ET - Energy Transfer: Our Old Friend Math Threatens A Bear Case

2023-09-19 11:32:43 ET

Summary

• The draft of the Environmental Impact Survey for the Dakota Access Pipeline has raised concerns about its potential closure.
• Energy Transfer and its partners would lose all income and be responsible for $1.85 billion in debt if the pipeline stopped operating.
• While that sounds scary, Energy Transfer is so large and diverse that DAPL represents less than 3% of its EBITDA and less than 4% of DCF.
• There's little risk to the distribution even in the worst case: Coverage would drop from 1.87x to 1.8x.
• After reading the EIS, I believe the probability that DAPL closes to be very low.

Energy Transfer ( ET ) and its controversial Dakota Access Pipeline are back in the news since the U.S. Army Corps has released a draft of the Environmental Impact Survey, or EIS, recently. Fears of Dakota Access being closed, either temporarily or permanently, are back on the minds of investors.

With the release of the draft, there's an awful lot of noise mixed into the signal, so I'd like to attempt to add some clarity to the situation.

Modeling a worst-case outcome

Fair warning readers, this section will contain math, which is usually absent when discussing this topic.

The Dakota Access Pipeline, or DAPL, is only 36.4% owned by ET. The non-operating partners are Enbridge ( ENB ) with 27.6%, Phillips 66 ( PSX ) with 25.0%, and MPLX ( MPLX) with 9.2%.

After construction, the partners jointly carried ~$2.5 billion in debt:

• $650 million aggregate principal amount of 3.625% Senior Notes due 2022.
• $1.0 billion aggregate principal amount of 3.900% Senior Notes due 2024.
• $850 million aggregate principal amount of 4.625% Senior Notes due 2029.

This subsidiary debt is effectively guaranteed by the partners, so they would be on the hook for repayment if DAPL stopped operating. The $650 million in 2022 notes was repaid by the partners, leaving $1.85 billion in debt today.

In early 2021, SA Analyst HFIR estimated 2020 DAPL EBITDA at $865 million and distributions to partners of $665 million. When Phillips 66 Partners was a standalone entity, it reported more information about DAPL than Phillips 66 now does (Phillips 66 acquired the remaining units of PSXP it did not already own in March 2022.) The last information we got from PSXP in 2022 stated:

Partnership's total equity in net income of Dakota is stated at $154 million, $139 million, and $177 million for the years ended December 31, 2021, 2020, and 2019.

To get a reasonable idea of where volumes have gone since, we can look at the EIA's latest Bakken report . It shows flattish production over the past three years. We can guesstimate that 2021 estimates will likely be in the ballpark of 2023 results.

From HRIF's 2020 estimates, I'll add $60 million in EBITDA (PSXP's $15 million increase for its 25% ownership = $60 million for the project.) Net Income and DCF should increase another $24 million due to the decrease in interest expense from 2022 bonds being retired.

We're looking at $865 + $60 = ~$925 million in EBITDA and ~$750 million in DCF for the project.

So, net to ET's 36.4% ownership interest, if DAPL stopped operating, ET could lose:

• $336 million in EBITDA
• $273 million in Distributable Cash Flow
• Be responsible for $673 million in DAPL project debt

At the midpoint of ET's latest 2023 EBITDA estimates and $7.5 billion in 2023 DCF, this represents:

• 2.53% of EBITDA
• 3.64% of Distributable Cash Flow

Distribution coverage would drop from 1.87x to 1.81x.

The added $673 million in debt represents about 32 days of distributable cash flow, or 67 days of excess cash flow after distributions.

Is this material? Yes.

Significant enough to impact the investment case? No.

Anything at the level where ET would have to reduce distributions? No.

My View on the likely outcome of the EIS

The draft Environmental Impact Survey can be found here . Section 5.0 contains the possible paths forward. I'd encourage everyone to read it, if nothing else, it is interesting!

At this point, let me issue a caveat: while I have a lot of experience reading legal contracts and documents, I am not an attorney. Please consider everything past this point my opinion.

The document shows five potential paths forward for the 7500 ft. portion of the pipeline that crosses federal property:

1. Pipeline Removal
2. Pipeline Abandonment
3. Continue as-is
4. Continue as-is, but add some additional conditions
5. Re-route the pipeline (this option can be in conjunction with 1 or 2)

The report is comprehensive and talks about the likelihood of a Worst-Case Discharge occurring is approximately 1-in-1,000,000 years (remote) to 1-in-10,000 years (very unlikely). It also talks about the economic harms to the region, and that in the case of a shutdown, that crude would be transported by rail or truck. It also talks about how invasive the Pipeline Removal option would be (a 6-20 year construction estimate!) and discusses what would be involved with rerouting the pipeline.

My educated guess on what happens: Option 4. The pipeline operates as is with some minor additional conditions.

Why?

The biggest reason, unlike 2021 when the price at the pump was far lower, the current administration is very sensitive to the price of oil, and even a temporary closure could cause a big price spike.

The other reason is that the report makes it very clear that if the easement for the 7500 ft. is voided, the pipeline will likely be re-routed, which will anger just about everyone.

Every once in a while, common sense does prevail, and I believe it will here.

Other outcomes that have a likelihood near zero in my opinion

I have seen some wild prognostications on other potential liabilities for ET, in excess of the loss of cash flow and added debt, should the pipeline shut down. Previous caveats that I am not an attorney still apply, so consider these my opinion, but I believe the following ideas have no basis in reality and are simply being made up by some ET bears.

• That ET has more liability than the non-operated partners; that it would have to "pay back" the other partners, etc. This is both without precedence, not to mention it fails all common sense. Who would ever sign up to be the operating partner if this could happen? Operators generally have no undue liability beyond their ownership interest and are indemnified by the other owners. No operator would ever accept minority partners otherwise.
• The past profits would be "disgorged" or clawed back by the court. Extremely unlikely, considering the court permitted continued operations while the EIS was done, and that the pipeline has operated safely with minimal issues.
• ET will have to reduce or eliminate its distribution if DAPL closes. See the above math.

Conclusion

All investing involves risk and unknown future outcomes. Generally, the more certain the future outcome, the lower the return. You can sleep well with your money in treasuries, but you'll never earn much of a real return.

I believe the risk of DAPL closing temporarily is low, and the risk of it closing permanently is even lower, and even if it did, it would be no more than a moderate setback for Energy Transfer.

Thanks again for reading, and I apologize if mixing this topic with math was triggering for any readers.

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