ONEOK: Things Are Not OK (NYSE:OKE)

Gas storage tanks at sunset.

Iurii Garmash

ONEOK (NYSE:OKE) is a perpetual favorite among many Seeking Alpha authors and readers alike, largely owing to its perceived safety: the balance sheet, dividend coverage, and perhaps most importantly the fact that it is not a K-1 issuer. Those are positives, but I’ve taken the counter view for quite some time, with the firm actually being one of the few large-cap midstreams that make my “Avoid” list internally at Energy Investing Authority. That’s been the right call of late, with ONEOK underperforming the Alerian MLP (AMLP) benchmark by more than 20.0% on total return from early 2020 to present. Past performance does not dictate the future, but in my view, this weakness is set to continue. To help, I’m going to lay out the three major concerns investors should have if they are long.

Quick Business Overview

ONEOK is a leading midstream services provider and is actually one of the largest owners of natural gas liquids (“NGLs”) fractionation facilities and inbound/outbound NGL pipelines in the United States. For those unaware, fractionation facilities process mixed streams of natural gas liquids (called Y grade”) into their various purity products: ethane, propane, butane, isobutane, and natural gasoline. While the company does own natural gas gathering and processing systems and ownership interests in larger interstate gas pipelines, at the end of the day these assets are owned solely to integrate and support its NGLs-focused business model.

To get the call right on ONEOK, directionally investors have to be comfortable with the outlook on NGLs. 60.0% of 2022 EBITDA is expected to be earned from the Natural Gas Liquids segment, with a further 25.0% of EBITDA stemming from its Natural Gas Gathering and Processing segment – assets that nearly wholly feed volumes into the Natural Gas Liquids business.

Asset Map

Asset Map (ONEOK)

To start with, I’m a fan of NGLs right now. Fractionation capacity in particular is quite tight, and gas processing capabilities are as well. For those following the midstream sector, that’s readily apparent as gas processing and fractionation is one of the few areas still seeing material growth capital investment. That said, frac spreads (the price difference between a typical NGL barrel and the underlying gas if not processed) have come in, and that’s starting to get felt when it comes to underlying demand.

Further, what makes ONEOK different than other entities that have significant NGLs is the location of its business. More than half of its fractionation capacity is located in the Mid-Continent at the Conway Hub – not at Mont Belvieu on the Gulf Coast. Compounding this issue, its gas processing plants – which separate NGLs from raw natural gas – are all located in the Rocky Mountain and Mid-Continent regions of the United States. It has basically no footprint in the Permian Basin beyond downstream assets that it owns (large NGL pipelines and its limited fractionation footprint).

Issue One: Geography

This brings us to the first problem facing ONEOK, and it’s a simple one: the location of its assets. Asset owners in the energy sector, analysts, and regulatory agencies rarely agree on much of anything when it comes to the space, but if there was a consensus view to be had, it is that the Permian is going to be growth engine for hydrocarbon development in the United States. NGL production is driven by drilling activity, and as the outlook for the rest of the country is far more tepid, so too is that at ONEOK. While management notes trends like reductions in flaring, higher gas to oil ratios, and other themes that all support higher raw natural gas volumes – indicative of higher underlying NGLs volumes – the reality is that in a post-pandemic world, raw natural gas production in the Mid-Continent and Rockies regions where the firm has its presence look flattish. Meanwhile, rig count share in the Permian continues to grow.

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Production By Basin (Author)

Per estimates, NGL production from the Permian hit a record 3.6 mmbpd recently, comprising two-thirds of overall volumes from the United States. This has offset declining production from the Marcellus Shale and net flat activity in the Mid-Continent and Rockies. The Permian being a powerhouse is all too perfect, as the geographical location of the premier shale play near the Gulf Coast suits itself to serving export activity. Domestic consumption is not expected to grow materially for most NGL products either on the residential or commercial side. Using propane as an example, fuel oil conversions are largely just expected to offset continued conversions to natural gas and electricity for heating for residential buyers. Meanwhile, commercial use is largely driven by the agricultural sector (crop drying) and petrochemicals, particularly refiners. Both are flattish markets. Thus, growing NGL volumes are largely expected to be moved internationally, particularly to the Asia-Pacific region where population growth and a rapidly improving middle class are spurring demand growth in the high single or low double digits for propane.

If a company wants to drive operating leverage via volumes, the Permian is the place to be. This is why the big fish like Enterprise Products Partners (EPD) and Targa Resources (TRGP) are working to dominate the energy production chain in Texas. These two already controlled a large portion of the upstream gas processing share prior to recent mergers and acquisitions activity and their stranglehold on the Texas NGLs market has only grown via their purchases of Navitas Midstream and Lucid Midstream. My coverage of these two deals illustrates why they were penned: not for earnings or cash flow, but the ability to integrate these upstream systems to serve their existing downstream gas processing, Y grade pipeline, and fractionation networks. Together, the two now have more than one-half of gas processing capability and significant ownership downstream in fractionation and export. ONEOK is a comparatively small player and at this point has no way to buy their way in, and this means they have limited ability to “encourage” (a softer word for direct) volumes onto their own limited holdings in the Permian. ONEOK will live or die by the SCOOP/STACK plays in the Mid-Continent and the Bakken to the north, and that’s a far more suspect place to be than the Permian.

Issue Two: Relative Valuation

I’ve pulled Wall Street consensus numbers for several midstream firms that are natural gas focused and have prominent gas processing and/or fractionation businesses. EBITDA trajectory is largely similar across these firms, with DCP Midstream being a notable exception to the downside (extreme leverage to commodity prices given by its contract structure plus no growth capital expenditures) and Targa Resources being the upside outlier (acquisition-driven synergies, continued growth on Grand Prix NGL). ONEOK comps in the middle, although 2023 and 2024 earnings benefit firmly from its fifth fractionation facility coming online in Q2 2023. Broadly though, the point is that the outlook is for largely flat earnings across these companies, mirroring that of many other midstream asset owners.

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Comp Table (Author)

What should stand out is the EV/EBITDA multiple at ONEOK. It trades at a material premium of between 1.5-2.0x turns of its close competitors, many of which arguably have better long-term basin positioning. Investors should not be afraid to pay a premium for assets and there are companies that deserve it. However, there has to be a reason why: longer tailwind of earnings, better growth outlook, stronger contract protection, or more resiliency in a downturn. As a whole, ONEOK does none of these things materially better than the firms listed above, particularly names like Enterprise Products Partners or Targa Resources. If ONEOK traded down to peer levels, that would represent more than 25.0% downside. Multiple contraction risk here is meaningful and, in my opinion, would be wholly justified even without any catalyst to cause it.

Issue Three: Impact From Medford Fire

On July 9, ONEOK’s 210 kbpd Medford fractionation facility caught fire. While there were no injuries, the plant has been offline in the weeks since and is expected to remain offline for quite some time. As of last week, the reasons for the fire remained unknown and a timetable for bringing the plant back online was far off. Damage was extensive, and in my view ONEOK is looking at a Q1 2023 startup at best, potentially stretching into Q2. This will be no quick fix, and analyst consensus above has not been updated to reflect this quite yet.

The facility is the second largest fractionator in its portfolio, and actually represents a bit more than 40.0% of ONEOK Conway fractionation volumes. This is a pretty big deal, as ONEOK already controlled the majority of total Conway fractionation capacity (520 kbpd of 650 kbpd, 80.0% market share). As the Conway NGL hub was purportedly as much as 85.0% utilized prior to this incident, there is only about 110 kbpd of slack-free capacity at the facility for these volumes to be offloaded onto, arguably less since hubs are always difficult to run at 100.0% utilization in practice. Some of this is going to be third party.

Because of this, there will be, without a doubt, lost volumes. Processed gas that was once destined for processing will no longer be able to be broken down into purity products. This event will have ripple effects at ONEOK, not only from its profits from Medford but also the volumes it was intaking from nearby owned gathering and processing systems and fractionated volumes it was sending southbound on the Sterling Pipeline.

What will the financial impact be? Spot fractionation rates have been roughly $0.05 per gallon at Conway prior to this event, so even if we assume that half of Medford volumes can be offloaded onto other ONEOK Conway facilities (Bushton, Hutchinson), those rates imply EBITDA impact implies $5.0 – 6.0mm in lost earnings per month. That does not include lost transportation fees on those frac volumes being moved downstream to end markets nor does it include lowered rates upstream within its gathering and processing footprint. I think investors can get comfortable that total impact will be in the $8.0 – 10.0mm per month range, or as much as $90mm in lost earnings assuming a late Q1 2023 restart. Insurance could provide an offset, but most midstream providers do not carry insurance that protects against lost earnings – instead only covering the majority or all of rebuild costs (assuming no neglect or poor maintenance as the cause).

The biggest beneficiary of this event is a tighter frac market in Mont Belvieu. Mont Belvieu is the much bigger fractionation hub and, despite utilization rates that are already in excess of 90.0%, it has the capacity to absorb 100 kbpd of additional volumes with no issue. But this does mean there is money going out of one pocket and into another: in this case, ONEOK loses and major fractionators in Mont Belvieu (Targa Resources, Enterprise Products Partners) win.

Takeaways

ONEOK is not a bad company. Management is well-regarded in the industry, its balance sheet is in great shape, and the distribution is not at risk at being cut. However, that does not make it a great purchase. Its long-term asset positioning is suspect given current upstream oil and gas drilling activity, a reality that just does not jive with its current premium valuation the market is rewarding it. While not a death blow by any means, the Medford fire is enough of a headwind to move analyst consensus lower and pressure comparable earnings results over the next several quarters.

Most quality midstream firms have crystal clear stories at the moment, and this one has gotten far too murky in my view. While I get the allure for those investors that shun K-1 forms, there are far better 1099 issuer options out there as well. Just stay away.

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