Excess Industry Capacity Not Enough to Disrupt Enterprise's Distribution

We have been watching Enterprise Products Partners closely in light of the substantial excess capacity in the midstream industry.

Service providers' forecasts of production growth have turned out to be overly optimistic, resulting in too much infrastructure development that has been further accentuated by the pandemic-driven decline in domestic energy production.

This environment could pressure midstream service providers' future cash flow as contracts expire and potentially renew at lower rates and reduced volume commitments. 

Enterprise hosted an analyst day earlier this month, providing the most recent look at where the midstream industry might be headed. The meeting highlighted improving production rates and increased capacity utilization.

Oil and gas production has bounced off pandemic lows while natural gas liquids (NGLs) and petrochemicals (C3+ in the chart below) have actually grown compared to 2019.

Although we'd like to see further improvement in oil and gas, we find comfort in Enterprise's diversified commodity mix. Last year, 51% of operating income came from NGLs and 13% from petrochemicals, areas with greater stability and less direct dependence on oil production growth.

This favorable mix helped Enterprise achieve a conservative 61% payout ratio in 2020. Distributable cash flow per share last year only dipped 3% as well, highlighting the resiliency of Enterprise's operations, which generate nearly 90% of earnings from fee-based businesses that have low volumetric risk.

Coming off last year's struggles, production growth is expected to continue for oil and gas, albeit at a modest pace.

Publicly-traded oil and gas producers have communicated they plan to end 2021 with production rates roughly in line with where they started the year as they prioritize repairing their balance sheets. Private producers, on the other hand, have been increasing production.

Under Enterprise's best-case estimates, oil production won't fully recover to pre-pandemic levels until some time in 2024 while natural gas production is expected to be restored by the end of 2023.

These estimates assumed oil would not trade above breakeven prices until later this year.  However, oil is now trading above $60 per barrel, which is comfortably above breakeven for most wells.

It is possible rising oil prices could increase planned production rates for the year, helping absorb some of the industry's excess pipeline and storage capacity sooner than management expects.

Regardless, even if Enterprise saw a 20% downturn in the cash flow contributed from its oil and dry gas businesses, we estimate that the firm's payout ratio would remain at a healthy level of around 70%.

As we discussed last year, we believe Enterprise's conservative approach will continue to offer some stability during turbulent energy markets while also supporting the distribution.

The industry's overcapacity issue is unlikely to go away any time soon.  But based on what we know today, we expect Enterprise's portfolio of fully-integrated midstream assets to remain in demand and keep the distribution safe.

Not only can Enterprise provide a single relationship and contract to efficiently move customers' products to downstream buyers, but they boast the industry's highest credit ratings, which appeals to producers who want partners that will outlive their contracts. 

Enterprise's high mix of long-term contracts with minimum volume commitments can also help shield its cash flow during the next few tumultuous years. Major contract expirations are likely spread out and diversified across different customers, commodities and geographies to provide a bridge until the industry reaches a better balance.

The longer-term outlook for Enterprise will depend on the path of fossil fuels.

Global energy demand will continue to expand from population growth and a growing middle class in emerging and developing nations.

The International Energy Agency (IEA) expects oil to become a smaller percentage of overall global energy consumption over the next twenty years, but for total consumption to actually increase.

The concern over climate change is growing and could eventually impact the global consumption of fossil fuels.  But, as of today, the world has not agreed upon a path forward.

Ultimately, we expect fossil fuel demand to remain stable with a gradual pace of decline over the long-term.

Overall, Enterprise is well positioned in the industry with a strong mix of take-or-pay contracts, healthy customers, and a self-funded business model.  The firm's low payout ratio offers plenty of coverage for the distribution should the next few years fail to meet expectations.

We are reaffirming our Safe Dividend Safety Score and will continue to watch for any new developments around industry capacity and global demand.