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.

Looking for an MLP set to soar on the back of the Permian shale fracking boom? Targa Resources Corp. isn't quite that. But it might still have what you need.

I wrote last week about the surge in natural gas production from the Permian basin, a by-product of higher oil output. That extra gas is already depressing prices on local hubs and adds to other pressures weighing on the outlook for the gas market, and gas-weighted E&P companies, in general.

On the other hand, higher gas production means more of the stuff being shipped and processed -- which should be good for relevant pipeline operators.

Think 'pipelines' and you might think master limited partnerships, with their high distributions to shareholders and fixed-fee businesses providing insulation against swings in commodity prices. The experience of the past few years, however, shows MLPs don't always fit the commonly held assumption they are like toll roads for oil and gas (see this).

Some MLPs are more exposed to movements in the underlying markets for the fuels they ship and process due to the fact they aren't operating regulated interstate pipelines but are instead running gathering pipeline systems at the field level or facilities to process, store or export fuels. These are riskier businesses that suffered mightily in the crash of the past couple of years, having overreached in the preceding building boom.

Which brings us to Targa. It certainly didn't escape the crash:

Taaaaaaaargha!
Targa lost as much as 90 percent of its value in the energy crash
Source: Bloomberg

It is not an MLP, though, and indeed bought out its listed partnership, Targa Resources Partners LP, about a year ago, when it became clear the meltdown in MLP valuations undercut the reason for having it out there.

Even so, Targa still pays a relatively high dividend. And its two main businesses involve gathering and processing output, primarily natural gas, in several shale basins and refining, transporting, storing and marketing natural gas liquids such as ethane. This makes it more exposed to swings in production volume and pricing than traditional pipeline operators.

What this means is that, if you're looking for an MLP with good exposure to rising Permian gas production, then best to look elsewhere. If, on the other hand, you're looking for a company which is leveraged to rising Permian output and pays a decent yield to help deal with the higher risks involved, then Targa looks more suitable.

Targa's gathering and processing business, which accounts for slightly more than half of its Ebitda, is spread around the Permian basin, the so-called SCOOP/STACK basins in Oklahoma, the Eagle Ford shale in south Texas and the Bakken shale in North Dakota. Of these, Targa's Permian and Oklahoma businesses dominate.

Together, these regions are forecast by Morgan Stanley to deliver an extra 8.2 billion cubic feet a day of associated natural gas supply -- meaning it's a by-product of oil output -- by 2020, implying production will more than double. Meanwhile, even if the Eagle Ford and Bakken basins aren't likely to grow at anywhere near that pace, production should stabilize if oil prices don't embark on another slide down.

Prospects for natural gas liquids, Targa's other big business, are also looking up. The growing gap between futures prices for crude oil and natural gas implies E&P companies getting more bang for their buck targeting liquids-rich natural gas wells:

Liquid Launch
Futures prices imply the economics of natural gas liquids should start improving this year
Source: Bloomberg
Note: Nymex crude oil price as a multiple of Henry Hub natural gas price. Data until April 2017 are historical; data beyond then reflect current futures prices.

U.S. production is forecast by Citigroup to grow from the current level of about 4 million barrels a day to almost 6 million over the next five years, with roughly half the extra barrels coming from the Permian basin. New petrochemical plants, mostly around the Gulf of Mexico, along with export markets are expected to take the extra supply. Targa is set to benefit from both rising production and pricing, and its export capacity provides some hedge if domestic demand doesn't absorb all of the extra supply. It helps that two-thirds of the export capacity is contracted through 2022.

To gain exposure to this, you could simply own gas-weighted or Permian-weighted E&P stocks. Targa's big difference, however, is its dividend.

Most E&P companies pay minimal dividends or none at all, preferring instead to plow their cash flow (and often a bit more) back into the ground. In that, they are responding not merely to their primal instincts but also, it seems, investor preferences. In a report published on Monday, analysts at Sanford C. Bernstein found E&P companies paying high dividends tend to underperform those paying less, mainly because they are viewed as having nothing better to do with the money.

Targa, meanwhile, currently yields about 6 percent. And while its payout has been flat since mid-2015, Targa should be able to start raising it again in 2018.

Consensus forecasts have Targa making Ebitda of $2.7 billion across this year and next. Take off about $1 billion for interest, preferred  and maintenance capex, and the $1.7 billion left would more than cover $1.5 billion of dividends -- including a 5 percent bump next year.

Add in $1.4 billion of growth capex, financed 50/50 with new debt and equity, and by the end of 2018, Bloomberg Gadfly analysis suggests Targa's net debt would be 4.15 times trailing Ebitda, down from 4.32 times at the end of 2016 and moving towards a level of 4 times by the end of 2019.

That combination of a decent payout and the Permian's progress makes Targa an interesting prospect for at least the next couple of years. Just don't mistake it for one of those MLP thingies.

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

  1. Several other pipeline operators followed suit with similar restructurings, most recently Williams Cos.

  2. Acronyms for the South Central Oklahoma Oil Province and the Sooner Trend Anadarko Basin Canadian and Kingfisher Counties basins. Catchy, huh?

  3. These numbers include the impact of Targa's recent acquisitions of Permian assets.

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

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