PAA/PAGP: Free Cash Flow Adds Fuel to Distribution Growth

Last week, management from Plains All American (PAA/PAGP), including Chairman and CEO Willie Chiang, participated in a fireside chat call series co-hosted by Morgan Stanley and VettaFi. Free cash flow generation, capital allocation, and opportunities in the Permian and Canada were among the key topics. 

Plains is well positioned to generate meaningful free cash flow, which provides financial flexibility and supports distribution growth (discussed more below). And the company expects to generate $1.6 billion in free cash flow this year. Management also highlighted that PAA’s mid-teens free cash flow yield is competitive with both midstream peers and energy companies broadly. 

Continued capital discipline is a key component to strong free cash flow generation. And management expects growth capital spending to remain in a range of $300-400 million for the next few years. Plains has earmarked roughly half of the spending for connecting new wells to their Permian crude gathering system. 

With excess cash flow generation, it can be helpful for investors to have a clear outline of how that cash will be deployed. In that vein, Plains announced a multi-year capital allocation framework in November 2022. And we believe other midstream companies could benefit by providing similar guidance (read more).  

Central to Plains’ framework is distribution growth. This includes a $0.20 per unit annualized distribution increase implemented earlier this year and $0.15 per unit annual distribution increases until distribution coverage reaches 160%. With 2022 coverage at 273% (read more), there is a long runway to reach 160%, and $0.15 per unit annual distribution growth will be targeted for several years. Management cited a 12.5% compound annual growth rate for the distribution as a differentiating factor for PAA relative to peers.

Additionally, debt reduction remains a priority. In 1Q23, PAA reduced debt by $450 million. And management expects its leverage ratio to be 3.5x at year-end. Buybacks are expected to remain opportunistic. Management views the buyback authorization as a tool to support the equity price when markets disconnect from fundamentals. 

Plains sees growth opportunities in the Permian and Canada, which they could pursue while maintaining capital discipline. In the Permian, Plains’ integrated crude system stands to benefit from continued production growth. Management expects Permian oil production to increase by 500,000 barrels per day this year, implying production of 6.15 million barrels per day at year-end. Extra capacity in PAA’s intra-basin and long-haul crude system allows for growth with minimal capital spending.  

And in Western Canada, Plains has an extensive natural gas liquids (NGL) business. Management is weighing a low-cost, high-return project to debottleneck and optimize assets to expand capacity there. More details will likely be provided on the August earnings call. 

Plains also sees an opportunity in low-carbon energy projects. Management noted that these projects have to provide attractive returns and compete for capital like any investment. At its joint venture NGL processing facility in Sarnia, Ontario, PAA is installing a battery system that will provide power at peak times and charge during off-peak times when low-carbon electricity is more readily available. Also in Canada, Plains is working with the Canadian government and Atura Power to explore opportunities in hydrogen. Specifically, they are considering using their NGL storage caverns to store hydrogen, which could then be piped to power plants.  

Plains is unique in the midstream space due to its dual tickers. PAA is an MLP that issues a K-1, while PAGP,  structured as an “Up-C,” provides a 1099. However, even though it issues a 1099, PAGP is expected to provide return-of-capital dividends for the next six years and is not expected to pay cash taxes for the next decade. Importantly, the economics and dividends for the two tickers are the same, but investors can choose the tax structure that best suits their needs. When asked about C-Corp conversion or consolidating into one ticker, management noted that they like having both tickers and cited the potential tax implications of a C-Corp conversion. 

Plains generates compelling free cash flow, which enhances financial flexibility and is expected to support distribution growth for years to come. The company can leverage existing assets to pursue growth while also prioritizing capital discipline.  

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