Given the Biden – Harris tickets previous statements regarding fracking and the fossil fuel industry combined with current poll numbers that indicate they have a solid lead, it seems prudent to consider what effects their win might have on our energy investments.
In doing so however we need to keep in mind that stock prices and underlying cash flows are not necessarily always well correlated, with a significant dichotomy between the two being a potential opportunity. At Cash Flow Kingdom, we attempt to take advantage of such dichotomies. Particularly when current investor sentiment differs from the expected longer-term underlying cash flows.
For instance, despite these previous statements to the contrary, I take Biden’s current statement that there will be no ban on fracking at face value. This is because a complete ban on fracking would almost certainly become a political disaster for the Democratic Party. Pennsylvania, Ohio, and other Midwestern Rust Belt swing states in the Marcellus and Utica regions would almost assuredly turn ‘Republican Red’ in response. An outright fracking ban could thus single handedly deliver to the Republicans both houses in the next midterm election and eliminate any chance of a second term in the White House for Biden or Harris.
Source: The New York Times, Upfront
Nevertheless, lip service is likely to be paid to such an idea to appease those on the left side of the party, and maybe even some sort of tax might be proposed or imposed. This could drive investor sentiment toward the energy sector even more negative than it already is. However, an outright ban, or even a tax substantial enough to prevent significant fracking, is a non-starter. The Democratic Party is not that stupid.
Likewise, retracting existing permits and stopping existing drilling on federal lands is a no-go. This would not only produce the same unacceptable political effect for the Democrats, it would also cost the federal government tens, if not hundreds of billions of dollars under the Takings Clause of the Constitution.
“Amendment V: No person shall …nor shall private property be taken for public use, without just compensation.”
Once again, maybe some threat of this occurring might affect stock prices for a time, but such action would quickly be held up in court. With prior Takings Clause precedent already having been successfully applied to mineral rights, such actions are going nowhere. All talk, no action, isn’t that one of the definitions of a political promise?
An action that I view as more likely to actually occur, however, is a ban on issuing new drilling permits on federal lands. The Biden website continues to call for “banning new oil and gas permitting on public lands and waters” and he repeatedly states, “I said I would not do any new leases on federal lands.”
This also is a political move that’s initially easy to make. During the first term of a Biden Presidency there would be little effect on actual energy production thanks to the slow run-off of existing wells and a much greater number of permits having already been approved (the time it took to process federal mineral development permits was cut in half the year Trump first took office). A refusal to issue new permits under a Biden Presidency however would eventually have significant effect on energy production in the west, since most federal land is in the west. Thus the western Niobrara, western DJ, northern Delaware, and San Juan basins are some of the most notable basins likely to be affected.
As an example of what I mean by long-term political risk involved in banning new permits, I point to the Pacific Northwest. Much of this region’s current natural gas comes from federal lands in the western Niobrara Basin. This gas is delivered through MPLX LP (MPLX) and Williams (WMB) owned pipelines. Should these gas supplies decline, prices to ship the other main source of gas for this region, western Canadian-sourced natural gas, would likely rise. In effect you would be taking a major region serviced by two basins, cutting of the US source, and making them dependent upon a single source from Canada. This reduced availability would likely result in higher prices and cause some turmoil within the population of the region. Moreover, were a Canada-to-US pipeline to become out-of-service during some winter months, you could actually see hundreds of thousands of people in Seattle and Portland going cold for weeks, risking the wellbeing and potentially the lives of some. This scenario could cost the Democratic Party the Northwest middle vote or even bring about some defections from the Northwestern Democratic base.
For this reason, I think any outright drilling permit ban on federal lands enacted under Democratic leadership would be temporary. Eventually a growing number of new drilling permit “exceptions” would have to be quietly issued. The president could still state that no fracking permits for federal lands would be issued for a few years, but the Pacific Northwest would eventually suffer, and “exceptions” would be granted.
Realistically, Democrats are not going to risk losing the support of both the Rust Belt and the Pacific Northwest over the long run. Thus lip service combined with a short-term ban of fracking on federal lands that later gets eviscerated by “exceptions” is a more likely scenario. Thus the actual long-term effect on cash flows of energy firms would likely be fleeting. Existing drilling would continue, existing permits would still be completed, and eventually enough “exceptions” would be granted to allow the flow to continue. There could even be some partially offsetting positive cash flow effects in the near term.
For instance, a federal land fracking ban would cause midstream energy companies to cancel new infrastructure projects in those areas, resulting in no additional competition from new pipes. Meanwhile, existing wells continue to pump, new laterals are extended, drilled but uncompleted “DUC” wells get finished, and already permitted wells continue to be drilled. Thus, the existing midstream infrastructure would be utilized for many years, and certainly longer than a four-year presidency. In fact, we could even see demand last longer than what might otherwise have occurred if enough new drill permit “exceptions” eventually came into play.
I foresee many companies continuing to maintain comparable cash flows via reduced capital expenditures, resulting in an increase in free cash flow. FCF could then potentially be used for other capital priorities such as debt pay down, stock buybacks, or dividend increases. In this way, restrictions on fracking could actually become a boon for midstream investors cash flows in much the same way restrictions on tobacco ended up a boon for the cash flows of tobacco companies. After all, heating your home and cooking your food is likely to be a just-as-sticky source of demand as nicotine addiction. The simple fact is, natural gas is needed – the spice must flow.
Another potential aspect of a Biden presidency could be a significant increase in fees and fines for gas flaring. Increased fees would reduce flaring, raise federal receipts, and create additional demand for getting the gas to market. In my opinion, this, when combined with the Kinder Morgan’s (KMI) Permian Highway natural gas pipeline coming online early next year (2.1-Bcf/d), and the Whistler Pipeline coming on line the latter half of next year (2.0-Bcf/d, MPLX led consortium), could be good for Permian compressor names like ArchRock, Inc. (AROC) as it will strongly encourage more natural gas to be shipped to market. Remember, you can’t move natural gas from here to there without a compressor.
Here’s how a Biden Presidency might affect a couple specific midstream firms we cover.
Source: Company Presentation
Williams would be negatively affected by a reduction in drilling on federal lands in the western Niobrara. It would probably not be very significant when compared to the cash flows coming from relatively unaffected Transco, but it is still a meaningful affect. The bigger issue long term – WMB’s Niobrara NWP pipeline services.
Can you envision the Pacific Northwest paying perhaps twice as much for natural gas as they do now? A Biden ban on new federal land fracking permits in the western Niobrara could eventually lead to just that. Note that the Pacific Northwest would still likely be able to access natural gas, however, it would be coming from western Canada instead of the Rockies Niobrara basin.
Source: NorthWest Gas Association
The Pacific Northwest simply isn’t going to be allowed to freeze even were US federal land natural gas supplies to become off limits. Instead what you would likely see is more gas flowing from Alberta into the Pacific Northwest and due to increased demands upon that source, higher prices. Alberta gas is cheap currently because much of its supply is landlocked by a lack of infrastructure. However, as export facilities being built on the British Columbia coast and demand for natural gas liquids as a diluent to tar sands oil increases, demand will pick up. If you also add greater demand from the Pacific Northwest, you are likely to see significantly higher prices for this resource as demand starts to overcome supply. Additionally, there’s the question of whether Alberta could even supply the Pacific Northwest with enough gas given current pipeline capacity between the two regions.
Moving back to Williams, the current dividend is likely to be secure regardless even if demand for the NWP pipeline started to fall off. This firm already enjoys what is probably the most successful and in-demand pipeline in North America, Transco. Transco moves energy from the Gulf States to areas of high demand electrical production and other uses on the East Coast. With tree huggers continuing to hold up and greatly increase the costs of any new pipelines to this region, they indirectly make Transco that much more valuable. So the NWP issue is probably more a question of future dividend growth rather than current dividend funding.
We last covered Williams publicly with early April’s, “Fear Creates Opportunity: Williams Companies” and June’s “Natural Gas Provides A Place To Ride Out The Storm: Williams Companies.” Since then the price of the stock has climbed a bit, but otherwise the COVID-19 effect on operations has been minimal. Once again, we remind our readers that natural gas demand persists during COVID-19 as we continue to heat our homes, cook our food, and produce electricity.
Williams Q2 earnings remained strong with results once again demonstrating the stability and predictability of this business. Remarkably, Q2 adjusted EBITDA was actually up 2.5%, and cash flow from operations up 7%, from the same quarter last year (COVID-19, what COVID-19?). Net debt / Adj EBITDA also improved slightly to 4.3x vs. last quarter’s 4.4x and is comfortably below the 5.0x covenant requirement. The stock currently offers an 8.2% yield covered 1.6 times (13% DCF yield) which is a bit lower than what is available from Archrock or MPLX (see below), but Williams operations, and thus, the predictability of their resulting cash flows, produce some of the lowest risk available in the sector. Those cash flows already fully cover operations and capex needs as well as the dividend.
“Overall demand for natural gas has proved resilient, and we continue to successfully execute on a number of critical expansion projects along our Transco pipeline, in the Northeast G&P and in the Deepwater Gulf of Mexico. We remain bullish on natural gas demand growth because we recognize the critical role natural gas plays in a clean energy economy. Thanks to this clean energy resource, the U.S. continues to see significant reductions in CO2 emissions, lower consumer utility bills and enhanced opportunities for investment in renewable energy….We’ve built a business that is steady and predictable, and this quarter (Q2) was a chance to show just how durable this business can be against a number of headwinds. Even with the significant and unexpected disruptions caused by geopolitical oil disputes, the COVID-19 pandemic and a tropical storm, our earnings remained consistent with our projections, largely due to the stability of our natural gas-focused business, our minimal exposure to commodity price volatility, and our proactive cost reductions instituted last year. We are pleased with our business performance to date and are confident in our ability to achieve 2020 guidance expectations and continued free cash flow….” – Alan Armstrong, WMB CEO
MPLX LP (MPLX):
Source: Company Presentation
Similar to Williams, MPLX also would suffer if its pipeline from the western Niobrara to the Pacific Northwest “NWPS” went dry due to a fracking ban on federal lands. In addition, its midstream assets servicing federal lands in the San Juan Basin would suffer. However, here too the greater proportion of MPLX assets service less affected area’s such as the Utica and Marcellus regions.
Despite Biden Presidency challenges, MPLX should remain a core position in any midstream investor’s portfolio. Q2 earnings were strong during what was supposed to be a challenging quarter. Shares currently offer a 17.7% dividend yield, covered 1.4x, with a 25% DCF yield. This diversified natural gas centric firm saw little reduction in overall demand, with the Logistics and Storage segment, and new projects that came online, more than making up for any shortfalls elsewhere. In fact, Adjusted EBITDA came in well above Wall Street expectations at $1,227 million, while both it and Distributable Cash Flow ‘DCF’ beat last year figures. COVID-19, what COVID-19?
Source: Company Presentation
We expect MPLX’s strength to continue with growth in assets offsetting any challenges posed by reductions in federal land drilling. The BANGL NGL pipeline has been cancelled, with its contracts instead being filled via expansion of capacity on other existing pipelines in partnership with WhiteWater Midstream and West Texas Gas. This deal helps to maintain revenue while reducing risk and capex, thereby resulting in a near-term boost to MPLX’s FCF. Additionally, as mentioned above. Whistler is still expected to come online the latter part of next year. This would likely more than offset any fall-off in revenue that might come from a ban on new drilling on federal lands in the San Juan and Western Niobrara basins.
Meanwhile, MPLX’s and Marathon Petroleum’s (MPC) strategic review resulted in a renewed commitment to MLPX as a separate entity, with MPLX exchanging wholesale assets acquired from Andeavor for 18.6 million MPLX units that MPC owned (worth approximately $300 million at current prices). EBITDA for this transaction was not disclosed; however, our estimates indicate the trade was accretive to MPLX shareholders.
This additional coverage of potential Biden Presidency effects on the industry includes other midstream firms such as Enterprise Product Partners (EPD), Archrock (AROC), Nustar (NS), and DCP Partners (DCP), as well as specific trading and timing considerations.
A Biden Presidency could lead to further sell-off in the energy sector. However, the resiliency of underlying cash flows for a few of these firms indicates such an occurrence would more likely be opportunity than challenge. In particular, if you are an income-focused investor there are specific equities which offer an attractive addition and complement to your portfolio. That’s provided you understand and appreciate how they work, to what extent their cash flows are likely to be affected and choose when and what to invest in logically. Midstream share prices have been beaten down over the last few years. For some of this was warranted, but for many others it was not. In fact, there are specific midstream firms that offer both an attractive, steady, large payout well backed by stable cash flows, and significant price appreciation potential.
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Disclosure: I am/we are long WMB, MPLX. 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: Investments in the energy industry can be volatile. We do not know your goals, risk tolerance, or particular situation; therefore, we cannot recommend any specific investment to you. Please do your own additional due diligence.