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Oneok Reports Strong Q3; Issues Better-Than-Expected 2023 Outlook Oneok Reports Strong Q3; Issues Better-Than-Expected 2023 Outlook Stephen Ellis Sector Strategist Analyst Note | by Stephen Ellis Updated Nov 02, 2022 Oneok’s third-quarter results were healthy, as its EBITDA increased 4% year over year. Its early 2023 outlook calls for a 10%-plus increase in adjusted EBITDA over 2022 levels of a bit more than $3.6 billion, or above $4 billion. We see the upside as both volume and fee driven, as Rockies volumes continue to be healthy while gathering fees are tracking to a 10% increase in 2023. The completion of the MB-5 fractionator plant in mid-2023 should also contribute. The fee increase is expected to be primarily due to inflationary trends. After updating our model, we are increasing our Oneok fair value estimate to $58 per share from $56 while maintaining our narrow moat rating. While Oneok continues to benefit from higher Rockies volumes (a 12% increase) and higher fees, its natural gas pipeline segment was well ahead of expectations this quarter. The strong performance is mainly due to Oneok’s recent investments in gas storage, as it recently completed a 1.1 billion cubic feet (bcf) expansion of its Texas storage facilities, and it is currently expanding its Oklahoma storage by 4 bcf, which is due online in the second quarter of 2023. Storage capacity is currently just over 53 bcf. The Texas assets are under contract until 2032, and the Oklahoma additions are under contract until 2029. Oneok is also evaluating additional Texas expansion opportunities. The primary driver here would be the increased value of gas storage to address the intermittency issues with renewables. Oneok’s Medford facility remains out of service following a fire during the third quarter. Oneok expects ongoing insurance proceeds as events progress. To date, it has received $45 million of an expected $100 million insurance payment, and we would anticipate additional recoveries as needed. Oneok has yet to determine if the facility can be repaired or if it will need to be replaced but doesn’t expect a material financial impact in either scenario due to insurance. Business Strategy and Outlook | by Stephen Ellis Updated Nov 02, 2022 Oneok brings together high-quality assets, some of the strongest near- to medium-term growth prospects in our coverage as Rockies volumes continue their ongoing rebound, a C-Corporation structure, and a well-respected management team in a compelling package. About 90% of the firm's earnings are fee-based, 80%-90% of its customers are investment-grade, and the firm hedges its limited commodity price exposure. With the reduced capital program, Oneok is forecast to have material levels of excess cash flow in 2023, perhaps 24 months behind other U.S. midstream peers to buy back more stock. We estimate there could be up to $675 million in buybacks in 2023, though knowing Oneok's penchant for finding accretive growth projects, this is also equally likely to be plowed back into attractive growth assets. Oneok experienced more volume volatility than peers in 2020. Natural gas liquids volumes in the Rockies fell more than 20% sequentially in the second quarter of 2020 but recovered with 2021 volumes up more than 40% over 2020 levels. The sharp decline and recovery demonstrate the challenging basin economics for producers and thus volume security for Oneok. On the flip side, concerns about Oneok's indirect exposure to the Dakota Access Pipeline and related assets have diminished as producers have lined up alternative takeaway options out of the Bakken, including rail. If DAPL were to shut down permanently, Oneok's exposure is immaterial. Still, Oneok's major growth opportunities in the near term lie in the Rockies and Williston Basin. Oneok's natural gas liquids volumes in the Rockies are around 370,000 barrels per day, well below its current capacity of 440,000 b/d (expandable to 540,000 b/d). Expected growth drivers are ongoing rig activity, ethane recovery, and reducing flared gas, and every 25,000 incremental b/d is about $100 million in incremental EBITDA. In the Williston Basin, there is also substantial upside for Oneok in terms of capturing now-flared gas, as Oneok has spare gathering and processing capacity and can benefit as rig activity in the area increases. Economic Moat | by Stephen Ellis Updated Nov 02, 2022 We view Oneok as a narrow-moat corporation as it benefits from a strong efficient scale moat source. Oneok’s business mix is more weighted toward no-moat natural gathering and processing (about one fourth of earnings) and thus sensitivity to natural gas volumes and drilling activity levels than we’d prefer to award a wide economic moat rating. That said, we expect Oneok’s returns on invested capital to average 12%-13% over the next five years well above our cost of capital, easily supporting our narrow moat rating. Oneok’s natural gas and NGL pipelines are more limited in scope than those of wide-moat peers such as Enterprise Products Partners, mainly serving the narrower midcontinent to Gulf Coast corridor. The narrower scope limits the firm’s opportunities, as a broader marketing presence would allow it to more actively take advantage of time, location, and product upgrade differentials. 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, for 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. The largest contributors to Oneok’s operating margin are its natural gas liquids assets, which we see as narrow-moat assets. These assets primarily deliver NGLs from the Rockies and the midcontinent to the Gulf Coast and include both FERC- and non-FERC-regulated NGL gathering and distribution pipelines, NGL fractionation capacity (the second largest fractionator in the U.S., by our estimates), storage facilities, and truck and rail loading and unloading facilities. It’s reasonable to expect much of the NGL supplied would come from Oneok’s gas processing capacity in the same regions. Altogether, Oneok has connections to 90% of gas processing plants in the midcontinent, where its biggest strength is its exposure to the low-cost Permian Basin, STACK, and SCOOP plays. Oneok’s network is deep enough in Texas and the midcontinent that it has options in terms of marketing NGLs in the midcontinent or moving them down to the Gulf Coast, depending on the widest differentials. We think Oneok’s NGL assets are well positioned. 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 only connect to 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 million-5 million b/d of fractionation capacity is in the United States. Given that NGL fractionation plants are between natural gas processing plants and refined NGL pipelines 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. We see Oneok’s gathering and processing business as no moat because of the lack of regulatory oversight, low capital intensity levels, and weak contract coverage. To be clear, we do think Oneok’s gathering and processing portfolio is generally well positioned in low-cost basins across the midcontinent (STACK, SCOOP, and the Bakken) where the facilities remove contaminants and NGLs from raw natural gas for further processing and then recompress the residual natural gas for delivery to pipelines and end users. In general, we see G&P assets as useful in terms of controlling the direction and amount of flows into Oneok’s pipelines. We see Oneok’s natural gas pipelines as narrow-moat assets, primarily because they tend to be weighted toward intrastate and thus subject to more light state regulation versus tougher FERC interstate regulation, meaning the barriers to entry are lower. The pipeline assets serve the midcontinent area (including STACK, SCOOP, Granite Wash, Woodford) and Texas (Permian Basin) and transport gas to end-use markets, but also export hubs in the Houston Ship Channel and Mexico. These pipelines are high quality, but we’re most intrigued by Oneok’s recent joint ventures, which are the Northern Border pipeline and the Roadrunner. The Northern Border pipeline (50% owned by Oneok) transports gas from the Canadian border to Indiana. In recent years, Bakken gas has been displacing Canadian imports, and we expect this to continue. The Roadrunner pipeline transports gas from the Permian Basin on a fully subscribed 25-year contract to Mexico and when combined with Oneok’s WesTex pipeline expansion positions Oneok to serve natural gas demand out of Mexico, where the national utility (Comision Federal de Electricidad) is retiring oil-fueled power plants. The biggest strengths of the network are that about 82% of its capacity serves end-use markets such as local natural gas distribution firms, electric generation facilities, and large industrial companies, meaning demand is highly stable. The business generated well over 90% of its revenue from firm contracts over the past five years, and utilization is typically 90%-plus. From a contract perspective, we see Oneok as in a healthy position. The natural gas pipelines typically garner the strongest level of contract coverage, and Oneok recently signed a 25-year contract to transport 570 million cubic feet of Permian Basin gas to the Mexican border for its Roadrunner pipeline (Oneok owns 50%). NGL contract coverage is similarly long-term for the pipelines, but around 7-10 years for the fractionation assets and 2-3 years for storage, by our estimates. The corporation continues to be a fairly heavy user of acreage dedications for gathering and processing assets during the last few years (for example, over 3 million acres in the Williston Basin), which we see as supportive of long-term relationships with key producers. The size of the effort means the firm is more dependent on producers having the capital to deploy and the acreage being economic still versus working with an already established and producing set of wells. 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. 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), 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 people. Examples of the opposition are seen in President Joe Biden’s revocation of the Keystone XL presidential permit and the legal challenges surrounding the Dakota Access Pipeline. Oneok is pursuing one of the more aggressive greenhouse emissions targets among its U.S. peers, aiming to reduce absolute Scope 1 and 2 emissions (most peers target emissions intensity) by 30% by 2030. Fair Value and Profit Drivers | by Stephen Ellis Updated Nov 02, 2022 After updating our model for third-quarter results, we raise our fair value estimate to $58 per share from $56, mainly to reflect a better-than-expected 2023 outlook due to higher fees and volumes. Our valuation implies a 2022 enterprise value/EBITDA multiple of 10.7 times, a 2023 EBITDA multiple of 9.4 times, and 2022 distribution yield of 6%. Oneok's growth prospects are being driven by its more than $8 billion in investment during 2018-20. Major growth areas include growth in Rockies natural gas liquids production and a reduction in the Williston Basin gas flaring, with more gas being processed by Oneok's facilities. We also expect Oneok to benefit from its substantial investments in fractionation capacity that is fully contracted under long-term contracts. A new plant is due online in 2023. Other major investments include its Elk Creek and Arbuckle II pipelines, which have expansion opportunities as market conditions warrant. As result, we forecast EBITDA to increase about 6% annually on average over 2022-26. We assume a 9% cost of equity. Oneok operates as a corporation instead of limited partnership, which brings certain advantages in terms of broadening the shareholder base, allowing it to be represented in indexes, and reduced tax complexity. Risk and Uncertainty | by Stephen Ellis Updated Nov 02, 2022 Our Morningstar Uncertainty Rating for Oneok is Medium. The single-greatest risk to the Oneok story is failure of international demand for natural gas liquids, particularly from China or India, to materialize. In addition to making up over 50% of the partnership’s gross operating margin today, Oneok's NGL business will serve as its primary growth engine through the rest of the decade as countries use more lighter olefins for heating and industrial end uses. However, much of this demand is out of Oneok's control. Any delays or reduced demand would have a materially negative effect on Oneok's earnings. Even as much of the downside risk is mitigated by sufficiently contracted capacity, failure of NGL demand to materialize would cap Oneok's earnings upside. Oneok holds some commodity price risk from volumes and equity ownership of natural gas and NGLs. The partnership addresses some of this risk through hedges and its diversified asset base. However, the main risk to Oneok’s marketing business is a narrowing of spreads. As with many yield-oriented investments, Oneok is exposed to interest-rate risk. If interest rates increase faster than expected, Oneok's shares could underperform, as a steepening yield curve increases expected distribution yield for competing assets. Oneok's major ESG risks, in our view, are related to managing its carbon emissions profile at its carbon-intensive gathering and processing operations. If the United States were to introduce a national carbon tax or similar approach, this could increase costs for Oneok. Oneok also has exposure to community relations or social issues in terms of managing stakeholder relationships. For example, even though it holds no direct ownership in the controversial Dakota Access Pipeline, its assets are exposed to the loss of volumes. Capital Allocation | by Stephen Ellis Updated Nov 02, 2022 We believe Oneok merits a Standard capital allocation rating. We think the company has generally pursued wise and somewhat outsize investments at attractive returns, which has resulted in fairly high leverage ratios historically, but they have declined as the projects have entered service and contributed to earnings. Oneok has also pursued a reasonable dividend approach and paused further dividend growth when it became clear that investors no longer valued the yield and payout. The investment in growth has come at a cost, though, as Oneok is about 24 months behind peers in terms of having substantial excess cash flow to devote toward buybacks or more aggressive debt reduction, and instead had to rely on EBITDA growth alone to reduce leverage. However, this can change in 2023 with substantial excess cash available, so we will see if Oneok chooses to pivot toward additional capital returns or investment. Given the still-attractive returns, though, we think Oneok has managed to strike the right balance from a capital allocation perspective. Oneok management managed the balance sheet well during the latest energy market turmoil in 2020, issuing both debt and equity to shore up liquidity while slicing capital spending significantly. The firm maintained a very strong near-term liquidity profile, while concurrently placing a number of large and complex projects in service with no major issues. Leverage is now beginning to decline fairly rapidly and stands at more reasonable 3.8 times as of the third quarter of 2022, and we expect it could be around 3.2 times at the end of 2023. Oneok's 2018-20 investment of more than $8 billion is largely sensible and value-creating over the next few years. We think highly of the well-planned Elk Creek and Arbuckle II pipelines in particular, given Texas' need for ethane molecules with several new Gulf Coast steam crackers in service. The G&P investment also addresses flaring issues in the Williston Basin, providing one of Oneok's best near-term growth opportunities. That said, not all of the earlier investments panned out. Oneok wrote off $257 million in 2014 and 2015 related to a coalbed methane natural gas gathering system in the Powder River Basin. The firm also impaired over $500 million in assets and goodwill in 2020 relating to natural gas processing and gathering assets in the Powder River Basin, western Oklahoma, and Kansas. Finally, the Oneok Partners transaction in 2017 was smart, as it eliminated the incentive distribution rights drag, lowered the combined corporation's cost of capital, and provided additional financial benefits in terms of a reasonable dividend growth pathway and a solidly investment-grade credit rating. |
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