Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

A specter is haunting the pipeline sector: Rating agencies.

A day after Kinder Morgan hosted a call about its sale of a pipeline to Southern Co. at what could be called an attractive price, it was Plains All American Pipeline's turn to bow to the bond market.

Plains All American has spent much of this year struggling to juggle big cash payouts with a depressed oil market while also investing for growth. It just decided to drop one ball: payouts.

Not Buying It
Plains' dividend yield has been coming down from February's spike but remains above 10 percent
Source: Bloomberg

It is doing this in two ways. First, it is simplifying its structure, effectively getting rid of the general partner that siphoned off $620 million of cash flow annually from the master limited partnership (for a fuller explanation of how this worked, see this). Second, having held its dividend flat since last fall, it will simply cut it by 21 percent later this year.

All told, this will save Plains about $320 million a year, moving it toward a goal of generating enough cash to cover its dividend by 1.15 times, which is broadly seen as prudent in the land of master limited partnerships. Plains hasn't had that level of coverage for a while, according to data from Bloomberg Intelligence:

Duck And Cover
Plains hasn't had a consistent cushion of cash flow above its distributions since 2013
Source: Bloomberg Intelligence

Until now, Plains had been trying to ride out the storm. Back in January, Plains instead issued $1.5 billion of convertibles in what it billed as a "one and done" transaction to shore up confidence in both its dividend and its credit rating. This echoed Kinder Morgan's own approach to dealing with the sudden seizing up of the equity market for pipeline operators: It issued its own convertibles last October to raise cash rather than cut its payouts. Less than 2 months later it bowed to the inevitable.

Even now, Kinder Morgan is having to work to pay off debt -- hence its pipeline sale this week. Similarly, Plains couldn't keep banking on a turnaround in the energy market to do the heavy lifting on bringing down its leverage, which was still almost 5 times trailing Ebitda at the end of the first quarter. Indeed, there were earlier signs of trouble with its approach, as Moody's initially balked at treating the "one and done" convertibles as 50 percent equity (it later relented).

On Tuesday's call, Plains emphasized that the dividend cut -- call it "two and through" -- would enable it to delever and maintain adequate coverage for payouts even if oil remains depressed.

Oil bulls should take note of that. Back in January, when oil was trading in the $30s, Plains was projecting it to rise steadily toward $70 a barrel in the second half of 2017. That was way ahead of what futures markets were indicating at the time. Since then, futures have moved closer to Plains' view.

Going My Way?
Oil futures have moved higher since Plains issued its projections in January
Source: Bloomberg, the company

What is interesting here is that even as the market has headed in the right direction, Plains has chosen to take a more conservative approach to the future. The bear case it is now positioning itself to withstand pushes out recovery in U.S. oil production to early 2018, implying a slower price rebound.

For Plains' investors, though, the Band-Aid has at least been ripped off. Conserving more cash and, by eliminating payment to the general partner, a lower cost of capital puts Plains on firmer ground. Hence the stock jumped nearly 10 percent on Tuesday morning (higher oil prices helped, too).

Investors shouldn't forget there is a ways to go, though: $320 million saved per year equates to just 3 percent of Plains' pro forma net debt. That will haunt the stock for a while yet.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net