A Weird Year for Pipeline Companies

In this episode of Industry Focus: Energy, Nick Sciple chats with Motley Fool contributor Jason Hall about the oil and gas pipeline industry. They provide a breakdown of the industry and talk about some recent deals, including one made by Warren Buffett. They discuss the regulatory and legal challenges faced by pipeline companies, the future of oil and gas in general, and much more.

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This video was recorded on July 9, 2020.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. We've got a great show for you today. We'll be taking a look at a week full of news in the oil and gas pipeline industry. Joining me to break it all down is Motley Fool contributor Jason Hall. Jason, welcome back on the podcast.

Jason Hall: It's so good to be on, and talking about oil stuff again.

Sciple: Yeah. I mentioned we're going to talk about oil and gas pipelines today. And of course, we've got to lead with Warren Buffett's latest deal. On Monday, we got news that Berkshire Hathaway (BRK.A -0.24%) (BRK.B -0.60%) Energy, the energy unit of Buffett's conglomerate, will pay about $4 billion in cash and take on $5.7 billion of existing debt to acquire Dominion Energy's (D 1.16%) natural gas transmission and storage business.

Jason, when you saw this news, what was your reaction?

Hall: Honestly, it was like, hey, this is exactly what Buffett does. I mean, this is as pure a Buffett deal as it gets. He finds a predictable cash cow, cash flow business, and he buys all of it, when he can, for a reasonable price. And I think that's what we saw right here. Buffett has been bad at energy investing on the equity side. He's been a terrible investor when it comes to buying oil stocks, but I think everybody [laughs] has over the past decade if you want to be fair. But this is exactly what Buffett has proven to be really, really good at.

Sciple: Yeah, this energy segment of Berkshire Hathaway, I think, Warren Buffett refers to it as his top dogs that really, kind of, drives the portfolio. When you look at these assets that Berkshire Hathaway acquired, what comes with them in this deal?

Hall: So first thing I'll note is, was it, over 7,000 miles of interstate gas pipelines. So that's like the arteries of the energy infrastructure in the U.S. So that's a great thing to own. We'll talk a little bit more about it on the show, why [laughs] right now it's actually a really good time to be buying these kinds of assets that are already in play and have been around for a long time. Again, these aren't oil pipelines, they're gas pipelines, they're gas transmissions.

So you think about natural gas as opposed to oil. It's generally pretty consistent in demand, it's what power plants really prefer to use, utilities really prefer to use it right now for energy generation. So it's a good, solid business, it's a toll-road business; you're not making a play on the commodity price. So that's like the core that, kind of, underpins what comes along with why Buffett would want to do this.

But what it also gets, it gets a 25% stake in Cove Point, which is an LNG export facility. It started out as an LNG import facility, but now it's an export facility. We'll talk about some of the advantages of owning that right now too. That's a pretty cool thing to get. He's paid $4 billion in cash and taken out about $5.7 billion of debt; which I wouldn't be surprised if we didn't see that debt get refinanced at current rates too.

Sciple: That's what I was thinking about. So [laughs] you know, when they buy this deal and they take on $5.7 billion in debt, OK. But given today's interest rates, I mean, they can refinance that as close to 0% as you're going to get. So I just view this as a cash deal, honestly, with Berkshire's access to capital.

Hall: Yeah, well, it's better than cash, right, because whatever interest rates you're going to pay, it certainly is going to be, I mean, [laughs] maybe they get negative rates, right? [laughs]

Sciple: Yeah, when you look at the price that Berkshire paid for these assets; I've seen some estimates, JPMorgan had these pipelines at about a $1 billion in EBITDA. So you get about 10X EV to EBITDA, [enterprise value to EBITDA] is what Berkshire is paying for these assets. What do you make of that valuation? Was it an attractive deal from a pricing point of view? Obviously, these assets have a long life and can drive cash flow over time.

Hall: Yeah. I don't think it was a steal, but I think it was certainly a fair price for what they paid. And then if you start looking at some of the publicly traded businesses out there, that are, you know, kind of somewhat similar in terms of what you can buy, it looks like a good value; it really does.

Sciple: So given that we've talked about the attractiveness of these assets over time, these are the arteries of the U.S. when it comes to the energy infrastructure. Natural gas is going to take more and more share away from coal as we move forward over the years. Why is Dominion selling these assets today?

Hall: You know, this is a really -- I don't want to say it's a touchy subject, but what you have to remember is that you think about the businesses that own and operate these kinds of assets. So typically you have two businesses. You have some utilities, like Dominion, that own some as part of a larger business that's primarily in regulated utilities. But then you have the stand-alone pure-play midstream pipeline companies, that's their business; they own pipelines, they own gathering infrastructure assets, they own storage facilities, and that's kind of all they do. And I think for Dominion, this is simply a case of having to make a decision about what it wanted to focus on going forward. [laughs] If you've paid any attention to the news over the past week, there's been a lot of bad news for the state of anybody trying to build pipelines or expand pipeline infrastructure; it's getting ugly out there right now.

Sciple: Absolutely. Dominion mentions, with the announcement, that they hope this will help accelerate some of their transition to reducing their emissions and things like that, but another thing they mention is in conjunction with the sale of these assets to Berkshire Hathaway, Dominion also announced that it is canceling its planned Atlantic Coast Pipeline that it had been working on with Duke Energy going back for six years. So this really looks like Dominion just wants to get out of this pipeline business. One of the issues they cite is continued legal costs, permitting costs, when it comes to trying to get these issues approved. They actually just won a 7:2 opinion in the Supreme Court last month that looked like they'd overcome some hurdles.

But they cite in their press release from canceling this pipeline that recent court announcement having to do with the Keystone XL pipeline in a Montana federal court. The judge there overturned an existing permitting scheme, Nationwide Permit 12, that had allowed a number of pipelines to pass with limited review. There has been continued challenges to that, and actually this week, the Supreme Court upheld that decision from the lower federal courts. So it looks like Dominion is looking out at the regulatory environment, the costs that it's going to take to bring this asset to market and comparing that with the potential returns over the lifetime of what they could potentially realize. They just wanted to get out of that business.

Hall: And I think you have to understand how the implications are different for a Dominion Energy, that has a large regulated utility business, than it would be for -- I think we'll talk about Energy Transfer (ET -0.09%) in a minute -- or one of these guys, that their sole business is pipelines and not any of this regulated business, it's when you start commingling utility customers business and those funds that are part of that regulated utility, with a side business or an unregulated business that you're trying to do, and it gets really hard and it gets really complex and complicated, and it can be really, really challenging. So if you're a Dominion and you see potential continued legislation, and those costs that can start -- you know, can get harder and harder to keep them segregated away from the regulated utility part of your business, because there are a lot of legal requirements to do that, that sometimes you just have to walk away, because unless you have a certain level of certainty that you're going to be able to move forward, the risk of unpredictability, it creates a problem.

So if you're an investor and you're looking for yield, you're looking for income, and you're looking for it to be higher than you can get from bonds, which is nothing now, right, but also you want to have it as safe as possible; utilities are typically a place in equities that investors are going to look. Because they generate those steady cash flows, and as an investor, you know that dividend is almost a promise, right, it's as close to a promise as you can get. Now, [laughs] obviously, that hasn't worked out too well for Dominion Energy investors. If you bought Dominion Energy stock last month or earlier this year, you're not happy right now, because the dividend is getting absolutely gutted as part of this deal. But again, the idea is they're kind of hitting the reset button, so they can just start over and just focus on the regulated business without the overhang and all the implications that come along with the unpredictable business that is [laughs] now building pipelines, which, you know, 10 years ago, you wouldn't have thought that this would be an unpredictable business, right?

Sciple: Yeah. To your point on unpredictability, the original estimates that Dominion and Duke had had for the cost of the project was $4.5 billion to $5 billion. Their most recent public guidance had increased around $8 billion, obviously, massive cost inflation when it comes to trying to get through all these regulatory hurdles. And, yeah, we mentioned this Atlantic Coast Pipeline that had been in development and is now being canceled. Keystone XL is a pipeline that had been proposed nearly a decade ago, at this point.

Hall: Not nearly, it was proposed in 2010. It's been 10 years.

Sciple: And so, this pipeline appears to have reached a point to where courts have ruled, it can't proceed forward. But you had mentioned Energy Transfer. This is another case, the Dakota Access Pipeline, they operate running from the Bakken, down toward Illinois helping to distribute that oil. That's a pipeline that's been controversial over a number of years, but it has actually been operational for the last four years. But on Monday, a U.S. district judge issued a ruling that the pipeline would have to shut down by Aug. 5 for a thorough environmental review, and some estimates say that could take up to 13 months. In response, Energy Transfer has said, "We're not complying."

What do you make of this, Jason? I mean, you've got a federal judge going toe to toe with a company that is saying we will not comply with your ruling. What does this mean for Energy Transfer, the business, today?

Hall: So philosophically, we can -- again, I think this is really like, this is like the epitome of the difference between a regulated utility and a stand-alone pipeline company. This is not a battle that you would have seen a company like -- I'm just completely drawing a blank here -- like the utility would, like Dominion. This is not about where you'd see Dominion being willing to want to fight because, again, we're not talking about the same pipelines here, but the reality is that if you count on regulators to be your friends, you can't fight city hall on something like this, because the political implications are just -- they're too big, right, they're too risky. But if you're Energy Transfer and your stock has been pummeled and your business is suffering right now because of your exposure to, say, I don't know, Chesapeake Energy, that's a big customer of theirs, and some of their contracts could be at risk, you know, in for a penny, in for a pound here, right, you have to, you have to take your risks and take your shots. And I think this is the kind of thing where they're saying, "We're going to push this as far as we can." You know, they still have legal options, and my expectation is that they're trying like hell to try to get some federal judge to issue a temporary injunction until this can go before the courts. And it can go all the way to the Supreme Court, right? I think it really could.

But this is their core business. This isn't a side business they're trying to grow, this is what they do, this is how they make a living. So I think they have no choice but to continue to push. And, I think, frankly, you know a Supreme Court ruling, simply from the perspective of giving some more clarity to the entire space for that predictability going forward, I mean, that may be the endgame. We'll see, we'll see.

Sciple: Yeah, certainly a lot of uncertainty going on here. And I agree, there's certainly a possibility that this could go to the Supreme Court. When you look at Energy Transfer today, you mentioned the Chesapeake Energy bankruptcy affecting them. The Chesapeake is trying to avoid several pipeline contracts. One of them is a nearly $300 million agreement with Energy Transfer. You look at the stock today, its dividend yield is nearly 20%. What do you make of the stock? I mean, what do you do with it here?

Hall: That dividend is getting cut, we all know it, that dividend is getting cut. But, no, I think here's the thing. So I think, if you're looking for a yield, if you're looking for income, when you see a 19% yield, with very few exceptions, that's not a place to go for yield. And I think the market is simply saying, we think there is a very high probability Energy Transfer's dividend is going to get cut. It's like, it's just going to have to come down, because the cash flows are affected. You know, there's substantial risk to its cash flows.

The Chesapeake deal is one thing, and now you have this with the Dakota Access Pipeline, that's a massive source of cash flows for the company that dividend investors aren't going to be able to count on, but I think what you can do is you can look at the business and say, "Wow! the stock price has really fallen a tremendous amount, if I think that there is any opportunity that they can salvage some of this and continue to move forward, maybe there's an opportunity for upside capital gains on buying the stock at this price, on a turnaround, if they can get their business prospects back lined up, so." But, again, that's a high-risk, sort of, scenario and it's two totally different investing thesis based on two totally different expectations.

So I think that's, kind of -- you have to put it in that bucket and decide whether or not you think that the risk is worth the potential returns. And for me right now, I can't give an answer to that. There's just too much uncertainty, there's too much litigation risk, there's too much legislation risk, we don't know, right, we don't know yet.

Sciple: Yeah, I agree with you, Jason. One of my, kind of, fundamental rules of investing is if my thesis depends on the government to do anything, it's probably not a good thesis. And so, I think in this case, you're dependent on the government coming back to you or the courts coming back to you with an opinion that reverses what has occurred in the lower court, which says that you can't maintain operations of your pipeline.

And, you know, if I own the stock already, I don't think I'd be selling, but I'm not going to borrow trouble buying into all this uncertainty right now, given that, again, you're dependent on the government making a favorable decision for you.

Hall: Something you and I spitballed a little bit that I brought up, I don't want to attribute this potentially terribly wrong idea to you, but something that just popped into my mind as we were looking at this is, maybe part of the endgame is, if the government is going to shut this down, at the risk of saying, OK, this pipeline is done, it can't operate. Maybe part of the endgame is saying, look, we've been operating this pipeline for multiple years based on you giving us the green light and you giving us the go-ahead. If you're going to take it away from us, you got to make us whole, right? I don't know, I think that'd be a pretty unprecedented thing for a pipeline, but last I checked, you know, and this is an eminent domain, I realize that, but if the government takes away your property for eminent domain, they have to pay you market value. So maybe there's still some expectation that if you're going to change your mind and say this can't go, maybe that's like a worst-case hope for the company is something like that happening. Just spitballing.

Sciple: Yeah, it's certainly abnormal for a pipeline that has been in operation for a number of years to be shut down, it is atypical. And so, to a certain extent, we're off the edge of the map on where we go from here.

You know, circling back to Buffett, we've talked about given the regulatory issues, Dominion doesn't want to be involved in building its Atlantic Coast Pipeline. We've had courts really restrict the ability to build new pipelines. What does that say about the attractiveness of these pipelines that Buffett just got, these pipelines that are already in existence, already operating, transport a key commodity when it comes to powering our country? Does that make these assets even more valuable, the fact that it's so, so hard to build new pipelines?

Hall: I think maybe it does. I think it certainly adds a layer of predictability to what they should be able to generate over the term of their existence. And I think we also have to delineate, too, that all pipelines aren't created equal. We're talking about Keystone XL and the Dakota Access, those are oil pipelines; these are natural gas assets. So in terms of, again, they feed energy for the electrical grid versus oil. And I'm pretty sure I saw you on Twitter take the bold stance that you think U.S. auto sales may have peaked, like, permanently peaked. So I mean, there's questions about, you know, in North America in terms of oil demand, that I think are some reasonable questions to ask. But gas, natural gas, is kind of a different story. I also think you start talking about taking natural gas to the next step, you start talking about LNG. So that Cove Point LNG export facility.

I think that's kind of a little secret value that's not getting enough play, because something that a lot of people aren't really aware of is that the oil crash this year also fundamentally affected the development of liquefied natural gas export facilities in North America. In the U.S., there's a bunch of these, there are a dozen or so, that were pretty lined up to start some stage of construction in the next year or so. I think they've all been delayed; I don't think anybody is moving forward with anything quickly. So I think that just adds an extra two years of zero competition for Cove Point as one of only a handful of LNG export facilities that are operating. And globally, LNG is going to bounce back, the demand is going to recover, and the thesis, long term, is still the same. So I think that's a nice little piece that's part of the pie too.

And then you start talking about biomethane, about renewable natural gas from landfills and dairy farms and other agricultural operations and human waste, that's like, that's a net positive, these are zero-carbon, negative-carbon sources of energy, that these pipelines can carry that too, because it's the same molecule. So like the long-term value of these assets is far different than oil, and, I mean, we could see a century of still use from these.

Sciple: I absolutely agree, Jason. On the car ownership peaking, I think the stats to know there is just that in the U.S., I want to say it's like, one-and-a-quarter [1.25] cars for every licensed driver in the U.S. and maybe even higher than that. There's just only so many cars that the country can take.

When you look at Warren Buffett jumping into this, and I also agree as well on your point about natural gas pipeline versus oil pipelines, I think that there's very little doubt in my mind that we're still going to be using natural gas as part of our electricity grid 50, 100 years down the line, and I don't have that same level of confidence about the role that oil is going to play. I think it's certainly going to be around; we're still going to be using plastics and things like that, but whether we're going to be using it on the same scale for transportation, which I think accounts for about 50% of oil demand in the U.S., I really don't know.

When you look at natural gas pipelines, specifically Warren Buffett moving into this space, a company we always hear a lot of questions about is Kinder Morgan, which is a company very involved in natural gas pipelines. When you see Warren Buffett move into this space, is this signal to you, hey, come on in, the water is fine? Maybe we should go look at some of these other pipeline companies for an attractive investment opportunity.

Hall: You know, yes and no. I think if you look at the price that Berkshire paid. I think it's about 10 times enterprise, so that's equity plus debt, about $9.7 billion. So about 10 times enterprise value to EBITDA, I think it kind of sets a good baseline to start looking at the pipeline companies. I think you might have to, kind of, normalize those a little bit, and maybe -- this is a weird year, right, and so, I think maybe you can apply those values and maybe look at last year's results and, kind of, think about future earnings potential a little bit. So some that might even look a little bit above that EV-to-EBITDA multiple might still be a good value, but I think it can definitely be a great place to identify pipelines that maybe do trade at a good value. Again, for investors that are looking for that steady, stable source of predictable income from dividends that pipeline companies, kind of, like utilities, tend to pay, you think maybe with a little more growth potential, as we need more of that infrastructure. But, dude! All bets are off right now [laughs] in terms of how much potential for growth there's going to be, especially when you cross the border or the federal government gets a bigger role in the thumbs-up or the thumbs-down.

Sciple: A lot of uncertainty in this space right now, and when [laughs] you're dealing with the Supreme Court getting involved and lots of court cases, we'll just have to see how things play out, but as we get more information, we'll be here to cover it, and I'll have you back on the podcast to break it all down.

Hall: I'm going to put one last piece of trivia on the end here. This just blew my mind. And so, over the past decade, Berkshire Hathaway stock has doubled plus a little bit. Did you know that the S&P 500 has generated twice the total return of Berkshire Hathaway over the past decade? It's lapped Berkshire Hathaway over the past decade.

Sciple: Do you think that maintains over the next decade?

Hall: I don't. I look at the price of Berkshire right now, the valuation, and I think it's an absolute buy. I think you look at the operating businesses, the cash flows they generate, and you look at its equities that have suffered -- Buffett has bought a hell of a lot of banks, [laughs] over the past decade, and banks have been hit very, very hard, and I think that's weighed a lot on the investing portfolio. I think that's carried over to the value of the stock.

So I sold my Berkshire shares about five years ago, but I'm looking at it right now as a strong buy, I really am.

Sciple: All right, folks, we're going out on a limb here. Berkshire Hathaway is a buy.

Hall: That's crazy to say that, huh?

Sciple: All right, Jason, thanks for coming on the podcast, as always.

Hall: A blast, always a blast.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for his work behind the glass. For Jason Hall, I'm Nick Sciple. Thanks for listening, and Fool on!