DCP Midstream, LP (DCP) is a fairly large midstream partnership that operates primarily in the Permian Basin of West Texas and the surrounding area. The midstream sector, in general, was devastated by the outbreak of the coronavirus pandemic and the crash in crude oil prices that accompanied it, although the cash flows of most midstream companies held up reasonably well. DCP Midstream was one of the hardest-hit companies by this collapse and it ended up earning the ire of many investors by cutting its distribution by 50% in response to the industry conditions. The industry as a whole has since recovered though and is now arguably stronger than it was prior to the pandemic. This has certainly had a positive impact on DCP Midstream’s unit price as it is up 42.93% over the past year. Despite this strong capital appreciation though, the company still yields a reasonably attractive 5.49% at the current price. Therefore, let us investigate and see if the company could be right for your portfolio.
About DCP Midstream
As noted in the introduction, DCP Midstream is a fairly large midstream partnership that primarily operates in the Permian Basin and the surrounding area. The company boasts approximately 56,000 miles of pipelines, 5.6 billion cubic feet per day of natural gas processing capacity, and twelve billion cubic feet of natural gas storage:
The Permian Basin is a reasonably good place for the company to operate. This is because this basin has long been the focal point of America’s shale energy boom due to it being the largest source of crude oil in the country. The basin is also a major producer of natural gas, which is often found alongside crude oil. This explains the reason for DCP Midstream’s substantial natural gas processing and transportation infrastructure. This is also something that could serve the company fairly well going forward since the long-term forward fundamentals for natural gas are significantly stronger than those for crude oil.
Although the unit prices of midstream companies like DCP Midstream often trade somewhat in line with crude oil prices, the companies themselves are only minimally affected by market price fluctuations. This is because of the business model that these companies utilize. Basically, the midstream company enters into a long-term (five to ten year) contract with a customer for the provision of transportation and storage services. The customer compensates DCP Midstream based on the volume of resources that are sent through the infrastructure and not their value. This volume-based pricing system ensures that DCP Midstream is not actually affected much by changes in energy prices. Admittedly, some readers might point out that this model is not perfect protection against energy price swings because upstream producers tend to reduce their output when energy prices decline, as they did in 2020. As a general rule, lower production could be expected to result in lower volumes, which would certainly have an impact on DCP Midstream. While this is certainly true, DCP Midstream has a way to protect itself against this. The contracts that it has with its customers contain what are known as minimum volume commitments, which specify a certain volume of resources that must be sent through the company’s infrastructure or paid for anyway. Thus, these minimum volume commitments ensure that the company’s cash flow will not decline too much even if production does. This provides a great deal of support for the distribution that the firm pays out. Approximately 75% of the company’s revenues come from these contracts:
Of course, these contracts do not mean very much of the counterparty is unable to honor them. As such, it might be comforting to learn that approximately 78% of the company’s contracts are with investment-grade companies:
The reason that this should prove comforting is that an investment-grade company is highly unlikely to default on its obligations under the contract with DCP Midstream. One of the reasons for this is that an investment-grade firm typically has a very strong balance sheet and reasonably stable cash flows that should allow it to weather through most periods of economic hardship without any need to default. A second factor that should provide some comfort is that an investment-grade company typically has a vested interest in protecting its reputation as a good partner to do business with. It is fairly hard to maintain such a reputation if the company becomes known for defaulting on its contracts. As such, it seems likely that most of DCP Midstream’s customers will do anything in their power to honor their contractual commitments with DCP Midstream. This should provide for incredible cash flow stability even though DCP Midstream does not have more than 80% of its customers being such high-quality counterparties like some other midstream providers, such as The Williams Companies (WMB), boast.
The fact that the company slashed its distribution back in 2020 would at first glance appear to be at odds with my statements that DCP Midstream enjoys remarkably stable cash flows. However, as I pointed out in a previous article, DCP Midstream did not, strictly speaking, reduce its distribution because it was forced to. The distribution reduction was instead due to a change in the company’s business model that was intended to make it more sustainable and less dependent on the capital markets. Prior to 2015, it was fairly common for midstream companies to pay out all of their cash flows to investors in the form of distributions. The partnerships would then finance their growth projects by issuing new partnership units and debt. When energy prices collapsed in the middle of the decade, the unit prices of these companies also declined. This made it incredibly expensive to finance projects by issuing equity so they responded by reducing their distributions and using their cash flow to finance their operations and growth projects. DCP Midstream adopted this model following the 2020 crude oil price crash and as a result of its distribution reduction, the company generated $378 million in the first three quarters of 2021 in excess of the cash needed to cover its distributions and maintenance capital expenditures. This excess free cash flow allows the company to undertake a variety of shareholder-friendly activities such as reducing debt, buying back its own equity, or possibly increasing its distribution. Admittedly, the company has not actually done any of these things yet, although management has suggested that the company might raise the distribution in 2022. In the absence of a distribution increase, the surplus free cash flow is still something that we can appreciate because it provides the company with a great deal of financial flexibility that it can use to pursue other opportunities as they present themselves.
Unfortunately, DCP Midstream’s forward growth potential may be somewhat limited. As I discussed in various articles on the company that were published throughout 2018 and 2019, DCP Midstream had substantial growth prospects before the pandemic. This was driven by the ambitions that shale producers had to continue to grow their output, which would have required a great deal of new midstream infrastructure to transport the newly produced resources away from the basins and to the market. However, this changed following the events of 2020. As I discussed in a recent article, many shale operators recently have been expressing their intentions to allow production to stagnate so that they can focus their attention on generating positive free cash flow. Unfortunately, this means that American crude oil production is unlikely to grow much in the years ahead. This somewhat limits DCP Midstream’s growth potential since many of the projects that it was previously planning to construct in order to support the growing production are no longer needed. With that said, many of the company’s contracts with its customers do allow for annual price increases so it should still be able to generate a limited amount of growth that way.
Fundamentals Of Natural Gas And Crude Oil
The long-term outlook for both natural gas and crude oil is surprisingly good, despite the narrative that politicians and the media have been delivering. This is because the demand for both sources of energy is expected to grow over the coming years. According to the International Energy Agency, the global demand for crude oil will increase by 7% and the global demand for natural gas will increase by 29% over the next twenty years:
Surprisingly, the growth in natural gas demand is being driven by international concerns about climate change. These concerns have caused governments all over the world to impose a variety of incentives and mandates that are intended to reduce the carbon emissions of their respective nations. One of the most common ways that this is being achieved is that governments are using various methods to encourage utilities to retire old coal-fired power plants and replace them with natural gas turbines. This is because natural gas burns much cleaner than other fossil fuels and is reliable enough to support a modern electric grid, unlike renewables.
The case for growing crude oil demand is more difficult to understand but it begins to make more sense when looking at various emerging markets around the world. These nations are expected to see tremendous economic growth over the projection period, which will have the effect of lifting the citizens out of poverty and putting them securely into the middle class. These people will naturally want to use some of their wealth to enjoy a lifestyle that is closer to what their counterparts in the developed nations enjoy than what they have now. This will require growing energy consumption, including energy derived from crude oil. As the populations of these nations are larger in aggregate than the populations of the developed nations, this demand growth will more than offset the stagnant-to-declining demand in the developed nations.
This could ultimately benefit midstream firms like DCP Midstream despite shale operators stating their reluctance to raise production. This is because it will likely result in higher energy prices going forward. The United States is one of the only areas of the world that is able to increase its fossil fuel production due to the wealth of regions like the Permian Basin. Thus, we have a situation in which demand is rising but production is not so economic law states that this must result in rising prices. It is reasonable to assume that if prices rise sufficiently, producers may increase their output to exploit it and thus require the services of midstream firms to transport this incremental production to the market. This would result in rising midstream volumes and, by extension, cash flows. DCP Midstream is very well positioned to exploit this due to its significant position in the Permian Basin, which would likely be where the bulk of this production growth would occur.
Financial Considerations
It is always critical to look at the way that a company finances itself before making an investment in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid. In addition, the company must make regular payments on its debt in order to remain solvent. As such, a decline in cash flows could push the company into financial distress if it has too much debt. Although midstream companies tend to have remarkably stable cash flows, it is certainly not unheard of for one to go bankrupt.
One metric that we can use to evaluate a midstream companies debt load is the net debt-to-equity ratio. This tells us to what degree the company is financing its operations with debt as opposed to wholly-owned funds. It also tells us how well the company’s equity could support its debts in the event of a bankruptcy or liquidation, which is arguably more important. As of September 30, 2021, DCP Midstream had $5.750 billion in net debt compared to $5.666 billion in total equity. This gives the company a net debt-to-equity ratio of 1.01. In the case of a midstream company, I do not typically like to see this ratio above 1.0 so, while DCP Midstream is above this level, it is close enough to it that I am certainly not going to worry too much, especially when we consider that its positive free cash flow probably added enough to the bank account in the fourth quarter that its net debt is now below this level.
The company’s ability to carry its debt is more important than the actual financial structure. The usual way that we judge this is by looking at the company’s leverage ratio, which is also known as the net debt-to-adjusted EBITDA ratio. This ratio essentially tells us how long (in years) it would take the company to completely pay off its debt if it were to devote all of its pre-tax cash flow to that task. In the third quarter of 2021, DCP Midstream had an adjusted EBITDA of $353 million, which works out to $1.412 billion annualized. This gives the company a leverage ratio of 4.07 based on its net debt at the end of the quarter. Analysts generally consider anything below 5.0 to be reasonable so DCP Midstream certainly meets this requirement. I am more conservative though and prefer to see this ratio under 4.0 in order to add a margin of safety to the investment. DCP Midstream does not meet this requirement but, once again, the company is close enough that I am reasonably comfortable with it. Overall, the company’s debt load appears to be fine.
Distribution Analysis
One of the biggest reasons why people invest in midstream partnerships like DCP Midstream is that they typically boast some of the highest yields available in the market. DCP Midstream currently yields 5.49% so it is not an exception to this rule but admittedly this yield is nowhere near as high as some of its peers. It is therefore quite possible that the market is pricing in a distribution increase sometime in 2022.
It is critical though that we determine whether or not the company can actually afford this distribution. After all, we do not want to be the victims of another distribution cut since that would cut our incomes and most likely cause the unit price to decline. The usual way that we judge this is by looking at the company’s distributable cash flow, which is a non-GAAP metric that theoretically tells us the amount of cash that was generated by the company’s ordinary operations and is available for distribution to the limited partners. During the third quarter of 2021, DCP Midstream had a distributable cash flow of $250 million, which was enough to cover the distribution 3.09 times over. Analysts generally consider anything over 1.20x to be reasonable and sustainable so DCP Midstream clearly meets their requirements. As usual, I am more conservative and like to see this ratio over 1.30x in order to add a margin of safety, which the company also comfortably exceeds. In fact, the company could very easily double its distribution and still meet all measures for sustainability. Thus, investors do not appear to have anything to worry about as far as the distribution is concerned.
Conclusion
In conclusion, DCP Midstream is one of the largest midstream partnerships in the United States. The company angered many of its investors back in 2020 by cutting its distribution, but it appears to have since recovered significantly, although it may still have some lacking confidence in its management. The company should have no trouble maintaining its distribution at the current level or even increasing it though, and given its reasonable debt load it does represent a good choice for an income-focused investor. The only potential downside here is that a 5.49% yield is somewhat lower than some of its peers so the market appears to be pricing in a distribution increase.