November 2015, Vol. 242, No. 11

Features

North Americas Midstream Sector Re-Emerges

The development of North America’s unconventional oil and gas resources has brought new life to the region’s midstream sector. The infrastructure necessary to gather and transport commodities to resurgent downstream and chemicals sectors, new gas-fired power generation, and other new demand requires investment approaching a trillion dollars by some estimates.

And investment opportunities translate to growth. However, the midstream sector’s history prior to this revolution in unconventional energy resources left it under-prepared and ill-suited for the current boom. As a result, the race is on to create the midstream company of the future; a company with the business model and supporting organizational model and capabilities to capitalize on the opportunities.

Though the recent oil price and earlier gas price decline slows the buildout, it also puts additional impetus on further industry consolidation. Creating the midstream company of the future will not be easy, but there is the possibility of significant profits.

In 2005, the Energy Information Agency (EIA) estimated the country would need to import 6.4 Tcf of natural gas by 2014. That estimate proved inaccurate. Last year, U.S. producers provided 25.7 Tcf in domestic production, enough production that they not only met domestic needs, but also positioned the country to become a significant exporter.

The horizontal drilling and hydraulic fracturing technologies that allowed the economic development of the Barnett, Marcellus, and other natural gas shale basins had fundamentally shifted global natural gas flows.

A similar series of events transpired in the development of North America’s “tight oil” resources of light crude. The development of the Bakken, Eagle Ford, and several areas of the Permian Basin increased domestic oil production by 2 MMbpd from 2013-15. And despite the subsequent decline in crude prices, production of light tight oil is still expected to rise, albeit it at a slower rate.

This unforeseen increase in domestic oil and gas supply presented an economic gift for North America’s chemicals, downstream, and other sectors that consume energy and use feedstocks. The large supply and competitive costs of natural gas shifted North America’s position in the global chemicals supply for products such as ethylene and its derivatives.

Increased domestic oil production widened price differentials against competing global crude markets, allowing U.S. refiners to boost profits and capture a larger share of global export markets. Downstream companies have moved to capture and capitalize on this boon through a series of significant investments to reduce bottlenecks, kit enhancements, and even to build new projects.

Infrastructure Constraints

The combination of an increased domestic supply of oil and gas and greater downstream processing capacity offers the prospects of a renaissance in U.S. manufacturing subject to one key constraint: the midstream infrastructure necessary to gather the inputs, process them, transport them to downstream hubs, and then move the finished products to markets. In response, a midstream infrastructure building boom is underway in the United States.

A recent study by IHS for the American Petroleum Institute (API) estimated the industry will need to invest $838 billion by 2025 in order to match projected supply and demand. Similar reports cite slightly higher or lower figures depending upon the infrastructure types included in the report, the timeframe of the study, and other underlying factors.

To put this in perspective, the estimated $838 billion in midstream infrastructure capital investment exceeds similar estimates for capital investment in all transport infrastructure, such as roads, bridges and tunnels during the same period.

Midstream’s Growth

It is important to remember that prior to the mid-2000s, onshore oil and gas activity in the United States had declined for nearly 20 years. As a result, the midstream sector was considered a mature, low-growth portion of the value chain. Many large integrated companies not only limited their investments in midstream, but also divested or spun-out midstream assets in order to harvest what value and cash flow they could from such mature assets.

The introduction of master limited partnership (MLP) structures through the Tax Reform Act of 1986 and the Revenue Act of 1987 accelerated the disaggregation of the midstream sector. These pass-through entities, which may only hold qualified income sources including midstream oil and gas assets, offered a lower cost of capital by which to hold mature assets. As of 2014, there were about 200 companies in the U.S. midstream sector and over half were MLPs, according to Capital IQ.

However, the combination of under-investment, disaggregation and a move toward entities intended to focus on harvesting the cash flow of mature assets meant many participants were not equipped to capitalize on the investment opportunities created by the shale revolution.

Many companies were small and unable to fund new capital investment. Other participants lacked the internal capabilities, such as business development, risk management and project management necessary to carry-out new strategies or projects.

Midstream’s Response

The midstream industry has responded well to the initial challenge. The sector has been able to raise significant capital as a result of the significant growth opportunities and the investment advantages of the MLP structure. Between 2005 and 2014, the midstream MLP sector raised $150 billion in capital, including equity and debt financing. Much of the capital funded expansions of existing gathering systems and regional pipeline projects. In 2013 alone, the midstream sector added over 13,000 miles of new oil and natural gas pipelines in the United States.

A portion of the capital raised was also used for acquisitions as companies that lacked either the number of new projects necessary to maintain a consistent flow of drop-down activity or the internal capacity required to carry out such projects. Deal counts have grown from 39 to 45 from 2011-14, and the average deal size increased from $1.9 billion to $3.9 billion during the same period. Midstream merger and acquisition (M&A) activity is expected to continue to grow, especially if the recent downturn in commodity prices extends through the remainder of the calendar year.

However, consolidation, in and of itself, does not represent an effective long-term business strategy. Similarly, growth through organic projects is more of a tactic than a strategy. In our perspective, the midstream sector participants to truly capitalize on what a recent Williams Companies investor presentation referred to as a “once in a generation industry super-cycle” will define and implement robust strategies – a series of moves that provides them with a differentiated set of assets and capabilities that allows them to increase profits over current trends.

Model of the Future

First, what is our ambition in terms of measurable, economic milestones, as well as more qualitative descriptions of the type of company that we want to be? Second, what is our area of focus with respect to the types of plays that we will pursue, the exposures that we will accept, and the means by which we will make money? Finally, how do we intend to source its opportunities including the desired balance between organic and inorganic growth?

Based on our observations of primary sector participants, their public comments to the market, and their recent investments, we see at least four “pure-tone” business models that companies are pursuing as illustrated below.

We recognize few companies, if any, are wholly consistent with such conceptual models and there are potentially other effective business models available. However, based on our work across the midstream sector, we believe companies need to be considering high-level business model choices and their implications before thinking specifically about tactics.

Such an approach helps align an executive team around an intended path, provides boundary conditions for future choices, such as which markets do we want to expand in and what is the appropriate mix of M&A vs. organic growth.

For example, MarkWest Energy leveraged its experience in the natural gas and NGL value chain to develop leading positions in the Marcellus and Utica basins. It then capitalized on the strong customer relationships it established in those regions to increase customers in other basins, including the Permian.

Sponsored MLPs provide an interesting lens through which to consider participation choices. At one bookend, sponsored MLPs might define strategy largely in terms of the pace of parent company drop-downs, which by definition are close to existing parent businesses. At the other bookend, sponsored MLPs might pursue growth agendas beyond their parent company geographies and businesses and thus face participation choices similar to that of independent MLPs.

Tesoro Logistics’ recent purchase of QEP Field Services provides one example of a sponsored MLP expanding beyond its parents’ initial business while maintaining a complementary strategic link by focusing on the parent company’s strategic footprint.

Operating Model

Decisions regarding a business model have profound implications for an organization’s capability requirements. A company pursuing a business model focused on large organic projects, for example, must ensure that it is particularly effective – meaning better than its peers – at capital project management.

A company that accepts a greater degree of commodity price exposure in its contractual approach requires a different set of risk-management capabilities than a competitor that focuses on volumetric or fee-based commercial arrangements.

Defining the necessary capabilities is the first step. Building those capabilities is the next and more challenging step, as a true capability is a complex combination of individual skillsets, underlying processes, and enabling technologies.

The process of identifying and building capabilities can be particularly challenging for sponsored MLPs. Inevitably, the discussion arises with respect to which particular services, be they front, mid, or back office, can and should be provided by the parent company and which should be developed within the MLP or outsourced to a third party.

In many cases, this debate is even more complex because the parent and sponsored entity have not sufficiently discussed the degree to which, or pace at which, the sponsored entity will expand beyond the footprint of the parent company’s asset base.

Operating Efficiencies

In light of the recent downturn in oil and gas prices, midstream companies must focus on operating efficiencies to hold costs in check. This is especially important, given the general perception that the downward trend is a long-term shift that will lead to structurally lower expansion in oil and gas production.

Approaches to cost management range from short to long-term, but they all share a focus on creating transparency into how spending supports organizational priorities.

Disaggregating costs into meaningful categories helps to identify where efforts should be directed to unlock value. After identifying the categories that have the greatest effect on operating efficiency, even more detailed analytics can identify which of these items are controllable. This will help determine what fundamental changes to business rules, policies, or procedures are required to ensure that these items are closely tracked and actively managed in the future.

Regardless of the extent to which external market realities, such as product pricing and regional flows may shift over time, a rigorous approach to managing costs will help set the tone for the organization and serve as preparation for success in a future that looks to be no less volatile than the past few years.

Capitalizing on Opportunities

The supply shock from shale gas and unconventional tight oil, and the resulting need for midstream infrastructure, placed the midstream industry at the center of a complex and rapidly shifting set of market forces. Recent OPEC policy shifts to maintain market share, coupled with this unconventional supply shock, have brought new complexities of lower and fluctuating commodity prices and expectations of a slower capacity buildout.

Consolidation, however, was already a trend and all the more likely in light of the additional pressures brought on by the industry slowdown. To capitalize on the opportunities facing the industry, companies need a dedicated focus on building advantaged capabilities, making the right business model choices and adaptations, and creating operating model flexibility to develop a sustainable, long-term competitive advantage. Extraordinary returns are the payoff for those companies that make the right moves.

Authors: Andy Steinhubl is principal, Energy and Natural Resources, Strategy Practice lead of KPMG’s Energy and Natural Resources Group with over 30 years of energy experience. Prior to joining KPMG, he worked for Booz and Company, where he served as the North America Oil and Gas Practice leader and the Houston office managing partner. asteinhubl@kpmg.com

Chris Click is principal, Oil & Gas, Strategy Practice lead of KPMG LLP’s (KPMG) Oil & Gas Strategy Practice. He has over 15 years of oil and gas experience. Prior to joining KPMG, he worked for Booz and Company, where he led the Upstream O&G Team, and JPMorgan Chase & Company’s Global O&G Investment Banking Division. cclick@kpmg.com

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