Our conviction that energy midstream is the best income opportunity available in the market today has grown stronger than ever.
Inflation continues to accelerate:
Which has historically proven to be a major boon to energy:
and is proving to be so again this time as well:
Meanwhile, COVID-19 cases are plummeting in the U.S., which indicates that the economy should resume its normalization trend, thereby increasing demand for energy.
While interest rates are rising and appear headed higher with the Federal Reserve increasingly convinced that it needs to take action to fight inflation, they still remain very low on the historical spectrum:
and real interest rates remain deeply negative.
Meanwhile, despite a strong recent run – especially in contrast to the broader markets – energy midstream stocks are still very attractively valued, with the Alerian MLP ETF (AMLP) yielding a safe and likely growing 7.4%.
Energy Transfer (ET) and Plains All American (PAA)(PAGP) are among the very cheapest of investment grade midstream businesses and have a lot going for them right now.
In addition to the strong momentum in the energy markets, both businesses recently announced substantial distribution hikes after slashing them in 2020. Furthermore, both businesses are making good progress towards deleveraging and securing their investment grade credit ratings. In the rest of this article, we will compare the two and explain why we believe that ET is a better buy than PAA/PAGP at the moment.
#1. Energy Transfer Vs. Plains All American – Business Model
PAA/PAGP is a large and diversified midstream business that provides midstream energy services for both crude oil and natural gas liquids. It operates through three business segments:
- Transportation (moves crude oil and NGL using tens of thousands of miles of pipelines and gathering systems, tens of millions of barrels of tank capacity, and hundreds of trailers)
- Facilities (provides crude oil, NGL, and natural gas storage, terminalling, and throughput services, NGL fractionation and isomerization, and natural gas and condensate processing services)
- Supply and Logistics (purchases, provides logistics for, and resells crude oil and NGL)
Plains’ extensive integrated business model spanning across the entire midstream value chain in the Permian Basin gives it the leading and irreplaceable position in the lowest-cost U.S. oil basin. Additionally, it gives the company a strategic position to capitalize on recovering global energy demand and to be a major player in supporting a potential U.S. energy export boom. Finally, the Permian Basin is expected to have enough reserves to keep demand for PAA’s top-notch assets busy for decades to come.
PAA also benefits from long-term lease-supply commitments in its transportation business, which represents a meaningful majority of its EBITDA of which the majority come from the Permian Basin.
The remainder of its business model engages in fee-based storage, terminaling, and throughput services as well as a small margin-based supply and logistics business. While the S&L business is struggling at present, over the long term we think its quality assets will recover with cyclicality and generate value to PAA that is being underappreciated by the market right now.
Last, but not least, its crown jewel Permian assets are enjoying relative cash flow stability thanks to its longer-term fixed-fee contracts and activity in that region is ramping up substantially (and should continue to do so) as the economy emerges from COVID-19.
While PAA/PAGP’s business model is certainly pretty strong, ET’s gets the edge due to its vastly superior size and diversification, particularly into natural gas and NGLs as we believe it has a brighter future than crude oil.
ET boasts a very large and diversified midstream asset base, generating largely fee-based cash flows. Adding further stability to its income stream is the fact that it operates five core business segments (crude oil, NGL and refined products, interstate transport & storage, midstream, and intrastate transport & storage), of which none contributes more than 30% of adjusted EBITDA.
ET also has the distinction of being the only midstream business with an asset footprint in all major producing basins in the U.S., once again boosting its diversification. This enormous size and scale enables the company to achieve economies of scale and makes bolt-on acquisitions particularly synergistic and therefore accretive. It also gives management maximum opportunity to identify and pursue high return growth projects.
While neither company has a stellar track record, with both management teams destroying significant unitholder value over the years in manners that have ultimately resulted in slashed distributions, overleveraged balance sheets, and total return underperformance, they both seem to have turned a corner lately. While both businesses’ business models appear to be in solid places, ET’s superior scale, diversification, and exposure to natural gas and NGLs gives it the clear edge here.
#2. Energy Transfer Vs. Plains All American – Balance Sheet
Both PAA/PAGP and ET have been aggressively paying down debt in recent quarters. Through the first 9 months of 2021, ET reduced its long-term debt by a whopping $6 billion against its enterprise value of $92.1 billion and PAA/PAGP repaid $1 billion of debt while also adding $450 million to its balance sheet against its enterprise value of $19.6 billion.
As a result, both companies strengthened and solidified their investment grade credit ratings (though both still sit at BBB-) and have substantially greater liquidity. PAA/PAGP enjoys a 5.5x EBITDA to interest expense coverage ratio while ET enjoys a 5.8x EBITDA to interest expense coverage ratio.
These improved balance sheets have since opened up the opportunity for both businesses to begin gradually restoring the distribution closer to their pre-cut levels. PAA/PAGP management just announced that they plan to recommend an annualized increase to their distribution of 20.8% to their board, while ET announced a 14.8% distribution increase a few weeks ago as well. PAA/PAGP is also buying back units at a steady clip and ET has signaled that they are considering doing so as well.
Both businesses have similar credit ratings and interest coverage ratios, and are both committed to continuing to paying down debt and further deleverage their balance sheets. As a result, we assign a tie on this metric.
#3. ET Vs. PAA/PAGP – Valuation
As we stated previously, PAA/PAGP and ET are among the cheapest midstream businesses out there:
|Midstream Business||EV/EBITDA (FWD)||EV/EBITDA (5-year)|
Note: * indicates that it is a C-Corp that issues a 1099 instead of an MLP that issues a K1 tax form.
The chart above makes a few things quite clear: ET is the cheapest of the investment grade midstream businesses and PAA is the second cheapest. Furthermore, they also trade at steep discounts to their 5-year average valuation multiples, whereas many of their peers actually trade at premiums or at least roughly in-line with their historical averages. In fact, this is pretty much par for the course among midstream C-Corps (including PAA’s 1099-issuing equivalent PAGP).
This shows that the market continues to severely discount a security for issuing a K1, though it is true that K1-issuing MPLX does trade at a premium to its recent historical average.
As a result, our appetite for PAA and ET remains warranted, as – despite substantially improving the strength of their balance sheets, seeing a strong rebound in industry fundamentals, and demonstrating a commitment to progressing towards restoring unitholder capital return levels – the units remain deeply undervalued.
While it is true that PAA has traditionally traded at a premium to ET and its current premium to ET is not as high as its historical premium, ET wins this battle (albeit, slightly). The reasons for this are simple:
(1) We believe that ET today has a better positioned business model with a similarly strong balance sheet
(2) ET trades at a cheaper EV/EBITDA multiple
(3) ET also trades at a significantly cheaper P/DCF multiple: (4.58x for ET vs. 5.15x for PAA based on 2022E DCF per unit)
The arguments in favor for PAA (besides its greater discount to its historical average) are:
(1) PAA is less likely to engage in a reckless acquisition or run into political/legal problems than ET
(2) PAA has already committed a much greater percentage of capital to returning to unitholders than ET is currently. PAA’s forward distribution yield is substantially higher than ET’s is and it is also buying back units whereas ET has yet to announce buybacks.
Overall, these are two very attractively priced midstream businesses that offer the most attractive risk-reward profile in the midstream space today. As a result, we view them as the most attractive income investments in the market today.
Choosing between the two becomes a more difficult task, but in the end – after conducting exclusive interviews with both ET and PAA/PAGP on behalf of our members at High Yield Investor – we favor ET, as its assets are better positioned for long-term success in our view and it remains a tad cheaper than PAA/PAGP. Still, we like both and are long both, so it does not have to be an either/or choice.
Read More: Energy Transfer Vs Plains All American: Which Is Better Stock