We Expect Targa To Increase EBITDA by Over 20% in 2023

Sector Strategist

Stephen Ellis

Targa Resources is primarily a gatherer and processor, or G&P, of natural gas, with 70% of its gathering and processing assets in the Permian, which generates about 80% of its volumes. The firm has historically outgrown Permian production growth, given its leverage to growth-oriented customers and robust gas/oil ratios. It has aggressively made acquisitions as well, with Lucid in 2022 for $3.5 billion in what its biggest deal yet. To date, it has contributed to very healthy near-term growth. However, we expect its fee floors and balance sheet to be tested in a down market. 

Targa’s strategy of controlling and moving its Permian molecules on its own assets throughout the entire value chain is a good one. It reduces costs by eliminating third parties, lets them capture spreads between two markets as opportunities arise, and by adding pipelines, liquefied petroleum gas, and fractionation assets, adds secure levels of fee-based income. It also offers opportunities for expansions, such as the Daytona expansion that Targa is undertaking for the Grand Prix natural gas liquids pipeline at very attractive returns. This higher-quality fee income contrasts with the percentage of proceeds contracts that typically define Permian gas and gathering contracts, meaning processors are linked to commodity prices (though Targa hedges for at least the coming year) for material fee income. 

Despite our concerns about the G&P assets, we’re optimistic about the future of LPG exports and Grand Prix. LPG exports are largely under contract and sent mainly to Asian and Latin American markets. India remains a potentially attractive option under a government scheme designed to encourage LPG usage. Targa has wisely expanded its export capacity recently, and volumes are at record levels. 

The Grand Prix NGL pipeline has been a material positive for Targa. As of late 2022, it is over 500,000 barrels per day of natural gas liquids, linking Targa assets at both ends of the pipe. Targa is now adding the Daytona pipeline, as an addition to Grand Prix, further expanding its value at what we expect to be a highly attractive per-unit cost.

Business Strategy & Outlook

We do not believe Targa Resources has earned an economic moat. The majority of the business is gathering and processing assets, which have no moat because of the lack of regulation, lower capital intensity, and weak contract quality. The rest is the higher-quality logistics and marketing segment, with substantial NGL fractionation assets and an important LPG exporting position. But given that the gathering and processing business is asset-intensive and receives the bulk of investments and acquisitions, firm-level returns on invested capital have typically been in the mid-single-digit range. 

Given Targa’s strong position as a gatherer and processor in many important U.S. shale plays and its status as one of the larger NGL fractionators in the U.S., we think making more investments in pipelines to retain control over the molecules it currently gathers for third parties would be its best move to improve the competitiveness of the business and boost ROICs above cost of capital. The Grand Prix NGL pipeline is a good start, but more maintained investment needs to be done. We expect improvements in Targa's ROIC profile over the next few years, but this is almost entirely due to the impact of higher commodity prices and the impact on Targa's operations via higher contracted fees, likely via percent of proceeds contracts as well as wider marketing spreads. With oil and gas prices well above our long-term expectations, we expect the current tailwind to eventually become a headwind. 

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, 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 firm to optimize the flow of hydrocarbons across the system and capture geographic differentials; use storage facilities to capture price differentials over time; and direct more hydrocarbons through its system via storage and gathering and processing assets, ensuring security of flows and higher fees. Finally, as an incumbent pipeline, it is typically cheaper 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.

We believe Targa’s gathering and processing assets have no moat because of the lower levels of capital intensity and poor contract quality. Producers typically have no shortage of G&P providers to pick from to meet their needs. 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. Impairments of customer contracts are frequent in the industry. 

We also consider the fee structure to be poor, because we expect a majority of Targa's contracts are percentage of proceeds, or POP, exposing Targa to commodity price risk. To some extent, the higher POP exposure is driven by basin history and producer expectations. In some cases, Targa will take ownership of the raw NGLs (or equity NGLs) and act as a shipper on third-party pipelines to move the NGLs to market, paying the tariffs out of its proceeds from the POP contract. The higher costs incurred here help illustrate the weakness of Targa’s competitive position and make the Grand Prix pipeline more important as Targa will then pay the tariffs to itself. These G&P assets are made up of over 10 billion cubic feet per day of onshore G&P capacity primarily in the Permian (6.9 billion cubic feet once under construction plants are completed), the Eagle Ford, Anadarko, and Barnett Shale plays. The remainder of the G&P portfolio is made up of 2.0 bcf/d of G&P assets serving the shallow water in the Gulf of Mexico. Here, processing volumes are in secular decline and have fallen more than 50% since 2010. 

Targa’s downstream operations, the other half of its asset portfolio, are much more attractive, and we would consider them to have a moat based on efficient scale. Earnings contributions are split about 65% fractionation, 20% LPG, and 15% marketing. These assets include gross capacity of 843,000 b/d of fractionation capacity located at Mont Belvieu, LPG exporting facilities that can handle 13.5 million barrels per month (once a recent expansion is complete), and NGL and gas marketing and distribution capabilities. The LPG business operates under long-term contracts with take-or-pay provisions.

For the fractionation assets, we see a number of moaty elements. We do consider fractionators to be higher-quality assets than natural gas and processing assets because of the more-concentrated nature of the market. Gas processing plants typically connect to only a single NGL fractionation plant because it is uneconomic to have multiple connections, whereas shippers often have multiple options for gas gathering and processing. We estimate around 4.5-5 mmb/d of fractionation capacity is in the United States. We estimate that 70%-80% of the fractionation market is concentrated within about seven or eight key players, all integrated midstream firms. Given that NGL fractionation plants are between natural gas processing plants, and in Targa’s case, an LPG export facility in the value chain, we think these investments are more likely to be sanctioned by a firm that owns all three parts of the chain versus an independent third party that will not be able to guarantee enough upstream and downstream supply to make the investment profitable. Contracts are also typically fee-based. 

With an estimated 40% of fractionation capacity in the U.S. at Mont Belvieu, Targa, Energy Transfer Partners (via Lone Star), and Enterprise Products Partners are dominant at this important market hub. The barriers to entry are sizable in terms of obtaining the necessary real estate, the related upstream and downstream parts of the value chain, and more specifically for Mont Belvieu, the salt caverns for NGL storage are quite important. Targa has 55 million barrels of storage at Mont Belvieu. These storage assets are critical for managing the logistics of exporting LPG, for example, and for allowing midstream firms and producers to take advantage of seasonal changes in demand and prices. Given fractionation’s position in the overall value chain, it only makes sense to expand capacity when new pipelines are added to deliver NGLs to the hub, and those assets are likely to be controlled by the same players who control the fractionation capacity, ensuring a rational and profitable market. 

Targa's marketing and distribution operations are sizable, depending mainly on NGL differentials. Further, the G&P and logistics assets are generally connected, allowing them to operate as a true network. The firm’s marketing operations include NGL distribution, where it purchases mixed NGLs for resale to petrochemical manufacturers; propane marketing, where it sells its propane supply to major retailers; and similar efforts for natural gas. It also has transportation assets, which include railcars, transport tractors, and NGL barges.

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 life cycle 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 Joe Biden’s revocation of the Keystone XL presidential permit and the legal challenges around the Dakota Access Pipeline system. 

Targa has laid out two ESG-related goals to reduce methane intensity across its gathering, boosting, and processing operations by 2025.

None

Economic Moat

Targa Resources

Targa Resources Corp. provides midstream natural gas and natural gas liquids services. It also provides gathering, storing, and terminaling crude oil, and storing, terminaling, and selling refined petroleum products. It operates through the following business segments: Gathering and Processing, and Logistics and Transportation. The Gathering and Processing segment includes assets used in the gathering of natural gas produced from oil and gas wells and processing this raw natural gas into merchantable natural gas by extracting NGLs and removing impurities, and assets used for crude oil gathering and terminaling. The Logistics and Transportation segment includes all the activities necessary to convert mixed NGLs into NGL products and provides certain value-added services such as the storing, fractionating, terminaling, transporting and marketing of NGLs and NGL products, including services to LPG exporters, and the storing and terminaling of refined petroleum products and crude oil and certain natural gas supply and marketing activities in support of its other businesses. The company was founded on October 27, 2005, and is headquartered in Houston, TX.

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Targa Resources Corp. (NYSE:TRGP ) Q1 2023 Earnings Conference Call May 4, 2023 11:00 AM ET Company Participants Sanjay Lad - Vice President-Finance and Investor Relations Matt Meloy - Chief Executive Officer Jennifer Kneale - Chief Financial Officer Pat McDonie - President-Gathering and Processing Scott Pryor - President-Logistics and Transportation Bobby Muraro - Chief Commercial Officer and General Partner Conference Call Participants Michael Blum - Wells Fargo Brian Reynolds - UBS Jeremy Tonet - JPMorgan Tristan Richardson - Scotiabank Keith Stanley - Wolfe Research Colton Bean - Tudor, Pickering, Holt & Co. Sunil Sibal - Seaport Global Neal Dingmann - Capsecurities Operator Good day, and thank you for standing by. Welcome to the Targa Resources Corp. First Quarter 2023 Earnings Call.

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