Plains All American Is Perfectly Positioned for the Permian Basin

While Plains All American Pipeline (PAA 1.90%) has a geographically diversified asset footprint, it is a Permian Basin growth story. The company recently completed one much-needed oil pipeline, and it has another under construction and an even larger one in development. That positions the company to deliver strong growth in the coming years. In this Industry Focus: Energy clip, host Nick Sciple and Fool.com contributor Matt DiLallo discuss what stands out about Plains All American, how Plains All American is playing the pipeline problem in the Permian, and what to keep an eye on in the future as new pipelines come online.

A full transcript follows the video.

This video was recorded on Nov. 15, 2018.

Nick Sciple: Let's go ahead and talk about our last talk we're going to talk about today, which is Plains All American Pipeline, ticker PAA. It's exactly what it sounds like. It's a pipeline company that's all-American. It's all in North America. They own gathering terminals and storage facilities in California, Louisiana, Oklahoma, Texas. In Canada, they're in Alberta and Saskatchewan. Yields about 5.2%. Has more than 90% of its cash flow tied up in long-term contracts. What stands out to you about Plains All American?

Matt Dilallo: Plains All American, even though you mentioned how diversified they are, they're really a Permian Basin story. They have one of the best positions there in the Permian. They've got a lot of growth projects in the pipeline, so to speak. They just finished the Sunrise expansion pipeline. That's taken crude oil up to Wichita, and then it's going to go up to Cushing, which is the nation's oil hub. Then they have another one, the Cactus II pipeline. It's an expansion of another pipeline that'll take oil to Corpus Christi, Texas, which is a big hub down along the coast. They've got these projects, and they've got a lot of other little what they call "de-bottlenecking projects." They look for if there's too much oil flowing in one direction, how can we fix that and invest capital and get a return and improve the flow of oil? They're really focused on the Permian, which is a great place to be. It will grow so fast once they get these pipelines online next year.

Sciple: We've talked about the Permian in the past, about the pipeline constraints there and how it's held back production in that region. A couple questions here. First, because there's a shortage in pipelines, what kind of leverage does Plains All American have in negotiating pricing with the producers there? Secondarily, as these pipelines come online, how quickly is their capacity going to get filled up and we reach another bottleneck again? There's a massive number of drilled but uncompleted wells, this latent demand in the Permian. What are your thoughts on those two questions there?

Dilallo: One of the things that the pipeline crunch has enabled Plains to do is be able to secure partners. They have this partnership with ExxonMobil. It'll be the next Permian pipeline that will probably be built. Exxon signed a big, long-term contract to be an anchor shipper on this pipeline. The pipeline companies have been able to do that, get big producers to anchor these pipelines. It de-risks the projects so that smaller producers are OK with signing on with them. That's helped them plan ahead and get the next ones lined up. This pipeline, it'll probably be 2021. So now, they're starting to get ahead of the curve.

I think there's three pipelines that are supposed to be finished by the end of next year. Energy Transfer and Magellan have a pipeline that's coming 2020. They're basically staging them almost every year. That should help them get ahead of the curve, as long as there's no permitting issues or other problems like that. It's really helped them to be able to get producers to focus on, "Yeah, I need to sign on now so that I can grow later."

Sciple: Right. It's the problem these producers have been having now. If they don't have some kind of pipeline deal to get the oil out, it's a useless asset. You're selling your oil below the spot price, and all those sorts of things.

We're seeing Planes All American building out all these new pipelines. They've also sold and some of their assets. They sold against their BridgeTex asset, a 50% stake in that, to Magellan Midstream Partners. They're going to use that cash to de-lever a little bit. What's their balance sheet looking like at Planes All American? What are the prospects for that going forward?

Dilallo: That's been the driver. They sold a lot of assets in the past couple years because they, like a lot of companies, were a little bit too tight when the market crashed. They've been trying to get that leverage ratio down. They expect to hit their target early next year. That's going to free them up to do some other things. In the case of BridgeTex, they didn't sell the whole thing; they sold a part of it so that they can still keep that. But there's kind of disconnect in the market where Permian pipelines are selling for ridiculous prices. They're cashing in on that, then using that cash to build new Permian pipelines for a really good rate of return. They're making a really good trade there.

Then, as these pipelines come online, the cash flow will go up. That's already starting to happen this year. They're projecting 12% growth next year. It's growing its cash flow stream at a time that their balance sheets are getting better. That's going to free them up to start increasing their distribution, probably next year. They're talking, with their May payout, they'll probably increase it. They could do any number of things. They're going to be covering their payout by 190% this year. It could go up substantially, or they could hold some back so that they can build some of these projects.

We mentioned the Exxon pipeline. Exxon's going to help fund that. They've got another joint venture partner there. As they secure more venture partners, it's less capital that they need to put up, and that's more potential growth for the distribution. That's what I think is interesting about them. They're heading into this period of growth. Their balance sheet's getting better. And they're pretty cheap. It's a really interesting company.

Sciple: All these things seem to be lining up. I think anybody can tell there's a massive shortage of pipelines in the Permian and there's going to have to be investment there over time. What would have to occur to disrupt this thesis for Plains All American and all the pipeline players supplying into the Permian? What would have to occur for that direction -- it looks like we're moving when it comes to pipeline demand there -- for that to be disrupted?

Dilallo: All this oil is flowing to the Gulf Coast, which is good because there are a lot of refineries there, but there's only so much that the refiners can handle. Some of the oil companies are concerned that the WTI brent spread -- WTI is West Texas intermediate. That's the domestic oil price. Brent is the global oil price. There's a $10-a-barrel difference. They're worried that's going to widen. Unless you have access to exports and can sell your oil at Brent, it's the same thing with producing in the Permian now; you're selling at a discount. Unless companies start building more export capabilities or more refineries get built, then we're going to be in the same trouble. At $10 a barrel, and the U.S. produces 10 million barrels a day, that's $100 million that they're potentially losing out with these pipeline and infrastructure issues.

One of the things Exxon's looking at doing -- and that's why they're partnering with Plains -- is, they're looking at building a new refinery or expanding a refinery. Exxon will have this cheap source of oil that they'll be able to refine to make more money. You'll see these downstream investments, where companies will look at, how can we make money on this discount? Are they going to build export terminals? Are they going to build new refineries? That's where the focus needs to be. How are they going to use this oil now that they're producing it?

Sciple: Sure. Maybe you answered my question then, of what people should watch if you're going to start a position in Plains, or monitor it going forward. Is refinery capacity the thing that you should be paying attention to? Like downstream? What are the things that investors should focus on to make sure that growth story is still playing out?

Dilallo: That's part of it. The nice thing about a company like Plains is, they already have long-term contracts with the pipelines that they have. They pretty much know where that cash flow is coming from for the next couple of years. In this case, it's more of, where's the growth coming after 2020? They're pretty confident that they're going to build this pipeline with Exxon. There's another pipeline that they're looking at up in Oklahoma. That'll move oil down south as well. But where's the growth coming next? They know the Permian is going to keep growing and growing and growing. But if we're not going to be able to get that oil to global markets, then the growth is going to stop, because it won't be as profitable to produce.

I would also pay attention what's going on downstream. Look especially at export capacity. There are a lot of companies that are trying to do that. Phillips 66 and its MLP, they're building some export capacity along the Gulf. That would be something I'd pay attention to.

Sciple: Matt, last question going away. This is general market. If we come back and record this podcast three years from now, do you think there will still be pipeline constraints in the Permian?

Dilallo: Probably not. It seems like they might actually overbuild at this point, with the number of pipelines they're doing now. Private equity companies are also involved in there. They'll build more on speculation than a lot of the publicly traded companies. I wouldn't be so worried about the Permian. We might run into pipeline issues elsewhere. Or, like I mentioned, so much oil flowing to the Gulf that they just can't handle it.