On Tuesday, August 4, 2020, pipeline and midstream giant Plains All American Pipeline, L.P. (PAA) announced its second-quarter 2020 earnings results. The market was rather disappointed by the headline numbers based on the news headlines, but admittedly, it did not punish the unit price too much. Plains All American’s management was certainly more pleased with these results and actually raised the full-year guidance. Thus, we can conclude that there were certainly some positives here despite the current environment being the most challenging that the energy industry has faced in years. Midstream companies are generally more stable than other energy companies, so this is certainly not difficult to imagine. We do indeed see some positive things in this report, and overall, we should not be too panicked here.

As my long-time readers are no doubt well-aware, it is my usual practice to share the highlights from a company’s earnings report before delving into an analysis of its results. This is because these highlights provide a background for the remainder of the article, as well as serve as a framework for the resultant analysis. Therefore, here are the highlights from Plains All American Pipelines’ second-quarter 2020 earnings results:

  • The company brought in total revenues of $3.225 billion in the second quarter of 2020. This represents a 60.92% decline over the $8.253 billion that it brought in during the prior-year quarter.
  • It reported an operating income of $210 million in the most recent quarter. This compares rather unfavorably to the $451 million that the company reported in the year-ago quarter.
  • Plains All American Pipeline transported 5.914 million barrels of oil equivalents per day on average during the period. This represents a 12.86% decline over the 6.787 million barrels of oil equivalents per day that it averaged in the equivalent period of last year.
  • The company reported a distributable cash flow of $359 million in the current period. This compares rather unfavorably to the $590 million that it reported last year.
  • Plains All American Pipeline reported a net income of $144 million in the second quarter of 2020. This represents a 67.86% decline over the $448 million net income that the company reported in the second quarter of 2019.

We have seen many energy companies report weaker results than they did in the prior-year quarter. Plains All American Pipeline was clearly no exception to this, as we can see from these highlights. The biggest reason for this was the outbreak of the COVID-19 pandemic, which prompted governments all around the world to shut down their economies and curtail unnecessary travel. This naturally had a negative impact on the market price of both oil and natural gas. Unfortunately, that forced many oil and gas companies, especially in North America’s shale plays, to cut back on their production spending in order to preserve their capital. As I pointed out in a previous article, these cuts totaled $17 billion in early May but are likely even higher today. While this will certainly result in much less overall production growth than what industry analysts were projecting at the start of the year, it also has an implication on current production levels. This is due largely to the very high decline rates of North American shale production. As I pointed out before, a shale oil well’s production can decline by as much as 69% in the first year alone:

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Source: Econbrowser.com

Thus, as a result of these cuts, the high decline rate results in the company’s upstream customers producing less oil in the second quarter than they did in previous ones. We can see this reflected in the fact that Plains All American had lower volumes than it did in the prior-year quarter.

The business model of midstream companies is much like that of a toll road. The company essentially charges a fee for each unit of oil or natural gas that moves through its transportation network. This fee is largely independent of the price of these resources, so these companies are largely insulated from energy price fluctuations. However, this is only true to the extent that volumes do not decline. As just discussed though, volumes in the Permian basin, which is where the bulk of Plains All American’s operations are based, declined significantly quarter over quarter:

Source: Plains All American Pipeline

As Plains All American’s revenues are largely dependent on volumes, it should be obvious why this volume decline would reduce the company’s revenues. As we can see here, the company did indeed see its fee-based revenues decline as a result of the lower volumes:

Source: Plains All American Pipeline

Fortunately though, there is some evidence that this decline in volumes may be short-lived. We have already begun to see various economies re-open, although we are certainly not back to where we once were. This has begun to increase the demand for resources, but estimates vary regarding how long it will ultimately be until we fully recover. Most sources think that it will take until at least 2022 for demand to reach pre-shutdown levels though:

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Source: Plains All American Pipeline

This could be an indication that the worst is behind us. It is reasonable to assume that the rising demand for liquids will prompt upstream producers to begin to ramp up their production, especially if we start to see energy prices go up. This would likely undo some of the negative impacts that Plains All American saw on its results and volumes in the second quarter. This would thus begin to bring the company’s results back up to the levels that it had prior to the pandemic. As we can see though, this could be a multi-year process.

We have seen many midstream companies reduce their own capital spending plans in response to the overall decline in production. This certainly makes sense, since it makes no real sense for a company to spend enormous sums of money to construct infrastructure that nobody needs to use anymore. Plains All American Pipeline has been no exception to this. At the start of the year, the company was originally planning to spend $2.30 billion to construct new infrastructure, but it reduced this plan to $1.55 billion in May in response to the weak market. The company ended up reducing this again prior to the earnings announcement, cutting spending by $100 million:

Source: Plains All American Pipeline

These spending cuts will slow Plains All American Pipeline’s growth compared to what we expected a few short months ago. This is unfortunate because its growth story was one reason why we were invested in the company. Plains All American has not completely abandoned its growth story, however. As we can see here, it still has quite a few growth projects under construction:

Source: Plains All American Pipeline

The largest of the company’s growth projects is the Wink-to-Webster pipeline. This is a project that we have discussed in past articles on the company. The pipeline itself runs 650 miles from the Permian basin to the Texas Gulf Coast and is designed to transport approximately one million barrels of crude oil and condensate along its path every day. The project is currently expected to begin operation in the first half of 2021, so we can expect it to boost the company’s revenues at around that time.

Despite its earlier distribution cut, Plains All American Pipeline still boasts a fairly high yield. The company currently has a distribution of $0.18 per trust unit quarter, which works out to an 8.81% yield at the unit price today. As is always the case though, it is critical to ensure that the company can afford the distribution that it pays out. This is because we do not want to be the victims of a distribution cut that reduces our income and likely causes further unit price weakness. The usual way to do this is to look at a metric called the distributable cash flow, which is a non-GAAP metric that theoretically tells us the amount of cash generated by the company’s ordinary operations that is available to be distributed to the common unitholders. In the second quarter, Plains All American Pipeline had a distributable cash flow of $297 million after paying the promised distributions to the preferred equity investors. This works out to $0.41 per common unit. We can see that this is more than enough to cover the current amount of the distribution with a fairly large margin of safety. This should be sufficient to provide us with a margin of comfort.

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In conclusion, there were certainly some things to like in Plains All American’s report, although it was certainly not as nice as what we truly want to see out of the company. We have seen the company throttle back on its growth ambitions, which is always a disappointment, as well as well as throttling back on the distribution in response to the coronavirus outbreak. It does boast a fairly attractive yield for new investors though, and this yield certainly appears to be stable.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Via SeekingAlpha.com