Enterprise Is Expected to See a Weaker 2023 After a Robust 2022

Sector Strategist

Stephen Ellis

Enterprise's asset and geographical diversity allow it to pursue growth in virtually any environment. It can aggregate supply of every type of hydrocarbon from multiple sources in major producing basins and deliver it to multiple end markets (refiners, petrochemicals, exports). Its robust marketing operations let it clip transaction-fee-like earnings during volatile oil and gas markets like we saw with winter storm Uri in 2021. With marketing spreads narrowing across the gas and petrochemicals markets, we expect Enterprise's marketing performance to be weaker in 2023 than its very strong 2022. 

The firm has established a dominant position in natural gas liquids, supported by a strong petrochemicals unit that converts low-cost U.S. molecules into more valuable U.S. exports overseas. Enterprise was years ahead of its peers in recognizing the opportunity and has built out a sizable and, in our view, underappreciated business. This means it will be the primary beneficiary as U.S. NGL exports increase in the coming years, as international markets take advantage of the structural advantages of cheap U.S. feedstock. Enterprise has numerous attractive investments on the way, including its second PDH plant, which should enter service in 2023, ethylene export expansions in 2023 and 2025, and an ethane export terminal in 2025. 

With U.S. producers focusing on generating cash flows versus growing production at costs, the U.S. midstream space has also had to adapt. Most U.S. midstream firms have focused on short-cycle efforts that can generate returns within 18 months, including expansions of existing pipelines. Enterprise is doing the same, but unlike most peers, isn’t afraid to spend big for the right deal. The Navitas purchase for $3.25 billion in 2022 looks to be a material winner, as Enterprise is clearly capturing substantial upside with the rapid near-term growth expected from Permian gas. Enterprise has also stood up an evolutionary technologies team to focus on carbon capture, hydrogen, and low-carbon fuels across its portfolio, with the earliest opportunities possibly around carbon capture on the Gulf Coast.

Business Strategy & Outlook

We believe Enterprise Products Partners has a wide economic moat based on its efficient scale moat source. On each of the major factors we use to evaluate midstream firms—asset quality and location and contracts quality—Enterprise stands out with differentiated advantages. We expect returns on invested capital to average about 10%-11% over the next five years, well above the company's cost of capital of around 8% by our estimates.

New pipelines are typically constructed to allow shippers or producers to take advantage of large price differentials (basis differentials) between two market hubs because supply and demand is out of balance in both markets. Pipeline operators will enter into long-term contracts with shippers to recover the project’s construction and development costs as well as a return on capital, in exchange for a reasonable tariff that allows a shipper to capture a profitable differential, and capacity will be added until it is no longer profitable to do so. 

Pipelines are approved by regulators only when there is an economic need, and pipeline development takes about three years, according to the U.S. Energy Information Administration. Regulatory oversight is provided by the Federal Energy Regulatory Commission and at the state and local levels, and new pipelines under consideration have to contend with onerous environmental and other permitting issues. Further, project economics are locked in through long-term contracts with producers before even breaking ground on the project. If contracts cannot be secured, the pipeline will not be built.

A network of pipelines serving multiple end markets and supplied by multiple regions is typically more valuable than a scattered collection of assets. A pipeline network allows the midstream company to optimize the flow of hydrocarbons across the system and capture geographic differentials. Finally, it is typically cheaper for an incumbent pipeline to add capacity via compression, pumps, or a parallel line than it would be for a competitor to build a competing line.

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.

Enterprise’s asset base quality is outstanding and easily merits a wide moat. For producers seeking options for their hydrocarbons, Enterprise offers an extensive menu. The partnership is connected to every major U.S. shale basin, every ethylene cracker, 90% of the refineries east of the Rockies, and offers export facilities out of the Gulf Coast. The heart of the asset base is clearly its NGL network, which is comprehensive and offers deep access to Mont Belvieu. To further its control over the NGL value chain, Enterprise has built out a number of petrochemical assets, including propylene pipelines, propane dehydrogenation (PDH), and isobutane dehydrogenation (iBDH) facilities, which allow the partnership to extract higher value olefins from feedstock. In effect, the firm is creating more of a demand pull for the ample supply of NGLs traveling through its network. Enterprise, in our view, was one of the first in the industry to recognize the shortage of NGL infrastructure in the U.S., and the eventual shift toward exports and has built an impossible-to-replicate collection of assets across the value chain, positioning it to capture differentials between U.S. and international markets. 

Enterprise’s natural gas assets are also strong. The impossible-to-replicate network is made up of natural gas pipelines across New Mexico, Texas, and Louisiana with 400-plus interconnection points to demand centers as well as substantial net gas processing capacity. The vast majority of the network is in Texas. Enterprise has benefited more recently from its exposure to the Delaware/Permian basin, where rich gas volumes have more than quadrupled since 2013 by our estimates and the partnership has been added processing capacity to feed its existing asset base.

Enterprise’s crude pipelines are primarily located in Texas, Oklahoma, and New Mexico, connecting the Eagle Ford, Permian Basin, Cushing, and Gulf Coast exports hubs. The reversal of the Seaway pipeline to flow oil to the Enterprise Hydrocarbons Terminal was a smart move. We’re particularly impressed with the partnership’s position on the Houston Ship Channel in terms of storage and export opportunities. The EHT can accommodate Suzemax tankers, which are the largest tankers that can navigate the channel. The firm also controls Beaumont West, Freeport, and Texas City systems, which adds dock access. We think the dock access is important, given geographic constraints, and it allowed the firm to export 34 million barrels of crude oil in 2016 following the lifting of the export ban in December 2015, as well as another 17 million barrels of processed condensate. It has continued to be a leader in U.S. crude exports ever since. Replicating Enterprise’s crude oil asset portfolio will be very difficult, in our view.

We view its marketing operations as a strong asset that lets Enterprise collect significant additional fees from its network versus being a pure toll-taker. With its marketing operations, Enterprise takes ownership of the hydrocarbon and seeks to exploit differentials based on time, location, or product arbitrage across the hundreds of connection points across Enterprise’s system. This type of asset is very difficult to replicate due to the complexity and richness of Enterprise’s system, and the few producers that do undertake marketing activities only focus on the relatively few basins they operate in versus the entirety of the U.S. oil and gas complex. It also lets Enterprise take full advantage of profitable opportunities in secondary markets across its pipelines for capacity not being used under firm contracts, versus ceding those fees to the shipper. Other examples would include taking advantage of seasonal changes in demand for propane, upgrade opportunities for raw NGLs to be converted to higher grade and more profitable olefins, and being able to use Enterprise’s network to move product to markets where differentials are the widest. Rather than operate as a separate group, the marketing operations are embedded within the natural gas, oil, and NGLs teams at Enterprise providing insights to help them make investments across the portfolio. Finally, we believe the marketing operations provide an added benefit in terms of sourcing and developing relationships with producers to serve as committed shippers for future investments but also sources of internal demand (for example opportunities to Enterprise to take ownership of hydrocarbons) to support incremental investments. Peers without this robust level of marketing operations will face higher hurdles in terms of being able to obtain commitments for large investments.

From a contract perspective, we have a favorable view. Initial contracts by shippers to reserve capacity on Enterprise’s new pipelines are typically 15-20 years. These industry standard contracts provide shippers with reserved capacity, for which they pay an origination fee, but do not obligate them to use the line if better opportunities exist elsewhere, for which the shipper would pay an additional transport fee. For Enterprise’s latest investments, which are the PDH plant, 100% of the 750,000 pounds per day are contracted for 15 years, and the iBDH plant is also fully contracted for 15 years, split between investment-grade companies and internal Enterprise marketing capacity. In times of market stress, we note that Enterprise has also been creative with its assets, obtaining area dedication contracts where the producers would be obligated to provide a certain number of barrels per day and then look to convert the contract to a long-term fee contract as the markets recover. We think this is supportive in terms of developing long-term relationships with important producers.

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 legal challenges surrounding the Dakota Access Pipeline system. 

Enterprise has yet to share any specific targets related to carbon emissions or other ESG risks. The partnership's main ESG-related target at the moment is to obtain 25% of its internal power needs from renewable sources by 2025. This is not particularly aggressive, as Enterprise was already at 17% in 2019.

Wide

Economic Moat

Enterprise Products Partners

Enterprise Products Partners LP operates as holding company, which engages in the production and trade of natural gas and petrochemicals. It operates through the following segments: NGL Pipelines & Services, Crude Oil Pipelines & Services, Natural Gas Pipelines & Services, and Petrochemical & Refined Products Services. The NGL Pipelines & Services segment manages a natural gas processing facility and a related gathering system. The Crude Oil Pipelines & Services segment owns a crude oil pipeline system. The Natural Gas Pipelines & Services segment stores and transports natural gas. The Petrochemical & Refined Products Services segment offers propylene fractionation, butane isomerization complex, octane enhancement, and refined products. The company was founded by Dan L. Duncan in April 1998 and is headquartered in Houston, TX.

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HOUSTON--(BUSINESS WIRE)--Enterprise Products Partners L.P. (NYSE: EPD) (“Enterprise”) today announced the completion of an expansion of its Acadian Haynesville Extension natural gas pipeline, the first of $3.8 billion of organic growth capital projects that are scheduled to be completed and begin service in 2023. This expansion adds approximately 400 million cubic feet per day of Haynesville natural gas takeaway capacity to meet growing industrial demand in the Mississippi River Corridor and s.

Enterprise Completes Expansion of Acadian Haynesville Extension

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HOUSTON--(BUSINESS WIRE)--Enterprise Products Partners L.P. (NYSE: EPD) announced today that it will participate in the 20th Annual Energy Infrastructure CEO & Investor Conference hosted by the Energy Infrastructure Council (“EIC”) on Tuesday, May 23 and Wednesday, May 24, 2023, in West Palm Beach, Florida. The latest investor deck that may be used to facilitate the investor meetings can be accessed under the Investors tab on the Enterprise website. Enterprise Products Partners L.P. is one.

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