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Smaller Midstream: More Pain Ahead

Close to forty energy companies have already announced distribution cuts this earnings season.

The latest round of cuts stretches from wellhead to burner tip. Three are drillers, including blue chip Schlumberger Ltd (SLB). Eight are oil and gas producers, including smaller major Equinor ASA (EQNR). Four are midstream master limited partnerships.

Their range of operations shows how thoroughly COVID-19 fallout has penetrated every corner of the energy industry.

Holly Energy Partners (HEP) provides logistics services to its refiners, the largest general partner Holly Energy. This business has historically been very stable, and the MLP has long-term minimum volume commitments for 70 percent of revenue, with 87 percent of its refiner customers drawing investment grade credit ratings.

Nonetheless, Holly is cutting its payout nearly in half. And while the stated purpose is fund CAPEX with operating cash flow, it’s a fair bet revenue is under pressure, as refinery throughputs suffer from sharply reduced demand for gasoline and jet fuel.

Weakness in the refinery and logistics business showed up in midstream leader Kinder Morgan Inc’s (KMI) Q1 results. For Kinder, the upshot of such extreme conditions is a 5 percent dividend increase, versus the 25 percent boost initially contemplated. But for one-business Holly Energy Partners—one-25th Kinder’s size by market cap—the same circumstances were nothing less than catastrophic.

Even smaller USD Partners LP (USDP) is cutting its quarterly distribution by a still larger 70 percent. Management maintains the move “is not driven by any material deterioration in the performance of our underlying business,” but rather balance sheet concerns.

Nonetheless, customers for USDP’s crude oil terminals and oil-by-rail assets in western Canada are under serious strain with benchmark Western Canada Select oil selling for less than $10 a barrel. And that potentially puts at risk revenue from capacity-based contracts.

Even in the unlikely event there’s no risk to sales, USDP’s dividend cut is still a cautionary tale for investors in smaller midstreams. That’s because it’s currently shut out of capital markets and debt is three times its market capitalization. Contrast that with Kinder, which actually has bonds maturing in 2098.

The other pair of midstream dividend cutters this week both demonstrate the danger of relying heavily on a single customer. In the case of Green Plains Partners LP (GPP), it’s ethanol producer and marketer Green Plains Inc (GPRE). For Western Midstream Partners (WES), it’s battered oil and gas producer Occidental Petroleum Corp (OXY).

COVID-19 fallout has hit ethanol/biofuels companies with both falling prices and reduced demand. That’s further straining what was already a tight margin environment.

As a leading transporter of ethanol in the US, Kinder has seen a hit to volumes. But it’s a full-blown crisis for Green Plains Partners, whose sole business is providing storage and transportation services for its GP.

Management says the 75 percent distribution cut will help “pay off debt within the next 18 months,” which consists of a $200 million credit line maturing July 1 of this year. That’s definitely a critical task, as there’s $132 million drawn, or about 1.3 times Green Plains’ market cap. And lenders generally look favorably on promises to pay down balances.

But so long as the ethanol business is under strain, there will be pressure on the Green Plains family. And that means the MLP’s now reduced distribution should still be considered at risk.

On April 20, Western announced a series of measures to preserve capital, which appear basically in line with reduced drilling activity by its primary customer, Occidental. The most important is halving the distribution beginning with the May payment. Management also reduced 2020 CAPEX plans by 45 percent to a range of $450 to $550 million, and set a target of $75 million in additional operating cost cuts.

We continue to have a favorable view for eventual recovery of Occidental shares, primarily because the company owns some of the most valuable shale acreage in the Permian Basin of West Texas. And a revival of activity would definitely result in higher oil and gas volumes for Western’s gathering, processing, compression and transporting systems.

Unfortunately, it’s still a matter of conjecture what Occidental will do in the meantime with its GP interest and 54.54 percent common share stake in Western. That ownership was acquired with the former Anadarko Petroleum in August 2019. And management has been under pressure ever since to sell at least a big chunk of it to reduce debt, which remains quite hefty at $45.7 billion.

Short of a highly unlikely Occidental default, Western’s reduced distribution appears likely to hold. But the hit to the company from weakness in the gathering and processing business provides yet another sharp contrast with much larger Kinder, which will be able to absorb the hit of reduced volumes this year.

There are currently a record 44 companies under review on our Endangered Dividends List. Roughly half have yet to declare their quarterly distributions for spring, so we can expect a lot more sector damage relatively soon.

The vast majority of the pain, however, will be concentrated with smaller midstream companies. They simply lack the scale and balance sheet strength to weather body blows to their core business. And they’re all but shut out of capital markets as well.

In contrast, if Kinder’s Q1 results are at all representative, large and financially secure midstream companies will keep weathering this worst-case environment. They’ll keep paying generous dividends, while remaining well positioned for the eventual sector recovery.

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