five years, and it was like, yeah this is ...

Muckerman: Yeah. Even Pembina. They're free cash flow-negative. And [Enbridge Energy Partners], free cash flow-negative.

O'Reilly: Are they just blowing money on new projects? What's going on?

Muckerman: A lot of capex. If you're building $4 billion in projects in one year and your operating cash flow is in the $2 billion range, up to $3 billion range.

O'Reilly: Have to go to the debt markets.

Muckerman: Little bit. But that's why you've seen -- not the only reason -- a lot of growth in this industry, because debt has been pretty cheap.

O'Reilly: For sure. OK. Thanks for your thoughts, Taylor, as always.

Muckerman: Yeah, brother.

O'Reilly: That is it for us, folks. Be sure to tune in tomorrow for the Tech show with Dylan Lewis. Special thanks once again to our producer, Austin Morgan. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman, I am Sean O'Reilly. Thanks for listening, and Fool on!