May 2016, Vol. 243, No. 5
Features
Low Commodity Prices: Redrawing Midstream Financial Picture
As energy commodity prices continued flat-lining at the start of 2016, a favored financial tool of the midstream oil and natural gas sector – the master limited partnership (MLP) – was under siege, buffeted by skeptical Wall Street analysts and wary unitholders alike.
A financial staple that had helped nurture growth in the oil and gas midsection during the past 30 years of cyclical commodity prices, MLPs have provided the ability to avoid corporate taxes and thus reduce the cost of capital. That spelled growth for corporate players in the midstream space who anxiously lined up to house many of their assets in MLPs.
As are the MLPs themselves, the full ramifications in 2016 for the midstream sector remain unclear. Research and analysis firms, such as RBN Energy LLC and its founder Rusty Braziel, began the new year in the midst of creating a series of analyses on the subject, penned by an expert, Keith Bailey, who some characterize as a legend in the industry for his past roles on the board of MarkWest Energy and Williams Pipeline Partners.
Bailey’s outlook is sobering, especially when you peel back some of the long-known flaws in the payout system used by many MLPs. “Within the midstream space you have all of these MLPs that are structured for growth, and you look at the sector [in early 2016] and no one is growing,” said Andrew Brooks, an analyst with Moody’s Investors Service.
Companies at the end of 2015 were still looking for financing for large-scale projects, and 2016 promises to be a “pivotal year,” according to Nora Pickens, director of midstream/merchant power for Standard & Poor’s Ratings Services (S&P). At the outset of the new year, Pickens viewed the equity markets as “prohibitively expensive” for most companies.
“We’re paying a lot of attention to how these companies are looking to finance their capex,” she said. “At this point (end of 2015), I think we will see some companies scale back from the guidance on capital expenditures that they gave just six months earlier.”
So goes the midstream financial picture in the midst of what everyone is predicting will be a continuing commodity price slump in 2016. A dozen midstream companies, just about all MLPs, were assigned negative credit watches by S&P at the end of 2015, and only one of those companies was given a strong business risk profile (Oneok Partners LP). The rest ranged from “satisfactory” to “weak” with a couple of “fair” or “vulnerable” ratings sprinkled in, according to Pickens’ listing. Most of the companies are carrying debt that is four to 10 times greater than their earnings-before-interest, taxes, depreciation and amortization (EBITDA).
The changed financial landscape in $30/bbl oil prices is littered with questions about how much capex budgets, workforce numbers and infrastructure work will plunge. What does this mean for mergers and acquisitions (M&A), which has been heating up as balance sheets have weakened? As indicated in the second half of 2015, bankruptcies seem inevitable for some in the sector. The trickledown started with the exploration and production (E&P) sector last year.
If the growing public resistance to pipeline infrastructure projects that is popping up regionally is also considered, the midstream outlook grows even darker. In January, private equity firms were beginning to question whether a number of gas infrastructure projects tied to new gas-fired power plants would ever get built, given the pushback from local citizens’ groups and environmentalists. (In mid-January, the U.S. Forest Service denied Atlantic Coast Pipeline LLC’s special-use permit for he proposed pipeline route to cross the Monongahela and George Washington forests in West Virginia and Virginia.)
After beating on the E&P sector pretty severely in 2015 (S&P counted over 100 company downgrades in credit ratings), most analysts agree that the financial markets are now closing in on midstream in 2016. The difficulties felt by large players with large cap-ex budgets have rumbled down to the smaller players and into the midstream. Analysts such as S&P’s Pickens advise keeping an eye on how much small player infrastructure work gets pushed into 2017.
“I think a lot of the projects are being put on hold, but I am sure some of them will be reactivated whenever there is any sense of a recovery building,” Pickens said. “A lot of projects can get going in six- to nine-month time frames.”
While the psychology and metrics may be decidedly pessimistic, there are individuals dissecting the sector and seeing opportunities amid the gloom. Growth may be absent, but declines remain modest. There are still cash flows even without the desired growth. The outlook and opportunities vary greatly among locales. Each shale basin offers something different as do in-basin and takeaway prospects. Private capital hasn’t turned away from the midstream.
Cutbacks are occurring across the entire industry, but within each basin there are subtle differences, according to Moody’s Brooks, who continues to see “an absence of growth,” as opposed to significant declines in production. He looks at the Barnett in Texas, Bakken in North Dakota and the Permian in Texas, and sees differences in all of them.
“Part of it is a function of technology, and another part is a function of transmission [infrastructure],” said Brooks, noting that the most robust producer of the shale basins, the Marcellus in Pennsylvania, is pretty much infrastructure-constrained, causing netbacks in gas to be very weak.”
Private equity firm, The Woodlands, TX-based Five Point Capital Partners LLC, has funded its midstream investment funds with up to $700 million over a 12-month period in 2015-16, seeking positions in midstream energy infrastructure, looking to partner with what is called “exceptional management teams to build world-class businesses.”
With $450 million laid out in early 2015 and another $250 million put in at the start of 2016, Five Point’s founder/CEO David Capobianco seems undeterred by the continuing commodity price slide. While the low prices for crude and natural gas may be inhibiting the E&P sector, making it problematic for any producers to own and operate their own midstream units, the same combination of factors is an opportunity for the companies that Five Points is funding. Similarly, the developing MLP upheaval could create more opportunities for private investors, he suspects.
Capobianco calculates that the unrest among the midstream MLPs, if it continues for several years, will force the partnerships to sell assets, something that has rarely been done. This becomes a potential sweet spot for the private equity firms. Five Points is poised to take advantage.
A co-founder with COO Matt Morrow of Five Points in 2012, Capobianco looks at the midstream sector in two increments: (1) in-basin operations and (2) takeaway operations. For the most part, he sees takeaway capacity being in excess of needs today, particularly in the Permian and Eagle Ford shale plays, for example, but a continuing need for more gathering pipe and processing capacity in-basin – everything from the wellhead gathering lines to processing lines and laterals.
“In this environment you really need to separate the two because they each have very different dynamics,” Capobianco said. “We find ourselves in a position in many, if not all basins, of having substantial excess takeaway capacity. It will take five-plus years at high oil prices to fill up all the takeaway capacity in the Permian and Eagle Ford, and that is a very challenging position.”
The alternative is the in-basin space, where there is substantial need for long-term infrastructure, Capobianco said. “The need is to take trucks off the road and lower gathering costs and to effectively improve the quality of gathering. Essentially, we need more in-basin plumbing, and in this situation I believe we will have a fair bit of backfilling over the next few years.”
Nationally, from a rail capacity and pipeline takeaway perspective, the United States is overbuilt, he thinks. Large midstream projects for takeaway are being canceled and new projects coming online are only operating at below or near capacity.
“The way we look at the world right now is that you have assets in midstream players, [other] assets that need to be built, and assets of the E&Ps,” Capobianco said. “We’re quickly getting to the point where E&P companies no longer have the luxury of owning their own midstream infrastructure; they’re having a very difficult time tapping capital markets to fund drilling programs and exploit their resources.
“We’re at a point where E&P players are actively looking at partnering with midstream players on joint ventures to take some money off the table and to have a partner build out their future infrastructure,” he said. “Also, some of the E&Ps are selling their midstream assets wholesale.”
In a time like this when E&Ps need the source capital, selling the assets and taking a dollar less (per barrel) in netback is a “pretty good deal,” he added. The deals can take the form of selling an asset and entering a contract with the buyer, or entering a joint venture with the midstream player. “We’re seeing this with E&Ps across the board,” Capobianco said.
As a chapter in the history of MLPs in the midstream space in recent years, these investment vehicles have been an integral part of the infrastructure buildout, according to analytical firms such as RBN Energy. And as MLP prospects soared, RBN noted that a major index tracking the sector, Alerian AMZ Index, shot up 286% from 189 at the start of 2009 to a high of 540 in late August 2014, just before the commodity price crash began. The Alerian index was back to 290 at the end of 2015.
There continue to be companies in 2016 that are thriving in this environment, firms such as San Antonio-based Tesoro Logistics LP (TLLP), an MLP affiliate of the refiner, Tesoro Corp. On a smaller scale there is Aurora, CO-based Cross Country Pipeline Supply Co., which has the backing of a $5 billion private equity firm (Odyssey Investment Partners LLC) and in the first weeks of 2016 managed to acquire separate businesses in the midstream space that provide testing and integrity management services and equipment.
With the new year, TLLP expanded its stake in the midstream Bakken shale play in North Dakota, closing previously announced acquisitions from Great Northern Midstream LLC, including a 97-mile crude oil pipeline, a 28-mile proprietary gathering system in the Bakken core and a 154,000-bpd rail loading and 657,000-bbl storage facility. On Jan. 20, TLLP announced the partnership’s 19th consecutive quarterly distribution to its MLP unitholders.
Without disclosing the financial terms of its three acquisitions, Cross Country’s CEO Gerry Plescia emphasizes the synergies from adding N2, Stone Pump & Trench, and Pipeliner’s Warehouse Inc. The trio was expected to help reinforce Cross Country’s capabilities as a leading provider of equipment, supplies and integrity services to the midstream and beyond. The acquisitions help expand diversity and continue “a strong pattern of growth” at Cross Country, a company spokesman said at the time of the purchase.
Questioning whether the current low commodity price environment was an impetus for the deal, the spokesman declined to say specifically, noting instead that:
“[We] continue to benefit from key secular trends in the infrastructure markets,” he responded in an email to P&GJ. “[Existing infrastructure] for water, oil and gas are old and in need of constant repair/maintenance, and this situation exists regardless of the underlying price of commodities. We continue to partner with leading management teams serving these industries to provide our customers with additional solutions in additional geographies.”
For midstream players, which are generally MLPs, there are several challenges, according to Five Points’ Capobianco. “MLPs are looking at their asset bases, trying to determine how they can cover their distributions and continue to grow them, which the market demands in order to give them an attractive cost of capital.”
He noted that each MLP is in a different position, based on its contract portfolio and location, and he refrains from talking about them in a broad swath. The MLPs will always need to cover their distributions and find growth opportunities. If Capobianco’s crystal ball is correct, the space is in line for sales of assets and more M&A, both of which is good for private equity firms such as Five Points.
“For private equity companies, these are very interesting times,” he said. “We think this is just a phenomenal opportunity because the cost of capital for MLPs just five or six months ago [mid-2015] was in the 5-6% range and it is now in the 10-14% range. That is a really unique increase. It makes capital more precious and the returns we can get with our capital have gone up substantially.”
RBN concluded in its series of blogs that is being turned into a book, Changing Horses in Midstream? The Future of MLPs? that 2016 promises to be a tough year for a number of MLPs. A fundamental problem inherent in MLPs, historically, could be corrected, according to RBN’s Bailey, namely, the use of a payoff device called the incentive distribution right (IDR). It has been a fixture for many general partners (GP) that is a disadvantage to the limited partners. The IDRs often provide preferential returns to the GPs at the expense of the limited partners.
“A number of the companies that started with an IDR feature have removed them, much to the benefit of their limited partner unit-holders,” Bailey said. “In these cases, the total distributable cash flow from investments accrues to their benefit and when successful, provides for returns compensatory for the risks being taken.”
Aside from what the MLP structure will be doing, the midstream space is sure to have more M&A activity, more cutbacks in capital expenditures overall, while some individual companies and supply basins will find active investors who recognize a continuing need for more infrastructure, given the growing U.S. role as a major global oil/gas provider.
“I expect M&A to increase substantially this year over the two previous years, which were relatively slow,” said Capobianco, who sees three principal sources – MLP consolidation, asset sales among the MLPs and more infrastructure sales in the E&P space. “With those three sources, I think we will see an extensive pickup of M&A activity over the next couple of years.”
Ditto from the two ratings agency analysts, Brooks and Pickens. “This remains a pretty fragmented industry aside from a few giants, such as Kinder Morgan, Energy Transfer Partners and Enterprise Partners,” said Brooks, adding that the smaller players have a difficult time trying to get capital in the ongoing low-price environment, which opens the door to more private equity firms that savor buying and selling assets. “Private equity firms own a plant here and a pipeline there, and it is all subject to M&A deals over time,” he said.
Pickens noted that many of the incumbent midstream companies, even those with investment-grade credit ratings, have what she calls “stretched balance sheets,” so she doesn’t know if there will be a lot of large-scale transactions among these firms.
“I don’t know how much of an appetite there will be for those transactions [in 2016], but to the extent that some companies become attractive to buyers, then those types of transactions might occur,” Pickens said.
When Capobianco and others were talking to P&GJ about today’s low commodity prices, the rig count nationally was in the low-500 range, having plummeted from the 1,600-level in less than two years. The energy market was looking at 12-month crude oil price strips in the $38/bbl range, something Capobianco attributes to a “very unusual” positioning for the oil/gas market.
“We’re at a point where there is very little work at these prices,” he said, but acknowledging some gathering and drilling continues. “Effectively, the real fundamental floor for commodity prices is cash costs.”
The U.S. and global energy sectors are at a point in early 2016 in which the world is oversupplied, new projects really don’t work well at sub-$40/bbl prices. Nevertheless, U.S. production is not dropping precipitously in line with the falling wholesale energy prices. In early 2016, that left all the keen observers to predict robust price recovery may still be years – not months – off.
In looking at the somewhat bleak picture in terms of new projects and investments in the midstream for 2016, it becomes apparent that service costs are unsustainably low, meaning when commodity prices do turnaround, service costs will be headed back up, too.
The real challenge for the sector, and the MLPs that dominate it, involves managing the traditional expectations for midstream growth in an environment in which it is unlikely to happen anytime soon.
“Prospects have diminished pretty remarkably,” said Moody’s Brooks. “There is still a ton of cash flow, but no upside in terms of growth,” he said.
Author: Richard Nemec is a Los Angeles-based contributing correspondent for P&GJ. He can be reached at: rnemec@ca.rr.ocm.
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