Could Plains All American Pipeline, L.P. Follow in Kinder Morgan Inc.'s Footsteps?

By Markets Fool.com

Oil pipeline company Plains All American Pipeline has struggled amid the oil market's downturn, which has affected its volumes and its margins, causing concerns about its financial situation. Given those concerns, the company is exploring all its options, which could include consolidating with its general partner, Plains GP Holdings . Such a move would follow the recent path blazed by Kinder Morgan and Targa Resources , which both consolidated MLPs into one single entity.

Continue Reading Below

The consolidation wave

Kinder Morgan kicked off the latest consolidation wave in the midstream sector in 2014, when it combined its four publicly traded entities into one. One of the keys to that move was that it eliminated the inter-company incentive distributions rights (IDRs) while also eliminating the structural subordination of debt, both which were having a negative impact on Kinder Morgan's overall cost of capital.

Meanwhile, Targa Resources' consolidation with its MLP was framed around the same benefits -- namely, that the elimination of the IDRs would improve the combined company's cost of capital and simplify its capital structure. That was expected to enhance the company's ability to fund growth projects at favorable rates.

It's this cost of capital reduction that would be appealing to Plains All American Pipeline given its current financial concerns. While the company addressed its near-term capital concerns via a $1.6 billion private placement of convertible preferred units, it still needs more cash to meet future obligations.In fact, that capital infusion is only expected to provide it with funds to meet its capex requirements through next year. Given its current business model, the company will need more cash in the future, which won't come cheaply, given that it hasn't been generating enough cash flow to even cover its distribution. That will make it tough to be able to greenlight growth projects in the future, because high-cost funding could make those projects less economically compelling.

Image source: Kinder Morgan Inc.

Continue Reading Below

Finding a balance between funding and distributions

Analysts see a potential consolidation of Plains All American Pipeline and Plains GP Holdings as the best long-term solution to the company's financial concerns. That's because such a combination would eliminate the costly IDRs paid to Plains GP Holdings, which have been eating into Plains All American Pipeline's cash flow. Interestingly enough, one of the impacts of the preferred unit sale earlier this year was the modification of future IDRs, which, assuming 100% conversion of the convertible units, would yield an IDR reduction of $90 million. In other words, given that Plains GP will see lower IDRs in the future because of that transaction, it would make sense to work out a permanent solution to those problematic payments.

That being said, Plains All American Pipeline's business model in general has become unsustainable given its weaker cash flow and its financial constraints. This is one thing that has become clear during the downturn, which is that the practice of midstream companies to pay out virtually all their cash flow to investors while using equity and debt to fully fund capex isn't an option going forward. Instead, these companies will need to retain more cash flow to fund growth projects. As such, Plains All American Pipeline might take a future consolidation one step further by following Kinder Morgan and make a significant distribution cut to free up enough cash flow to fully fund future capex requirements. By structuring its business to be completely self-funding, Plains can avoid having its fate tied to the capital markets in the future.

Investor takeaway

It is becoming more likely that Plains All American Pipeline will get swept up in the current consolidation wave hitting the midstream sector. It really doesn't have a choice given its unsustainable business model and its financial concerns. Such a deal would enable the company to not only improve its cost of capital but also readjust its distribution to a much more sustainable level.

The article Could Plains All American Pipeline, L.P. Follow in Kinder Morgan Inc.'s Footsteps? originally appeared on Fool.com.

Matt DiLallo owns shares of Kinder Morgan andhas the following options: short January 2018 $30 puts on Kinder Morgan and long January 2018 $30 calls on Kinder Morgan. The Motley Fool owns shares of and recommends Kinder Morgan. The Motley Fool has the following options: short June 2016 $12 puts on Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.