DCP Midstream (NYSE:DCP) is a significant player in the North American midstream industry, but units of the MLP have been trading all over the place. At its worst, DCP was down more than 90% in 2020 before its over 100% surge since April 1. Units are still down over 67% from the beginning of the year to the time of this writing.
Let's determine if the company is strong enough to get through the current crisis, if its long-term trajectory remains intact, and, ultimately, if DCP is a buy.
The oil and gas market
You can imagine that times have been tough for DCP given the unprecedented collapse in oil prices. The company is a top natural gas liquid (NGL) producer, https://www.dcpmidstream.com/getattachment/Asset-Bundles/DCP-Midstream-%E2%80%93-Sand-Hills-Pipeline-(Joint-Venture/DCP-Midstream-Partners-Sand-Hills-Pipeline-factsheet.pdf.aspxgas processor, and energy logistics company with operations across nine states, including major basins like the Permian Basin, the Denver Julesburg-Basin, the Eagle Ford, and Mid-Continent. Like many players with assets in U.S. shale, DCP will probably face a drop in oil and gas volumes for 2020 and 2021.
Based on its May 2020 short-term outlook, the U.S. Energy Information Administration (EIA) expects both natural gas consumption and production to decrease in 2020 compared to 2019 and then decrease further in 2021 compared to 2020. Both the EIA and the International Energy Agency (IEA) anticipate continued U.S. oil and gas production declines to be one of the largest contributors to a prolonged low supply that extends throughout 2021.
Natural gas prices averaged a three-year low in 2019 at $2.57 per million British thermal units (MMBtu) and have spent most of 2020 below $2 MMBtu.
As a result of these low prices and anticipated drops in oil and gas production, DCP withdrew its initial 2020 guidance to focus on strengthening its balance sheet and increasing liquidity. The company has a $500 million bond maturity coming up in September 2021 that it can cover with its $600 million of existing liquidity, but the company still wants to raise more liquidity just in case.
Its new guidance calls for "a 50% distribution reduction, 75% growth capital reduction, $90 million cost reduction, and $40 million sustaining capital reduction." Basically, DCP is spending very little money this year, cost-cutting where it can, and cutting its distribution by 50%. Even with that cut, DCP still yields over 20%.
The good news for DCP is that the majority of its cash flow is fee-based or hedged, which reduces its exposure to commodity prices and short-term market volatility. For example, the company targeted 80% of gross margin to be fee-based or hedged in 2019. By hedging prices of NGLs, gas, and crude, DCP is essentially using financial markets to lock in desired prices as a means to limit downside risk. The company also emphasized the reliability of its customers, in that "74% of top customers are investment grade," "top three customers are Phillips 66, Targa [Resources], and CP Chem [Chevron-Phillips Chemical], accounting for 23% of revenue," and "73% of producer customers are super-majors with A ratings." DCP's effort to focus on the balance sheet by cutting distribution and spending is a step in the right direction.
Over the long term, DCP is dependent on the strength of its customers, no matter how large most of them are, as well as commodity prices, to sign favorable fee-based terms in the future. As far as what it can control, DCP has made a serious attempt to transform its business since 2015. It is arguably one of the most vocal and adamant midstream players when it comes to digital transformation. Its digital strategy, called DCP 2.0, is a complete makeover of how the company does business.
Aligning C-suite objectives with the way employees throughout the company do their jobs was a multi-year attempt to position the company ahead of its competitors when it comes to integrating technology into the business. One such example is its Integrated Collaboration Center (ICC). The ICC combines several operations such as data systems, contracts, financial systems, and all of the company's real-time market prices for gas, crude, and NGLs.
The most interesting thing about DCP 2.0 is that the company built the program based on input from its employees, customers, and communities. The benefits of DCP 2.0 are economic, but they are also about safety, sustainability, and reliability. Although DCP hasn't fully quantified the benefits of DCP 2.0 yet, it does say that its "digital solutions, process optimization, and predictive analytics [are] driving cost savings through workforce efficiencies."
During its Q1 2020 conference call, CEO Wouter van Kempen had the following to say on DCP 2.0:
"Our DCP 2.0 transformation effort allowed us to not only take cost out of the system early through automation and digitization, it has allowed us to better optimize cash flows and enhance flexibility and speed within the organization and perform operations completely remotely, including currently operating 20 gas processing plants from employees' homes, which truly gives us an advantage during stay-at-home orders."
In terms of differentiation, not all midstream companies claim to be as sophisticated and successful with their use of real-time data. Being a more digitally integrated company during the pandemic is allowing DCP's employees to better hone their skills by forcing them to rely more on remote workflows and processes.
DCP viewed the 2014–2015 downturn as an existential crisis and a catalyst for change when its two general partners, Phillips 66 and Enbridge Spectra Energy (now Enbridge), had to bailout DCP with cash and assets. Unfortunately, DCP's debt has risen along with the company's quest for digital transformation. Total long-term debt and debt-to-equity are now the highest in 10 years.
As impressive as DCP's long-term growth trajectory is, the current crisis puts an emphasis on financial strength over operational strength. That's why you're seeing DCP cut its spending and slash its dividend to the degree that it has. Without those extreme measures, the company would be in even deeper trouble. DCP may be more accustomed to working from home and virtual workflows thanks to its digital emphasis, but its transformation, along with other growth efforts, came with a major price tag that has weakened its financial strength.
Although midstream companies aren't usually "exciting" investments, DCP is making a real effort to be a better and more responsible company that can compete for the coming decades. It's unfortunate the crisis has stymied a lot of that excitement. Given its high debt and distribution obligation, DCP is simply too risky to buy at this time. If conditions in the energy sector improve over the next couple of years, DCP will be worth another look.