Pipeline companies typically pay high-yielding dividends, making them ideal options for income-seeking investors like retirees. However, not all pipeline stocks are the same. In this Industry Focus: Energy clip, host Nick Sciple and Fool.com contributor Matt DiLallo discuss:

  • Infrastructure issues in the Permian Basin
  • Natural gas flaring
  • Key metrics investors should look for in a pipeline company
  • How to differentiate between midstream projects
  • Why Plains All American (NYSE:PAA) is an ideal pipeline stocks for dividend investors to consider

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This video was recorded on Oct. 10, 2019.

Nick Sciple: Today we're going to talk about pipelines. A couple of weeks ago, I had Jason Hall on the show and we talked about T. Boone Pickens' legacy. We also talked a little bit about attacks that had happened on the Saudi Arabian oil facilities. We got a question back from one of our listeners. Leland Payne said: "I appreciated your commentary about the attack on the Saudi Arabian oil facilities and the market reaction for crude oil as a result. It was mentioned that there is a takeaway problem from the Permian Basin. It is my understanding that Kinder Morgan and Enterprise Products Partners are constructing significant pipeline capacity to take away oil and natural gas to the Texas Gulf Coast and to Mexico. I would appreciate hearing a podcast on these two midstream companies."

Matt, first off, on the pipeline takeaway, constraints in the Permian, for folks that are unfamiliar with what's going on here, what's the high-level story there?

Matt DiLallo: The Permian Basin has a ton of oil and gas. Oil companies have been drilling and drilling and drilling, and they've drilled so much of it that it's overwhelmed the infrastructure that was there. It's slowed down the progress out there and created this huge bottleneck of oil in storage, and then there's too much gas they can't use. So, they need infrastructure. That includes pipelines, among the whole bunch of other things, like processing plants, and that type of stuff.

Sciple: Yeah, exactly. Production exploded so much in the past decade or so in these big shale plays, particularly the Permian. I've cited these numbers in the past -- between 2008 and today, the United States accounted for 73% of the increase in oil production worldwide. If you look at natural gas, the Permian Basin accounts for 10% of America's total natural gas volume, and expects to double that output by 2025. When it comes to pulling hydrocarbons out of the ground, that's an incredible growth in production. You have to take this to market. As you mentioned, there's huge oversupplies, which has depressed prices in the region. It's also led to this trend of flaring that's been in the news a lot. Matt, can you talk a little bit about that, and what the controversy has been there?

DiLallo: Flaring is a way of getting rid of gas that they don't have pipelines for. Oil, they can truck to different storage places, but natural gas has to flow through a pipeline or be liquefied. So, their options are to either reinject it back into the ground, which costs money; or to flare it off, which is to burn it off. They've been doing that. They burned off so much gas at the end of last year, it was stunning. They could power every home in Texas with the amount of gas they're flaring off, just because it was cheaper to burn it than use it. But these pipelines are going to help solve this problem. They'll be able to monetize this gas.

Sciple: Exactly. Whenever pipelines come on line, the cost to get that to market decreases, so it can make economic sense to start delivering this gas to market, which is obviously great. This is a clean-burning fuel that we would like to see put to good use.

Before we dive into Kinder Morgan and Enterprise Products Partners, I want to talk a little bit about investing in pipelines from a high level. When you first look at a pipeline or a midstream company, what are the first things you pay attention to from a financial metrics point of view, Matt?

DiLallo: There's three things that I look for in a pipeline company. The stability of their cash flow. One of the big draws of pipelines is that they pay these big dividends. That's because they generate very steady cash flow. A lot of times, it's based on these fee-based contracts that they sign with producers. So, an ExxonMobil drills wells in the Permian Basin, and they need to get their oil to the Gulf Coast, so they'll sign a contract to ship, let's say, 100,000 barrels a day on a pipeline. These pipeline companies collect basically a toll booth fee as this oil goes through. They offer stability of cash flow. The number that sets off for me is 85% or more. That gives them a really predictable cash flow.

The second one is the payout ratio. We mentioned that dividends are a big thing with these pipeline companies. I want to make sure that they can sustain that payout. I'm looking for a payout ratio of less than 80%. Another metric they use is a distribution coverage ratio. The equivalent of that is 1.2 times.

And then, a healthy balance sheet which is an investment-grade balance sheet. In my book, that means that bond rating companies take a look at their books and say, "This company is worthy of investor trust." The typical number that they look at is 4.0 times debt to EBITDA or less, which is basically a company that's generating enough cash flow per year that within four years, they could pay off their debt.

Those are the three metrics that I look for.

Sciple: What's attractive particularly about these midstream companies, we talked earlier about this huge increase in production of oil and natural gas. That makes it hard for the folks that are pulling this stuff out of the ground to make money because the price is pushed down. However, the folks that are distributing this product to market, there is more oil and natural gas flowing through the pipes. On these fee-based contracts, they're able to make predictable, increased returns on that.

One question I have when I look at pipeline companies, it's hard to differentiate one project from another when it comes to what value they're going to return to the firm, and how to differentiate one pipeline company from another. When you look at projects that these companies are investing in, how do you differentiate high-quality projects from low-quality projects when it comes to investing in these companies?

DiLallo: As I mentioned earlier, it's the stability of the cash flow. There's different types of projects that have different types of cash flow backing to them. A gathering pipeline -- so, an oil company drills wells out in, let's say, Texas. Then they put these pipelines right close to gather all the oil and bring it to a central processing plant. These have a lot more variability to them. If the oil production drops from those wells, the revenue will drop. Same thing with natural gas processing plants. Sometimes they're not even volume-based. It'll be the money they can make on the difference between what they buy natural gas, and then what they sell the end product from. I don't like companies that are involved in those types of, they're called gathering and processing.

I like pipeline companies that do the long-haul pipelines. When you're talking about these projects that a Kinder Morgan are building, they're these long pipelines, they're 100% contracted. So, they know exactly what they're going to get. Every quarter, every year, they're going to get the same amount of money. I like that stability when I'm looking for a midstream company.

Sciple: Sure. On the back half of the show, we're going to talk specifically about Kinder Morgan and Enterprise Products Partners. Is there another midstream company that comes to mind that checks off all those boxes that you like to see that maybe investors should pay attention to?

DiLallo: One of the favorites that I have, specifically oil in the Permian Basin, is Plains All American Pipeline. They're a master limited partnership, but they also have a corporate option that investors can do called Plains GP Holdings. There's two different options for investors. It pays a great dividend, 7.5% right now.

Again, what do I look for? I'm looking for those big three. In this case, it's 85% fee-based cash flow backed by those long-term pipelines. And their dividend payout ratio is actually 50% right now, which is exceptional. That means they're only paying out half of what comes in for the dividend, and the other half they can use to reinvest in pipelines. The third thing that they excel at is their balance sheet. Investment-grade. It has a 3.0 leverage ratio, which is obviously better than a 4.0. So, they've got a great balance sheet, great payout ratio, steady cash flow. That gives them all this financial flexibility to invest in new projects. I think they're up to seven pipelines that they're working on right now. The most exciting one is this Wink to Webster pipelines, an oil pipeline project with ExxonMobil that will start in 2021. It's going to ship over a million barrels per day from the Permian to the Gulf Coast. It'll help Exxon, putting some oil in some of their refineries, and then they'll export it. So, a great project. It'll help Plains grow its dividend. They're looking at least 5% per year for the next several years. It's super safe, like I said, with those great metrics. I think it's a really interesting company for investors to take a look at.

Sciple: Yeah, it's one to check out. The tickers on those are PAA and PAGP.