2023-11-02 19:13:18 ET
Summary
- Western Midstream's increasing organic throughput and recent M&A add confidence that the partnership can grow earnings and distributions.
- Quarterly distributions should exceed 2019 levels by the second half of 2024. WES also has the capacity to increase buybacks.
- I believe Western Midstream Partnership units should finally break out of their 2-year trading range based on this outlook.
Long Sideways Trend About To End?
Western Midstream Partners ( WES ) partnership units have traded in a long sideways channel between $22 and $29 since the start of 2022. During that time, the partnership has restored much of the throughput cuts seen during 2020 and 2021 when upstream producers were cutting production and reducing new drilling activity. After improving its balance sheet to survive the downturn, WES also restored the quarterly distribution to about 80% of pre-2020 levels in early 2022. Since then, the partnership has paid out a special distribution in early 2023 and delivered 2 more regular distribution increases.
I cover WES fairly regularly , including last quarter when outperforming wells upstream ironically caused operational issues for WES resulting in a guidance cut for the year. These issues seem to have put the long-awaited price breakout on hold, but the recent 3Q earnings release contains some developments that add confidence in the partnership's growth. These include a return to record throughput in the Delaware basin, the acquisition of Meritage Midstream in Wyoming's Powder River basin, and the buyback of some units from Occidental ( OXY ), taking Oxy's ownership below 50%. These actions could finally supply the catalyst needed for the unit price to return to levels not seen since 2019 in my view.
Record Throughput
WES saw record throughput for all three of its products in the Delaware Basin: 1.67 Bcf/d of natural gas, 220 mb/d of crude oil and natural gas liquids, and 1101 mb/d of produced water. This suggests an end to the short-term issues identified last quarter. Within Colorado's DJ basin and other regions, as well as WES's equity invested assets, throughput was also up sequentially from last quarter, however still down a bit year-to-date compared to the first 9 months of 2022. Still, for the partnership overall, WES had impressive growth in the mid to high single digits for gas and oil, and in the mid-teens for water.
Meritage
WES recently closed on the $885 million deal for Meritage Midstream Services II that it announced in September. The deal includes 1500 miles of natural gas gathering pipelines, 380mmcf/d of processing capacity, and a 38 mb/d NGL takeaway pipeline. This overlaps and more than doubles WES's capacity in the Powder River basin, creating opportunities for cost synergies with existing operations. Relative to the overall natural gas throughput at WES, the acquisition adds between 5% and 10%. This volume will start showing up in WES's 4Q results. This drove the upward guidance on EBITDA for the year to the high end of the range ($2.05 billion) and natural gas throughput growth to "mid-single digits" from "low single digits" previously.
OXY Buyback
WES bought back 5.1 million units from OXY in 3Q for $127.5 million. This took OXY's ownership stake in WES below 50% including both the limited and general partnership units. WES has long been on a pathway of greater independence from WES, including the installation of independent managers a few years ago and the increasing amount of third-party business. Non-OXY volume now makes up 66% of natural gas throughput, although it is still just 13% of crude oil/NGL's and 23% of produced water.
The decline below 50% in OXY ownership probably won't greatly raise the probability of a third-party takeover. OXY still exerts a lot of influence as the general partner. Berkshire Hathaway ( BRK.A ) ( BRK.B ) is sometimes cited as possible buyer in article comments on this site, but Berkshire is unlikely to act without the backing of OXY management. What the sub-50% ownership does do, however, is open up the possibility for further incremental buybacks without driving up the price in the open market. Still, the lower unit count will drive the price up steadily over time as income and distributions per share increase.
Earnings Model Update
Compared to last quarter, I increased the 2023 EBITDA estimate to $2.05 billion, which is the high end of the company's range. Thanks to the Meritage deal, as well as new business signed in the Delaware after quarter-end, I still assume EBITDA can grow 10% in 2024 and 5% each in 2025 and 2026 off this higher base.
WES issued $600 million of new debt to help fund the Meritage deal, although they also bought back $159.1 million of debt in the quarter below par. This increases interest expense slightly in the near term. With the Meritage acquisition, I am assuming a $40 million working capital build (in line with YTD actuals), which moves my free cash flow forecast to the middle of the $0.9 - $1.0 billion company guidance. There were no changes to the capex forecast.
The added debt from the Meritage deal increases the leverage forecast to 3.54 at the end of 2023 and 3.07 at the end of 2024. Both of these are above the stated targets in the partnership's enhanced distribution policy. Therefore, I am now forecasting no special distributions in 2024 or 2025. Still, WES has plenty of capacity to raise the base distribution. The partnership should be able to increase it to $0.625 quarterly in the second half of 2024, finally surpassing the record set in 1Q 2020. After that, I continue to expect $0.25/year increases, hitting $0.75 quarterly ($3.00 annual rate) by the second half of 2026. Based on the current unit price, the yield in 2026 is expected to exceed 10%.
Since no debt is due in 2024, WES has plenty of capacity to increase buybacks next year. $1 billion of debt is due in 2025 but paying it all off without refinancing would take leverage far below what is needed to maintain an investment grade rating. This allows for continued strong buybacks in 2025. While not shown here, WES could pursue additional M&A instead of share buybacks if attractive opportunities are available.
Bond Update
Since last quarter, WES bond yields have increased by around 40-50 basis points all along the curve. For the longer maturities, this is in line with the increase in Treasuries. At the shorter end (1-2 years), Treasury yields have not moved, meaning the spread has increased. I don't believe this reflects any new short term credit risks with WES, so the 1-2 year maturities could be a good alternative to Treasuries for an investor's bond allocation. Overall however, the partnership units are a better investment, with higher current yield and the strong likelihood of distribution growth.
Conclusion
Western Midstream has worked through the operating issues associated with bringing production from new wells into the system that I outlined last quarter. Along with the inorganic growth from the Meritage deal, this creates confidence in throughput growth in 2024 and beyond. The added debt for Meritage seems to basically eliminate the chances for special distributions in the next couple of years, but the model still suggests the base distribution can grow by about $0.25 per year.
Unit prices have moved sideways in the $22-$29 range since the start of 2022, but I believe a breakout is now possible, driven by throughput growth and either strong buybacks or further M&A. OXY's ownership decline to below 50% does not necessarily suggest an upcoming third-party takeover, but does support the chances of further buybacks. With the long-awaited breakout looking more likely, WES remains a Buy.
For further details see:
Western Midstream Partners: Latest Actions Should Drive A Breakout