Earnings Call Transcript - HESM Q3 2020

Operator, Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2020 Hess Midstream Conference Call. My name is Kevin and I'll be your operator today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to Jennifer Gordon, Vice President of Investor Relations. Please proceed.

Jennifer Gordon, VP of Investor Relations

Thank you, Kevin. Good afternoon, everyone, and thank you for participating in our third quarter earnings conference call. Our earnings release was issued this morning and appears on our website www.hessmidstream.com. Today's conference call contains projections and other forward-looking statements within the meaning of federal securities laws. These statements are subject to known and unknown risks and uncertainties that may cause actual results to differ from those expressed or implied in such statements. These risks include those set forth in the Risk Factors section of Hess Midstream's filings with the SEC. Also on today's conference call, we may discuss certain non-GAAP financial measures. A reconciliation of the differences between these non-GAAP financial measures and the most directly comparable GAAP financial measures can be found in the earnings release. With me today are John Gatling, President and Chief Operating Officer; and Jonathan Stein, Chief Financial Officer. In compliance with social distancing protocols as a result of COVID-19, we are conducting the call remotely. So please bear with us. In case there are audio issues, we will be posting transcripts of each speaker's prepared remarks on www.hessmidstream.com following their presentation. I'll now turn the call over to John Gatling.

John Gatling, President and COO

Thanks, Jennifer. Good afternoon, everyone, and welcome to Hess Midstream's Third Quarter 2020 Conference Call. Today, I'll review our operating performance and highlights as we continue to execute our strategy and discuss Hess Corporation's latest results and outlook for the Bakken. Jonathan will then review our financial results. Third quarter results reflect continued strong Bakken performance by Hess Corporation and increased gas capture by Hess Midstream, which drove throughputs above expectations. This, along with our continued disciplined approach to managing costs, enabled us to exceed our guidance for the third quarter, allowing us to again raise our full year 2020 guidance. We now expect our 2020 full year adjusted EBITDA to be in the range of $725 million to $735 million, which represents a 33% growth year-over-year at the midpoint. We're also reiterating adjusted EBITDA guidance for 2021, where we anticipate an approximate 20% increase from our expected 2020 outperformance. Additionally, our targeted annual distribution per share growth of 5% through 2022 remains unchanged, validating the strength, stability, and visibility of our financial outlook. Focusing more closely on our third quarter results, gas processing volumes averaged 296 million cubic feet per day, and crude terminaling volumes were 141,000 barrels of oil per day. Both approximately flat compared to the second quarter. Third parties contributed approximately 7% of our gas and 9% of our oil volumes in the third quarter, also flat with the second quarter and slightly ahead of expectations at the midpoint of our adjusted EBITDA guidance range. Water gathering volumes averaged 78,000 barrels of water per day in the third quarter, an 18% increase compared to the second quarter, as we continued to capture incremental trucked water into our expanding gathering system. Now turning to Hess upstream highlights. Earlier today, Hess reported strong third quarter production results with Bakken production averaging 198,000 barrels of oil equivalent per day, an increase of 21% from the year ago quarter and above guidance of approximately 185,000 barrels of oil equivalent per day. During the quarter, Hess continued to leverage Hess Midstream's pipeline and rail terminal system, which provides significant export capacity and optionality north and south of the Missouri River to key markets throughout the United States. For the full year 2020, Hess forecasts Bakken production to average approximately 190,000 barrels of oil equivalent per day, an increase from previous guidance of 185,000 barrels of oil equivalent per day. Turning to Hess Midstream guidance. As a result of continued strong performance, we have increased our full-year throughput guidance for gas gathering and processing. Through the first nine months of the year, the installation of an additional 40 million cubic feet per day of gas compression capacity has significantly improved our gas capture capability, which helped mitigate the anticipated throughput impact from Hess's rig reduction. Furthermore, we expect to add approximately 30 million cubic feet per day of additional compression capacity in the fourth quarter with the restart of two newly refurbished legacy compressor stations, an innovative solution that created near-immediate capacity at a low incremental cost. This highly localized approach is an important component of our strategy to capture more Hess and third-party volumes that enable customers to continue to meet or exceed North Dakota's wellhead gas capture targets, which are increasing to 91% effective November 1, 2020. As a result, we now expect gas gathering volumes to average 315 million to 320 million cubic feet per day and gas processing volumes to average 300 million to 305 million cubic feet per day for the full year 2020, both increasing by 8% at the midpoint compared to previous guidance. Our complete financial and operational guidance is available in our earnings release that was distributed earlier this morning. For the fourth quarter, we expect gas throughputs, which generate approximately 75% of our revenues, to be roughly flat compared to the third quarter. Fourth quarter oil and water volumes are expected to decline compared to the third quarter in line with Hess's guidance. The midpoint of our financial guidance also assumes third-party activity remains consistent with the third quarter. Turning to Hess Midstream's Capital program. Our 2020 guidance remains unchanged. Full year 2020 expansion capital is expected to be $250 million, comprising approximately $140 million in gas processing, $25 million in gas compression, and $85 million in gathering and well pad interconnects. We continue to make excellent progress on the expansion of the Tioga Gas Plant, and as previously announced, expect construction to be complete by the end of 2020. Incremental gas processing capacity is planned to be available in 2021 upon completion of the turnaround, during which time the expanded plant, including the residue and natural gas liquids takeaway pipelines, will be tied in. Maintenance capital guidance remains unchanged at $10 million. In summary, we continued to demonstrate strong operational and financial performance in a challenging macro environment. We're again increasing volume guidance, enabling us to raise our full-year 2020 adjusted EBITDA guidance to be in the range of $725 million to $735 million. In addition, we're reaffirming our 2021 guidance, where we expect another year of double-digit adjusted EBITDA growth, a growing distribution per share, and with the tie-in of the 150 million cubic feet per day expansion of the Tioga Gas Plant, which creates significant new opportunities for gas capture growth in the basin for years to come. Finally, we want to again emphasize our continued commitment to operating safely and reliably during this unprecedented pandemic. The safety of our workforce and the communities where we operate remains our top priority. I will now turn the call over to Jonathan to review our financial results.

Jonathan Stein, CFO

Thanks, John, and good afternoon, everyone. As John described, we have continued our track record of delivering strong results within a challenging macro environment, again emphasizing how both our contract structure and financial strength differentiate our business model. Our third quarter results again beat our quarterly guidance. As a result of our continued strong volume performance and our expectation that we will maintain our higher third quarter EBITDA level in the fourth quarter, we are again raising our full year 2020 financial guidance. We are increasing our full year 2020 net income guidance to be in the range of $465 million to $475 million. Adjusted EBITDA is expected to be in the range of $725 million to $735 million, representing at the midpoint a 33% growth compared to full year 2019 results and an increase of 4% compared to the midpoint of our previous guidance. We expect to maintain approximately 75% EBITDA margin for 2020, consistent with our historical margin. Maintenance capital and cash interest are projected to total approximately $100 million for the full year 2020, and distributable cash flow is expected to be in the range of $625 million to $635 million, resulting in an expected distribution coverage of approximately 1.3 times. We expect to end the year with leverage at or below our conservative 3 times adjusted EBITDA leverage target. Our contract structure and financial strength enable us to provide visibility and stability to our forward trajectory. We are reiterating our 2021 adjusted EBITDA guidance, which is growing 20% from our updated 2020 adjusted EBITDA guidance, primarily from our expected annual rate redetermination at the end of this year, as well as the contractual inflation escalator and increasing 2021 MVCs. In both 2021 and 2022, we also expect approximately $750 million of free cash flow, defined as adjusted EBITDA less CapEx. That includes approximately 95% of our revenues protected by MVCs sufficient for Hess Midstream to be free cash flow positive after funding interest expense and growing distribution, while maintaining distribution coverage of approximately 1.4 times without the need for any incremental debt or equity. Turning to our results. I will compare results from the third quarter to the second quarter. For the third quarter, net income was $116 million compared to $108 million for the second quarter. Adjusted EBITDA for the third quarter was $182 million compared to $173 million for the second quarter. The change in adjusted EBITDA relative to the second quarter was primarily attributable to the following: Total revenues increased by $12 million, including an increase in gathering revenues of approximately $8 million driven by higher Hess production, gas capture, and increasing MVCs. An increase in processing revenues of approximately $3 million, driven by higher Hess production and gas capture, and an increase in terminaling revenues of approximately $1 million driven by increasing MVCs. Total operating expenses including G&A, but excluding depreciation and amortization and pass-through costs were higher, decreasing adjusted EBITDA by approximately $4 million, including seasonally higher maintenance and operating costs of approximately $4 million, higher overhead of approximately $2 million, and higher insurance and property tax of approximately $1 million offset by lower costs associated with the TGP turnaround of approximately $3 million. LM4's proportional share of earnings and depreciation, net of processing fees increased adjusted EBITDA by approximately $1 million, resulting in third quarter adjusted EBITDA of $182 million exceeding the top end of our guidance range by approximately 10% primarily due to higher-than-expected volumes. Third quarter maintenance capital expenditures were approximately $4 million and net interest excluding amortization of deferred finance costs was $22 million. The result was that distributable cash flow was approximately $156 million for the third quarter covering our distribution by approximately 1.2 times. On October 26th, we announced our third quarter distribution that increased 5% on an annualized basis. Expansion capital expenditures in the third quarter were $63 million. At quarter end, debt was approximately $1.9 billion, representing leverage of approximately 2.7 times adjusted EBITDA on a trailing 12-month basis and below our conservative 3 times adjusted EBITDA targets. Turning to expectations for the fourth quarter. As implied in our updated full year 2020 guidance, we anticipate fourth quarter net income and adjusted EBITDA to be relatively consistent at the midpoint with our higher-than-expected third quarter results that we reported today. In the fourth quarter, with seasonally lower operating costs, we expect distribution coverage to be approximately 1.2 times with revenues that are approximately 95% protected by MVCs. In summary, even in this period of macro uncertainty, the strength of our business model is clear. We maintain differentiated visibility to our financial metrics including adjusted EBITDA growth of approximately 33% in 2020 and approximately 20% in 2021, with revenues that are 95% protected by MVCs, expected free cash flow of $750 million in 2021 and 2022, distribution per share targeted to increase 5% annually, fully funded from free cash flow in 2021 and 2022, and conservative leverage expected to be approximately 2 times adjusted EBITDA in 2021 on a full year basis. With our strategic asset base, visible financial metrics, and contract structure, we have a differentiated value proposition across the midstream sector. This concludes my remarks. We'll be happy to answer any questions. I will now turn the call over to the operator.

Operator, Operator

Our first question comes from Phil Stuart with Scotiabank.

Phil Stuart, Analyst

Good morning, everyone. I appreciate the time today.

John Gatling, President and COO

Good morning.

Phil Stuart, Analyst

Sorry, I guess my question is on M&A. Obviously, you guys have talked about it in the past. Just curious, with all the volatility that we've seen in 2020, has anything changed in terms of your views as to where you'd be interested in M&A? I guess what I'm getting at is, are you maybe more likely to want to do an acquisition of the Gulf of Mexico assets from Hess as opposed to potential bolt-on in the Bakken, just given that you'll have very strong counterparty strength with a deal with Hess in a similar contract structure relative to maybe what's out there with some third-party Bakken assets?

John Gatling, President and COO

Yes, Phil. Thanks for the question. I think, you hit it right on. The most important thing that we've got, obviously, is our relationship with Hess. Now Bakken remains our focus. We're continuing to look to strengthen our strategic footprint. Fortunately for us, with the contract structure we have in place, we're able to be highly selective on that. So, it really comes back to focusing on the right assets that integrate well into our system and have immediate returns and benefits to Hess and third parties. As we look at acquisition opportunities in the Bakken, that’s our primary focus. It is focused on those kinds of highly strategic, well-integrated assets that strengthen our position and continue to support third parties. As you mentioned, yes, we are absolutely interested in evaluating the Gulf of Mexico assets. Having a contract structure similar to what we have in the Bakken with Gulf of Mexico assets is extremely attractive. It extends the relationship between the Midstream and Hess, and we see that as a huge enabler and highly valuable from our perspective. So, those are our focused areas. We’re continuing to look in the Bakken, but again being selective and continuously evaluating the Gulf of Mexico assets. We are excited about the opportunity there and the ability to expand our relationship and enter a new basin with a bit of diversification as well. Those are all very attractive things to us.

Phil Stuart, Analyst

Okay. Great. Appreciate the color there. And then the next questions are on the TGP expansion. I guess my understanding is that the majority of the capital has already been spent. But I guess, just curious, on the timing of the turnaround in 2021 to finish that project up.

John Gatling, President and COO

Yes. And you're exactly right. The plan is that we'll wrap up construction at the end of this year. We're well advanced on the actual construction activity. In fact, we're in the process of essentially wrapping up construction. Everything will be prepared and ready for the turnaround activity in 2021. We're not really specifically discussing exactly the timing for the turnaround, as that really will depend on what the environment and COVID-19 situation is. As I mentioned in my opening remarks, we're focused on the safety of our personnel and the communities where we operate. That's our top priority. We do anticipate and expect to do the turnaround in 2021, and as soon as it is scheduled, we will be fully capable of tying in the expansion and be ready to increase the total capacity at the gas plant.

Phil Stuart, Analyst

Okay. Great. That’s it from me. Thanks.

John Gatling, President and COO

Okay. Thank you.

Operator, Operator

Our next question comes from Shneur Gershuni with UBS.

Shneur Gershuni, Analyst

Hi, good afternoon everyone. Just a couple of quick questions here. To start off, when I look at some of your peers in the Bakken talking about flat volume for 2021, Hess seems to be maintaining a rig on its footprint. When I think about the COS structure, should we expect Hess to keep production roughly flat as you enter the second term of your COS contract? Just wondering how we should think about that as we set up for the next contract.

John Gatling, President and COO

Sure. Maybe I'll start off with the kind of operational side, and then Jonathan can address some of the financial aspects. As you heard this morning, Hess talked about two rigs to hold production flat at 180,000 barrels of oil equivalent per day. From our perspective, as Hess runs at the current rates and then moves into future years, we definitely see the production plateau sustaining as it continues into 2023 and into that second term. But I'll hand it over to Jonathan to address any of the financial components.

Jonathan Stein, CFO

Yes. I think, as Hess has said, certainly they're looking to add a rig as you get closer back to 50. Staying at one rig on a long-term basis is not necessarily the plan we would see. But even in that scenario, I think the contract structure really endures, and we really have strong visibility to continue free cash flow. Even at one rig on a long-term basis, we would still be free cash flow positive after distributions at our expected 2022 level really for the foreseeable future. The way that works is a combination of the cost of service over the next number of years leading to the long-term second term. We anticipate approximately 20% growth at the end of this year in terms of EBITDA that will take us to a new level. As John described, Hess will be able to hold production flat at one rig. Certainly, we would expect that they would reach that level by 2023. During that period, our annual rate reset would adjust the tariff, that would allow us to maintain our EBITDA approximately at 2021 levels. As we get to 2024, we would convert to a fixed-price contract still with MVCs, with the fixed price steadily increasing from 2024 through 2033 with the inflation escalator on flat production. Our revenues would therefore just be steadily increasing over that long-term period. In a low rig count, we would focus on sustaining capital, which is what we expect to be, which is around $100 million to $150 million. Interest, of course, will be stable because we have no incremental debt. At 2022 levels of distribution growing 5% that's approximately $550 million. So when you combine all that, it indicates we can be approximately $100 million free cash flow after distribution on a long-term basis even if Hess were to stay at one rig. This highlights that we maintain free cash flow generation and leverage, which provides us financial flexibility. Certainly, we have the opportunities to do things like John mentioned, whether it’s in the Gulf of Mexico or bolt-on opportunities in the Bakken. But this also allows us to execute buybacks from our sponsors, which could be accretive to all shareholders. We really have a model that is very unique in terms of our contract structure and our visibility to continue to deliver free cash flow, making us free cash flow positive after distributions on a long-term basis.

Shneur Gershuni, Analyst

I appreciate all the color. If I can paraphrase a bit and add my own assumption here. With Hess in a flattish production environment, should we be thinking of it as a $1 billion base run-rate business starting in, let’s say, 2022? Is that kind of the right way to think about it?

Jonathan Stein, CFO

Yeah. What I would say is, look, we're increasing EBITDA this year by 20% into 2021. With production staying flat, there are increasing rates because as we go into the second term, they'll be fixed and steadily increasing. Everything else, whether it be interest or capital, remains stable. All of this provides enough to fund our distributions on a long-term basis. Our free cash flow positive scenario remains intact.

Shneur Gershuni, Analyst

Cool. Maybe just one last question, just given the free cash flow discussion. You're in a free cash flow position while at the same time not having a large float on your stock. Everyone's talking about buybacks. Is there a way to conduct a pro-rata buyback from Hess and GIP as a way to return capital to shareholders? I'm curious about what options you’re considering both in and outside the box.

Jonathan Stein, CFO

Yes. We can buy back shares directly from Hess and GIP. Our float is too small to conduct public buybacks. However, buybacks from Hess and GIP would be accretive to shareholders and a good use of the financial flexibility we have. We also have opportunities, as John stated, whether it be Gulf of Mexico or bolt-ons in a disciplined manner. The good news for us is that we don't have to choose just one option. We could look at both opportunities while maintaining financial discipline.

Shneur Gershuni, Analyst

Regarding Gulf of Mexico assets acquisition, what due diligence has Hess done regarding potential impacts from the ban on drilling on federal lands?

John Gatling, President and COO

The only thing I'd say there is that there's uncertainty in the upcoming election. However, we do not anticipate significant impacts, regardless of whether the administration continues or changes.

Shneur Gershuni, Analyst

All right. Perfect. Thank you very much, everyone. I appreciate the time today.

John Gatling, President and COO

Okay. Thank you very much.

Operator, Operator

Our next question comes from Spiro Dounis with Credit Suisse.

Spiro Dounis, Analyst

Hey, good morning, guys. First question for Jonathan. Regarding M&A, is there a blueprint in terms of debt/equity mix for financing future spending? I know you've been focusing on deleveraging over the next year.

Jonathan Stein, CFO

The good news is we can manage all our needs through our free cash flow after distributions and debt. If we end next year with leverage around 2 times EBITDA, that is well below our conservative 3 times EBITDA target. We would continue to build financial strength and flexibility. Any opportunity, for example, if we proceed with the Gulf of Mexico acquisition, would also contribute additional EBITDA. Collectively, we have ample capacity to fund these opportunities without needing equity.

Spiro Dounis, Analyst

Great. Thanks, Jonathan. Another question on M&A. As we see combinations in the upstream space, if your sponsor were to engage in M&A, how would that impact Hess Midstream? Would anything change for you?

Jonathan Stein, CFO

From a contract perspective, we see that as unlikely. However, there would be no change to the current contract or governance. Hess would have a minority position relative to GIP and the independent directors. Our structures remain intact, and we would continue to operate independently.

Spiro Dounis, Analyst

Great. Thanks for the color, guys. Do well.

Jonathan Stein, CFO

Thank you.

Operator, Operator

Our next question comes from Vinay Chitteti with JPMorgan.

Vinay Chitteti, Analyst

Hi guys, good afternoon. Thanks for taking my questions. I wanted to primarily ask on free cash flow, but Shneur covered it all. Just touching on gas capture and gas processing volumes for the third quarter. They are still above MVCs right now, with plans of adding more compression capacity by the end of Q4, signaling potential upside. What is driving the additional volumes? Are you observing any shifts in what Hess is doing, such as moving towards more gassier wells, or is this just increased gas capture rates?

John Gatling, President and COO

Sure. I'll address the general gas capture question and the operational aspects, and then I can hand it over to Jonathan to talk about the MVC levels. Overall, we've seen a significant improvement in gas capture in the basin. We have been progressively building out our infrastructure to support Hess and our third-party customers. We’ve witnessed an increase in gas capture which has benefited us because oil is stable, meeting or exceeding expectations. We are starting to see more gas come through, which we are ready to support. This positive trend reflects our continued execution plan over the past three plus years, and it remains ongoing. We've also added capacity this year as part of our strategy with a 40 million cubic feet daily compression capacity installed recently, plus the expectation for an additional 30 million cubic feet added in Q4 via the refurbishment of legacy facilities we had not originally planned to bring online. Throughout our infrastructure optimization process, we’ve managed to avoid overbuilding while effectively leveraging our capabilities. Though Hess' rig reduction slightly impacted throughput, our infrastructure allowed us to capture these volumes effectively. Now I’ll pass it to Jonathan to elaborate on the MVCs.

Jonathan Stein, CFO

Thanks, John. From a physical standpoint, we anticipate our systems will be near MVCs or below through the remainder of the year. This results in MVCs providing a revenue floor that supports our ability to maintain our expected EBITDA at Q3 levels. Looking ahead to next year, we expect increasing MVCs with higher volumes driven by our increased performance this year. The growth rate will be lower since our higher volumes this year will influence next year's MVCs. While oil and gas are generally flat, we expect water to increase by approximately 25% against 2020 levels. We anticipate running at MVC levels for both 2021 and 2022 as those MVCs will be determined under the prior development plan.

Vinay Chitteti, Analyst

Got it. I wanted a follow-up on the 2021 guidance. You mentioned 20% growth, which has been conservative on the third-party business. What drives your 2021 guidance? Any upside seen there?

John Gatling, President and COO

For the third-party contribution, we’re anticipating flat performance as we approach 2021, remaining somewhat conservative. While there's some backlog of volumes ongoing and an expansion at the gas plant that could bring about timing uncertainties, we will continue to exercise caution in our projections. Our substantial asset base supports a favorable strategic footprint conducive to attracting more volumes, so while we’re projecting conservatively, we’re aware of potential growth upside, we think it's prudent to base projections primarily on MVC levels.

Jonathan Stein, CFO

Exactly right. The majority of the growth will stem from the rate reset, primarily accounting for about 15% of the expected 20% growth. As Hess has established a lower development plan this year than last year, the adjusted rates for our updated contracts will ensure the proper return on capital. The remaining growth stems from the inflation escalator and modest MVC growth. Overall, while we may observe upside, our main focus remains on ensuring steady growth through our revised rate structure.

Vinay Chitteti, Analyst

Got it. Thanks, guys. That's it from me.

John Gatling, President and COO

Okay. Thank you.

Operator, Operator

Thank you very much. This concludes today's conference call. Thank you for your participation. You may now disconnect. Have a great day.