Midstream consolidation
HEALTHY MIDSTREAM COMPANIES POISED TO MAKE ACQUISITIONS IN DOWN MARKET
GLENN PINKERTON AND DAVID DENECHAUD, SIDLEY AUSTIN LLP, HOUSTON
E&P COMPANIES in the United States, capitalizing on advances in fracking and horizontal drilling to extract abundant quantities of oil and natural gas from shale formations, have become victims of their own success, as the surge in production over the last few years created an oversupplied market - with the resulting decline in prices. This price decline has led to a precipitous drop in revenues for both E&P companies and their services companies. Midstream companies, on the other hand, have been more insulated from the effects of the price decline, as their revenues are typically tied to volumes of hydrocarbons transported, processed or stored and not the price of the hydrocarbons themselves.
However, it is axiomatic that sustained unbridled infrastructure development growth by multiple parties leads to overcapacity. According to reports, the seven major pipelines bringing crude to the Gulf Coast market have been between half and two-thirds full during the late summer months. That's probably to be expected and there may be logistical explanations unrelated to overbuilding, but there are more than a dozen new pipelines already in construction and set to come on line in 2016 and subsequent years, bringing crude either to Cushing, Oklahoma, or the Gulf Coast, or debottlenecking Gulf Coast logistics. Will these and similar situations in the NGL and natural gas pipeline and related gathering and other infrastructure space cause underutilization to increase dramatically and put midstream players at risk?
In a world of only disciplined development, the capacity on those pipelines and other infrastructure would have been contracted for by E&P companies with solid credit on a take-or-pay contract basis (where the producer pays fees to the midstream company covering a fixed amount of volume regardless of whether the producer ships any production) such that the midstream players' risks are well covered. But few frothy markets contain only disciplined development, and there is no reason to think this most recently concluded one would stand out from the rest. Furthermore, some of those take-or-pay arrangements may be with E&P companies with badly fading credit, and take-or-pay obligations are subject to rejection in bankruptcy.
For much of the last few years, midstream growth has been based on internal buildout of assets, but those opportunities are clearly disappearing as demand for midstream services decreases as oil and natural gas volumes decline. Lower demand will create overcapacity in pipelines and processing plants, and midstream companies, after years of steadily increasing budgets for capital expenditures, are expected to reduce construction of new facilities. With organic growth curtailed and in the face of reduced revenues resulting from lower volumes, midstream companies will look outward to maintain revenues.
So where does that leave midstream M&A activity in the coming period?
The turmoil in the E&P space, the expectations of reduced growth in midstream infrastructure, the current fragmented state of the midstream market, and the need for a more diverse midstream platform all argue for well-positioned midstream companies being in position to acquire their rivals' companies and assets. These forces presage a coming wave of consolidation in the midstream sector, led by the companies with stronger balance sheets and better assets. A follow-on effect of this consolidation will be that some midstream companies shed fewer strategic assets or projects to generate cash, or that they streamline for the next acquisition, or sell the non-strategic assets of a newly acquired entity. This could lead to new opportunities for smaller private equity-backed management teams to enter or re-enter the midstream space.
Other factors weighing into this trend are the market condition of E&P companies and the fragmented state of the market. The E&P companies' losses will also accrue to the gains of the midstream companies, as E&P companies divest of midstream assets to increase cash flow. E&P companies often in the course of developing their oil and gas assets construct proprietary gathering systems and other midstream infrastructure. As E&P companies look to raise cash by selling non-core assets, these midstream assets are prime candidates for sale, and midstream companies are among the likely buyers. The fragmented state of the midstream market itself creates an environment ripe for consolidation. The consistent growth in the midstream sector over the past several years has led to a proliferation of both public MLP and private midstream companies. With so many different companies holding midstream assets, would-be acquirers will find no shortage of midstream targets. In a down market, assets will likely be cheaper on Wall Street than they are to develop.
Finally, there seems to be no limit to the ranks of private equity and capital looking to find bargain prices and be the smart money buyer. Broadly speaking, private capital formation does not seem to be an impediment to M&A activity. On the public side the bloom is clearly off the rose, but it is not likely this will materially affect the larger MLPs' ability to raise capital, even on the assumption that the long trend of distribution growth has to end at some point.
However, there are several factors that make the current environment a more tricky M&A landscape to navigate.
Pricing is harder to determine, and the bid and ask differentials could create a problem for activity in the private M&A space. In the public arena, MLPs continue to be companies with complicated structures where pricing is hard to determine and large voting blocs exist as a potential impediment to transactions, including instances where management teams and founding private equity have significant positions in the general partners.
While equity seems readily available, the debt markets seem more difficult to assess, as the high-yield markets do not seem particularly active and bank acquisition financing may or may not be widely available. That being said, at the same time there are private equity and hedge fund-backed lenders emerging in the E&P space willing to provide stretch senior financing, there is no reason to believe such financing will not appear in the midstream M&A space if traditional bank finance is not there.
The right basins will matter more than ever, and within those, the right sub-plays are key. Other than midstream players caught in only "dry gas" regions and not getting the benefit of strongly rising crude and NGL production, midstream players have for the last several years benefitted from huge increases in business volumes across almost all markets. That is clearly changing, as only some oil and gas basins are more likely to sustain midstream infrastructure both in up and down markets. These basins, in particular the Delaware Basin and the Midland Basin in the Permian, the Scoop and Stack plays in Oklahoma, the Utica/Marcellus, the Niobrara and the Eagle Ford, have the most favorable production metrics of low costs and high returns. But there will be a lot of focus on sub-plays, as core areas with low break-evens become even more emphasized. E&P companies are more likely to continue production in these basins, making them more desirable to midstream companies. By acquiring assets in these basins, midstream companies will diversify their product offerings and secure more stable revenue streams.
Diligence will be key. Acquisitions in the heady days of the past where Bakken gathering "systems" were bought and sold for high multiples based solely on paper plans for future development have clearly fallen into the current price abyss not to be soon seen again. But in those heady days, not all midstream business models, particularly in the gathering and processing space, were built on demand charge-based take-or-pay contracts. Buyers in new acquisitions have to take a hard look at contracting models, the credit and operational strength of customers, and projected production. The new world of downward pricing means that credit and bankruptcy considerations need to be in the forefront of the deal team's thinking. Does the producer/customer have debt maturing or show signs of stress? Will the targets' contracting models work amid a customer's bankruptcy or in a severe production downturn? Are there key use rights to infrastructure that could be harmed by the bankruptcy of a joint venturer, supplier or co-owner? It is a very different set of questions that have to be answered as the downside risk looms larger.
In each of the above, the trends toward consolidation favor the midstream company with a stronger balance sheet and better assets. Companies with weaker balance sheets will not be able to take advantage of the acquisition opportunities and may need to combine to gain access to capital, while companies with less-performing assets will be more likely to experience revenue declines as growth slows. As stronger midstream companies acquire targets, they will further diversify their product offerings and become even better positioned for the next acquisition. The consolidation opportunities in the midstream sector created by the downturn in the energy markets will therefore create a sector with fewer companies, but the remaining companies should have stronger balance sheets and better, more diversified assets.
ABOUT THE AUTHORS
Glenn Pinkerton is a partner in the Houston office of the law firm Sidley Austin LLP where he is a member of the Energy and Global Finance groups. He assists E&P and midstream clients with infrastructure development and all aspects of energy projects, including extensive international experience. He is a graduate of Columbia University School of Law.
David Denechaud is a partner in the Houston office of the law firm Sidley Austin LLP where he is a member of the Energy and Private Equity groups. He has extensive experience representing E&P, midstream and oilfield service companies in private equity and oil and gas transactions. He is a graduate of Georgetown University Law Center.
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