DCP Benefits From Wide Commodity Marketing Spreads

Sector Strategist

Stephen Ellis

DCP Midstream represents a leveraged bet on the growth prospects of U.S. natural gas liquids, in our view. It struggled with leverage issues in early 2020, as it had to pay off a maturity with its credit facilities, but it was able to pay down its credit facilities in June 2020 with a bond offering. It has substantial maturities over the medium term that it has yet to address. DCP's gathering and processing operations are sensitive to volumes, but the offset is that DCP's logistics operations are better protected with take-or-pay contracts for the Cheyenne Connector and Gulf Coast Express. 
DCP has finally taken the needed steps to start to address its leverage. Its distribution is down 50% to $1.56 per unit annually, while its growth capital spending program for 2021 has been slashed to well over 50% below historical levels. As well, DCP indicated it would look to reduce expenses. We expect it to generate substantial excess cash flow in 2021 and 2022, all of which should be applied to debt reduction.
The partnership's simplification transaction in 2017 created one of the largest gatherers and marketers of NGLs in the United States, with an asset base of gathering and processing assets across the Permian, Eagle Ford, Scoop/Stack, and DJ Basin. In turn, DCP has leveraged its asset base to make growth investments in pipelines, including the important Sand Hills project, which will take advantage of growth in Permian NGL production and the Permian Gulf Coast Express, which should capture growth opportunities in Permian gas. Further, the partnership's DCP 2.0 investment in technology has improved asset optimization, reliability, and real-time decision-making efforts. 
Despite the partnership's position in the Permian, which has very attractive well economics, we actually think its DJ Basin assets are more attractive. The entity's 45% market share in G&P by our estimates as part of a midstream duopoly means competition for new investment opportunities is minimal as competitors would need to build both G&P assets and pipelines because of the ability for DCP to block connections, lowering returns.

Business Strategy & Outlook

We do not think DCP Midstream has earned a moat. DCP's asset base is primarily gathering and processing assets from an invested capital perspective, while its earnings stream is split roughly 50%/50% between owned G&P assets and partial ownership stakes in pipeline and logistics assets. However, because the G&P assets generate lower returns and contribute the bulk of invested capital, returns are low for the consolidated entity. We believe G&P assets have no moat because of the lower levels of capital intensity and poor contract quality. Unlike many pipelines, G&P assets lack efficient scale. Producers typically have no shortage of G&P providers to pick from. Further, contracts are typically acreage dedication contracts that can last for 10-20 years but expose the G&P provider to both capital risk and changing basin economics. Given high well decline rates, there’s constant investment required by the G&P provider to maintain and increase volumes, and if basin production peaks and declines, the G&P assets risk being stranded. We estimate adjusted return on capital of 5% over the next five years, below its cost of capital. 
To assess the strength of a midstream firm’s moat, we consider two factors: the location and quality of the firm’s assets and the strength of the firm’s contract coverage.
DCP has about 6 billion cubic feet per day of gathering and processing assets. The Permian is one of DCP’s biggest G&P market (about 20% of capacity), along with the DJ Basin, Scoop/Stack, and Eagle Ford. Given current production levels, this implies around 10% market share across Scoop/Stack, Eagle Ford, and the Permian. The Eagle Ford is acknowledged to be oversupplied from a G&P perspective. The Scoop/Stack and the Permian assets are decent-quality assets overall. Both regions have very well-located plants and others in less opportune counties. Despite strong growth prospects for gas production in both areas, we do not think DCP has a large enough market share from a G&P asset base perspective (existing share is about 10%) in either region to command sustained pricing power (defined as utilization levels sustainably above 85%) as competitors can easily add new capacity and create oversupply conditions. It is somewhat telling that DCP is having to hold back on new investments in the Permian, in particular because the new customers seem to be more private equity players, which do not have a long-term commitment to the basin. This is important for DCP to consider, since an acre dedication contract can require decades of drilling to justify a several-hundred-million-dollar investment for a new plant that can be quickly stranded if the activity dries up.
We consider the DJ Basin/Niobrara to be where DCP enjoys its strongest competitive position, with about 45% G&P market share as part of a midstream duopoly with Western Gas Partners (the midstream arm of Anadarko), though Williams has now entered the basin with a small position via purchasing TPG's assets as part of a joint venture with KKR. Still, DCP's assets are nearly entirely located within Weld County, Colorado, which has some of the play's best economics. Utilization has typically been very high. The DJ Basin is a reasonably attractive play, though we harbor some concerns regarding potential new regulation that could restrict drilling activity. The majority of DCP's capital investment is going into the DJ Basin. However, as the overall DJ Basin portfolio (both G&P and pipeline assets) make up only about a third of DCP's earnings stream, we don’t award a moat rating to the company.
DCP's pipeline assets, which contribute about half of DCP's earnings, are in a markedly better competitive position, led by the Sand Hills Pipeline. Pipeline utilization for Sand Hills (primarily moving NGLs from the Permian to Mont Belvieu, Texas) is nearly maxed out, offering the potential for further expansion as markets slowly recover over the next few years. The other pipelines (Southern Hills, Front Range, Texas Express) are fairly well utilized, and are all in the DJ Basin, where DCP enjoys some advantages. 
From a contract perspective, DCP's G&P contracts are generally unimpressive. The firm has made improvements in terms of shifting the earnings base toward fees, as now when including hedging, fee-based income makes up nearly 80% of earnings from around 40% in 2010. However, we don't consider this to be that impressive because the bulk of the earnings is probably underpinned by acreage dedication agreements, which are subject to exploration and production capital flight and acreage quality issues. Further, the agreements are generally not take or pay, and just pipeline and plant dedications for a set fee, reducing commodity price risk, but not eliminating volume risk.
Material ESG exposures create additional risk for midstream investors. In this industry, the most significant exposures are greenhouse gas emissions (from upstream extraction, midstream operations, and downstream consumption) and other emissions, effluents, pipeline spills, and opposition and protests. In addition to the reputational threat, these issues could force climate-conscious consumers away from fossil fuels in greater numbers, resulting in long-term demand erosion. Climate concerns could also trigger regulatory interventions, such as production limits, removal of existing infrastructure, and perhaps even direct taxes on carbon emissions.
Midstream emissions are relatively low in the lifecycle of oil and gas, and midstream firms have relatively lower risk than upstream and downstream firms from carbon taxes. Canadian firms already pay carbon taxes on their carbon emissions, most of which are generally passed to their shippers and other customers. Spills represent a major threat and have created great resistance from environmentalists, Indigenous groups, and other climate-conscious persons. Examples of the opposition are seen in President Biden’s revocation of the Keystone XL presidential permit and the potential shutdown of the Dakota Access Pipeline system. 
DCP has set a goal to reduce total greenhouse gas emissions by 30% from 2018 levels by 2030.

None

Economic Moat

DCP Midstream

DCP Midstream LP engages in the business of gathering, compressing, treating, processing, transporting, storing and selling natural gas. It operates through the following segments: Logistics and Marketing and Gathering and Processing. The Logistics and Marketing segment includes transporting, trading, marketing and storing natural gas and NGLs and fractionating NGLs. The Gathering and Processing segment consists of gathering, compressing, treating and processing natural gas, producing and fractionating NGLs and recovering condensate. The company was founded in August 2005 and is headquartered in Denver, CO.

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DCP Midstream LP engages in the business of gathering, compressing, treating, processing, transporting, storing, and selling natural gas. It operates through the Logistics and Marketing and Gathering and Processing segments. The Logistics and Marketing segment includes transporting, trading, marketing, and storing natural gas and NGLs and fractionating NGLs. The Gathering and Processing segment refers to the gathering, compressing, treating, and processing of natural gas, producing and fractionating NGLs and recovering condensate. The company was founded in August 2005 and is headquartered in Denver, CO.

DENVER, June  17, 2020  (GLOBE NEWSWIRE) -- DCP Midstream, LP (NYSE: DCP) (the “Partnership”) announced today that its wholly owned subsidiary, DCP Midstream Operating, LP (the “Operating Partnership”), has commenced a public offering of $400 million aggregate principal amount of its senior notes due 2027 (the “Senior Notes”).  The Senior Notes will be fully and unconditionally guaranteed by the Partnership.

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DENVER, Feb.  27, 2020  (GLOBE NEWSWIRE) -- Today, DCP Midstream, LP (NYSE: DCP) announces the publication of its inaugural Sustainability Report. The report, titled “Transforming Energy through People, Process and Technology” provides a review of DCP’s performance on safety, environmental, social, and governance initiatives. An electronic version of the report is available at https://www.dcpmidstream.com/sustainability.

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