Introduction

It’s Sunday morning, on the early side as I start this article, so perhaps you’ll permit me a moment to ramble and reminisce a bit. I do have a point with this little epistle. It’ll take a moment, but I will get to it.

I was never really one of the cool kids growing up. When the other kids were going to dances and debutante balls, and hanging out at Crystal Lake, I was down in the cellar pouring NaCl granules into D.I. water just to see how much it would hold before precipitating, or “salting out.” Then raising the temperature and starting again, keeping careful track of my results in my Nalgene lab notebook, as any good junior scientist would do. Good times! I can still hear my mom calling down to me at dinner time…

“Fluidsdoc (even mom called me that), come upstairs for dinner, and be sure to turn off that noisy old roller oven before you do.” After a moment…”Be sure and wash your hands, Lord knows… that boy!” Mom was tolerant about my passion for drilling fluids – she’d bought me that oven for my 11th birthday, but never really grasped the concept of inducing dynamic stress aging on fluids performance targets, her eyes would just sort of glass over when I would explain the idea. Mom and many others! Looking back, I may have been a bit of a nerd. It was a lonely existence until I discovered others like me. That’s another story.

After high school, when my classmates all went off to Hah-vud, and Yale to study stuff really smart people learn. I plucked up my courage and went down to Texas A&M to see if I could slide on in. The line for English majors was pretty long. So were the lines for Finance, and IT. I hate lines so I looked around a bit and saw, there was a fairly short line for Engineering, so I got in the back, and hunched my shoulders down and trooped in. Four.. maybe five… was it six… seven years later I managed to avoid expulsion, and joined the ranks of Aggie grads and set out to make my fortune in the only place they really care about fluids on a regular basis, The Oilfield.

Reveille

By now you’re starting to ask yourselves… will he ever get to the point? Okay, here it is. I was the dumbest guy on the rig for 40 years, and even I know there is no commodity support for pipeline companies in the present market. In particular I am referring to Energy Transfer, (ET), and Enterprise Products Partners, (EPD), that are the subject of this article. I’ll lay out my case as we go.

What the heck are people thinking?

At one time or another over the last five years (nearly) every writer on Seeking Alpha (including this one) has written a bullish article on the major pipeline companies that transport oil and gas from their points of origin in the faraway oil fields to their destination, mostly on the Texas/Louisiana gulf coast.

Companies like Energy Transfer and Enterprise Products Partners have attracted bullish calls from the leading writers on this platform. I am not linking them, or naming names because I don’t care to wage a comment battle (I am all about peaceful protest!) with anyone, and they’re pretty easy to find. Just click on the stock symbol of one that interests you and you’ll find a plethora of them. Take ET as an example, if you’re bullish or very bullish, you’re in good company. A quick check reveals that since the end of May about ten bullish to very bullish articles have come out on this one. I’ve read some of them and they are all great articles without exception, feast your eyes on one or ten. I expect it’s the same for EPD. Feel free to run that trap.

The logic behind these calls is fairly compelling. The companies have the perfect business model. (Cramer told me that years ago!) Without having any money tied up in the base commodity, the companies operate “Toll roads” for oil and gas. Even better they get long-term contracts that include “take” (capacity in these cases) or “pay” clauses that insulate them from some of the market madness extant today. Sound good? Wait, it gets better.

Yield! A disappearing commodity in today’s market place, the toll roads offer a very nice distribution carrying an outstanding yield at today’s price. I told you it got better… until it doesn’t.

Don’t get me wrong, I like yield as much as the next guy. I have a small position in Shell (RDS.A),(RDS.B) for its decades-old, rock-solid yield as an example. One thing I’ve noticed about yields above 10%, is in most cases, if you wait a while the yield almost invariably improves, meaning in most cases the value of the equity declined as opposed to a distribution raise. And then it gets cut… savagely. I am not necessarily predicting this for either ET or EPD as the point of this article is more about the flaws I see in the fundamental theses for them. Flaws that anyone writing a bullish article about either must be missing, or maybe they’ve seen deeper into the tea leaves, than I?

Here’s the takeaway from this section though. Every single bullish article written on ET or EPD in the last five years… has been wrong, even though the thesis submitted by the author at the time may well have been rock solid, investors in these companies have lost money from every single entry point covered. An argument may be made that if you factor in the lofty distributions that have been made along the road down, it’s not so bad. I will acknowledge that fact and just move on.

I will close this section with a question. Why is it better now?

The Flaw(s)

#1, Perhaps no one but myself has noticed but… the market for Natty is horrible. Atrocious. End of the world as we know it… bad, hitting all-time lows last week. In short, it really, really stinks!

Source

#2, Oil volumes are dropping. Rapidly. Precipitously. And, they won’t stop for a while, although they may moderate some as some of the roughly 1 mm BOPD or so of shut-in production comes back. The trajectory regardless will still be down as we close out the year.

EIA – Drilling Productivity Report. Dotted red line denotes EIA estimates for these months!

If you add in the roughly 1.8-2 mm BOPD we get from offshore, the +/- 360K BOPD that gets piped down from Alaska, you can see that if the EIA is even close to being right, U.S. domestic production will be down about 30% YoY, as we exit 2020. In the best case. I actually think the true exit number will surprise to the downside, by a couple of million barrels. That’s a story for another time though.

In summary my friends, even Aggies know… this is a shrinking market.

Okay, I’ll stop here. I was a little over the top with the previous few expository outbursts. I wanted to be sure I had your attention. I am fairly good at this oilfield stuff. I spent my working life – almost 40 years, in the oilfield. A few things stuck.

Signs of trouble?

I think we can agree that building pipelines is a capex-intensive business. A look at the most recent 10 Q of either company I’ve singled out will reveal huge capex and huger debt, from past capex. Growth requires the fronting of huge sums of capital. When a pipeline company starts cutting capex it’s telling you, “We expect less growth in future markets.” Perhaps it escaped the pipeline bulls’ notice that ET cut capex by $400 mm last quarter? Some juicy tidbits from the linked article.

Energy Transfer says it is cutting its 2020 growth capital outlook by at least $400M to $3.6B, with another $300M-400M of capital under evaluation for potential further reductions during the year, after it spent ~$1B on growth capital projects during Q1.

The company expects 70% of growth capital in 2020 will be spent on projects that already are 60% or more complete and will be in-service in 2020 or early 2021.

“It is unlikely we will add any major organic growth projects to our backlog for 2021,” CFO Thomas Long said during the company’s earnings conference call.

Source

Try as I will, I can’t see anything bullish in the comments above. Let me scroll up and see what else ET is telling us. Ah, yes… pink slips are going out. In a recent article it was noted the company would be releasing about 6% of their staff.

Having worked in corporate America (Sort of, Schlumberger (SLB) is a French company.), I can tell you that when business drops off, the biggest lever you can pull to “right-size” the business is reducing “headcount,” an HR term for describing people who are going to lose their jobs. I was turned into a “headcount,” in 2015 and shortly thereafter became unemployed.

A deeper look at the Reuters article behind the linked article above reveals the company’s rationale for these headcount reductions.

U.S. oil and gas producers have curtailed or shut in wells in response to crude prices down 45% since the start of the year, reducing deliveries to pipeline operators. Oil production could decline as much as 2 million barrels per day by December, from nearly 13 million barrels per day in January.

Reuters

Somebody high up, perhaps in a choice corner office at ET’s Dallas headquarters, has taken this information and come to the conclusion: “Business is going to decline over the next year or so, and I have more employees than I need for the business I have, or will have.”

Now, I threw Shell under the bus in this article, so let’s go back and review their history. In March they told us they were cutting capex for 2020 and suspending stock buybacks. Then in May, they announced additional job cuts to the 10,000 or so they cut in 2019. This after announcing a 66% cut to their cherished, and much-lauded dividend at the end of April.

Is anyone besides myself seeing a parallel with Shell? Wells Fargo did recently and included ET with a number of midstream companies who might be forced to cut dividends in the coming months.

It can be argued that Shell and ET have very little in common. That’s true. But that observation misses a larger point. Folks, they all drink from the same trough, so to speak. Meaning that when there is pain and suffering in the energy business generally, no one is immune forever. Not even tollways!

What is the fundamental problem?

There was a thesis going around last quarter that with the reduction in associated gas from all the production curtailments, that the supply of gas would fall, and that would be bullish for companies that derive their living from producing or transporting it. I first explored it in an article on EQT (EQT) earlier this month. It followed an article on Cheniere (NYSEMKT:LNG) where I detailed some structural problems in the gas market. Nothing has changed for the better. Not one single thing. In fact, things have gotten structurally worse.

The virus has wreaked a fair amount of havoc, I think we can agree. Saudi’s brief but dramatic spat with Russia in March did the oil and gas markets no favors, I think we can agree. After a strong rally early this spring, EQT and Cheniere have sold off 10 to 30% respectively. Why?

EIA gas inventories

There is just too much darn gas right now. The price of Natty is supposed to be rising now. It’s injection season when produced gas is stored for withdrawal in the wintertime. It’s going down. Starting from an already high base last fall, we’ve been adding 70-80 BCF weekly since.

EIA

In fact, there are concerns that gas production may reach a “tank top” scenario where there is just no more room in underground storage, with capacity at ~4.258 bn TCF.

There is no question that gas production volumes are on the decline. Last week’s EIA-WPSR calls for Natty production to decline by 693 BCF between June and July. That’s all good, it just may not be enough.

Yes, they have free cash flow and dividend coverage… but for how long?

I haven’t read any of the bullish articles for either company in any detail. They are way over the head of an old rig rat like me. That said, I don’t understand how anyone can possibly write a bullish article on a company in such a market in a current state of extreme oversupply – gas that is. In the case of crude, volumes are going to fall, fewer “tolls” will be collected.

I expect many of these bullish articles mention that there are some disconnects between market expectations and market realities, particularly where the price for Natty is concerned. Bully for their candor in that regard, if so.

If in the title there is a suggestion that you reach out for ~15% yield, I expect there’s also a comment about dividend coverage and being covered with cash flow. If so, that’s certainly true in the case of both ET and EPD. It’s worth noting the distribution coverage for both companies is well below twice free cash flow, so concerns noted above aren’t out of touch with reality.

Bottom line. Today it’s good, tomorrow has a question mark.

So why sink money into the stock? Only you can answer that one.

Your takeaway

In summary, the fundamentals of the commodity market are not moving in either company’s favor. I don’t see much upside to either stock in the present market, given the conditions of gas oversupply and crude volumes that are likely to decline.

Like I said, I was always the dumbest guy on the rig, and I had to go to A&M instead of one of those Ivy league schools. There may be something I just don’t see that these other really smart authors so see, and are dead-on accurate in their assessments. Time will tell!

So there you have it. I think these midstream companies, ET, and EPD need an extra hard look before investors plunk down their money. I’ll let that stand without further comment. Now you have to decide for yourselves. Are you smart like those other authors? Or do you move at my speed? Again, your call.

I am actually neutral on these stocks, in terms of their present prices. Meaning I don’t see a lot of downside in the near term. If you want yield, it’s there. At least for a while. Boa sorte, amigos!

Disclosure: I am/we are long RDS.B, SLB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not an accountant or CPA or CFA. This article is intended to provide information to interested parties and is in no way a recommendation to buy or sell the securities mentioned. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to do their own due diligence before investing their hard-earned cash.

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