Fitch Ratings has upgraded DCP Midstream, LP (DCP) and DCP Midstream Operating, LP (DCP Operating)'s Long-Term Issuer Default Rating (IDR) to 'BBB-' from 'BB+'.
Fitch has also upgraded DCP Operating's senior unsecured ratings to 'BBB-' from 'BB+'/'RR4', and the junior subordinated notes have been upgraded to 'BB+' from 'BB-'/'RR6'. DCP's preferred equity ratings are also upgraded to 'BB' from 'BB-'/'RR6'. The Rating Outlook is Stable.
The upgrade and Stable Outlook reflect DCP's continued expected outperformance spurred by tailwinds from the elevated commodity price environment. The company remains focused on reducing leverage (measured as total debt with equity credit to operating EBITDA) which Fitch forecasts to range between 3.0x-3.3x in 2022 and 2023 before moderating to 3.6x-3.8x in the latter forecast years per the Fitch commodity price deck. DCP has a diverse asset footprint and customer base comprised of mostly investment grade customers. Offsetting these factors are DCP's volumetric risk and higher commodity price risk relative to midstream peers. Management maintains a hedging program to partially mitigate exposure to commodity price drops.
Key Rating Drivers
Scale and Scope of Operations: DCP's ratings reflect the size and scale, and diversity of its asset base. Also incorporated is its position as a large producer of natural gas liquids (NGLs) and processor of natural gas. The partnership has a robust operating presence in most of the key production regions within the U.S., specifically within the DJ Basin and Permian Basin spanning both the Midland and Delaware Basins. DCP has a diverse set of largely investment-grade customers and producers with no material customer concentration.
The size and breadth of DCP's operations allow it to offer its customers end-to-end gathering, processing, storage and transportation solutions, giving it a competitive advantage within the regions where they have significant scale. Excess capacity on several of DCP's systems provide opportunities for volume growth with incremental optimization expenses in higher margin regions to improve utilization.
Volumetric and Commodity Price Exposure: DCP's ratings reflect its exposure to volumetric and commodity price risks associated with the domestic production and demand for natural gas and NGLs. Approximately 50% of DCP's gross margin is provided from the logistics and marketing (L&M) segment, which generally provides fee-based cash flows with exposure to volumetric-risk.
Gathering and processing (G&P, approximately 50% of gross margin) contracts are largely backed by dedicated acreage and are a mix of non-commodity sensitive fee-based contracts and commodity sensitive percent-of-proceeds and percent-of-liquids contracts. DCP is expected to further benefit from its unhedged commodity-price exposure in 2H22, as higher commodity prices spur increasing production and DCP completes additional well connects in the DJ Basin and Permian Basin.
As of 1Q22 approximately 70% of gross margin is fee-based and DCP has hedged 13% of the remaining margin. The company has taken advantage of favorable pricing across associated hydrocarbons and added hedges that reduce its sensitivity to a large drop in prices. DCP's hedging program contributes to a steady cash flow profile but also exposes it to longer-term hedge roll-over and commodity price risks. The company is well hedged for each quarter in 2022.
Improving EBITDA Drives Leverage Decline: Fitch expects leverage to decline to a range between 3.0x-3.3x in 2022 and 2023 driven by improving G&P volumes in DCP's key DJ and Permian Basin. (Fitch's leverage calculation gives 50% equity credit to the junior subordinated notes and 0% equity credit to the preferred units.) Producers are expected to ramp production over the next few quarters given commodity prices levels. DCP is investing in incremental bolt-on opportunities and optimizations to drive continued future growth into 2023.
On the L&M side of the business DCP is benefitting from third-party shippers shifting into ethane recovery and is expected to see increased throughput in 2H22. As the Fitch price deck returns closer to mid-cycle leverage in the outer forecast years, leverage is expected to moderate to 3.6x-3.8x range.
Capital Allocation Strategy: Management has reached their targeted leverage metric per their bank covenant calculation as of 1Q22 LTM financials and is expected to continue to produce excess FCF throughout Fitch's forecast period. Modest growth capex is expected to continue to fund bolt-on opportunities in their G&P business in the DJ and Permian basin footprints. Incremental optimization and investment projects will be aimed at improving asset utilization and added connectivity to Sand Hills and Southern Hills to better serve customers. No large-scale M&A is assumed in Fitch's forecast, and DCP has adequate FCF for a distribution increase in 2H22.
Supportive Ownership: Fitch rates DCP on a standalone basis, with no explicit notching from its parent companies' ratings; however, the ratings reflect that its owners have been and are likely to remain supportive of its operating and credit profile. DCP's ultimate owners of its general partner, Enbridge, Inc. (ENB; BBB+/Stable) and Phillips 66 (PSX; not rated) have in the past exhibited a willingness to forgo dividends. This support was most recently demonstrated by the approval of the March 2020 distribution cut.
Parent Subsidiary Linkage: There is a parent subsidiary relationship between DCP and DCP Operating. Fitch determines DCP's standalone credit profile (SCP) based on consolidated metrics. Fitch believes DCP Operating has a stronger SCP than DCP. As such, Fitch has followed the stronger subsidiary path. Legal ring-fencing is open as there are minimal limitations between the entities. Access and control is evaluated as open given DCP's 100% ownership of DCP operating and centralized treasury. Due to aforementioned rating linkage considerations, Fitch rates DCP Operating on a consolidated basis and, as such, has assigned the same IDRs to both DCP and DCP Operating.
DCP's ratings are reflective of its favorable size, scale, geographic and business line diversity within the NGL production and transportation and natural gas G&P space. The ratings recognize that DCP has greater exposure to commodity prices than other midstream peers, with approximately 70% of gross margin supported by fixed-fee contracts. This commodity price exposure has been partially mitigated in the near term through DCP's use of hedges for its NGL, natural gas and crude oil price exposure, pushing the percentage of gross margin, either fixed-fee or hedged, up to 83% as of 1Q22. This helps DCP's cash flow stability, but exposes it to longer-term hedge roll-over and commodity price risks.
DCP is slightly smaller in terms of EBITDA generation but more geographically diversified than NGL focused midstream peer Targa Resources Corp. (BBB-/Stable). DCP's assets span across several U.S. regions in multiple basins with significant footprints in the DJ Basin, Delaware and Midland Basins in the Permian, and SCOOP/STACK in the Midcontinent region, with volume growth expected to come from the DJ and Permian assets. Targa's operations are focused in the Permian Basin. Targa's gross commodity price exposure is similar to that of DCP as Targa's gross margin is 80%-85% supported by fixed-fee or fee-floor contracts and hedges.
Fitch expects DCP's leverage to be around 3.0x-3.3x through 2023. Targa's leverage should decline below 3.5x following redemption of the preferred shares. Both companies' leverage position them well within the 'BBB-' rating category.
ONEOK Inc (BBB/Stable) is significantly larger in terms of size and scale in comparison to DCP. ONEOK's NGL transportation network is larger than that of DCP, with comparable basin diversification. About 85%-95% of ONEOK's revenues are generated from fee-based contracts, the majority of which are subject to volume risk. DCP earns less than half the EBITDA than ONEOK. DCP's leverage is comparable to that of ONEOK. ONEOK's leverage which is expected to decline below the company's 4.0x target. ONEOK's limited commodity exposure and larger size and scale account for the one-notch rating difference.
Fitch's Key Assumptions Within Our Rating Case for the Issuer:
Base case WTI oil price deck $95/bbl in 2022, $76/bbl in 2023, $57/bbl in 2024, and $50/bbl in 2025 and beyond; and Henry Hub natural gas price of $4.25/mcf in 2022, $3.25/mcf in 2023, $2.75/mcf in 2024, and $2.50/mcf in 2025 and long term. Fitch expects ethane to be influenced from the natural gas price deck and the other NGL hydrocarbon movements to be influenced from our WTI oil price deck;
Growth and sustainable capex in line with management's guidance;
Distribution increase expected in 2H22;
No significant acquisitions are included in the forecast;
Upcoming debt maturities to be repaid with FCF.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
A demonstrated ability to maintain the percentage of fixed-fee or hedged gross margin at or above 80% while maintaining leverage (total debt with equity credit/operating EBITDA) below 3.5x for a sustained period could lead to a positive rating action;
Meaningful increase in scale.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Leverage expected above 4.5x on a sustained basis and may result in at least a one-notch downgrade;
A significant decline in fixed-fee or hedged commodity leading to gross margin less than 70% fixed fee or hedged without an appropriate significant adjustment in capital structure, specifically a reduction in leverage, would likely lead to at least a one-notch downgrade;
A significant change in the ownership support structure from GP owners ENB and PSX to the consolidated entity particularly with regard to the GP position on commodity price exposure, distribution policies and capital structure at DCP, the operating partnership.
Best/Worst Case Rating Scenario
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
Liquidity and Debt Structure
Adequate Liquidity: As of March 31, 2022, DCP had approximately $1.2 billion of available liquidity. DCP's liquidity consists of the undrawn portion of their $1.4 billion senior unsecured revolving credit facility. There were $172 million of outstanding borrowings and $17 million letters of credit. DCP's $350 million accounts receivables securitization facility was fully drawn, and there was $1 million of cash on the balance sheet.
Maturities are manageable. The nearest maturity is the $500 million senior unsecured notes due in March 2023, followed by the $350 million accounts receivable facility is set to mature in 2024. The revolver was recently amended to extend the maturity to 2027. As of March 31, 2022, DCP was in compliance with all covenants.
DCP is a midstream energy company that is a large producer and marketer of NGLs, and processor of natural gas with operations in the U.S. The G&P assets span several regions with significant footprints in the DJ Basin, Delaware and Midland Basins in the Permian. DCP's general partner is owned 50% by Phillips 66 and 50% by ENB.
Summary of Financial Adjustments
Fitch applies 50% equity credit to DCP's junior subordinated notes and 0% equity credit to DCP's existing preferred equity in Fitch's forecasts. Previously 50% equity credit was given to DCP's preferred units but due to lack of established permanence they now receive 0%. Fitch typically adjusts master limited partnership EBITDA to exclude equity interest in earnings from unconsolidated affiliates but includes cash distributions from unconsolidated affiliates.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.