Wave of midstream M&A is coming

LOW PRICES HAVE SLOWED THE INFRASTRUCTURE SUPERCYCLE; PREPARE FOR MORE CONSOLIDATION IN NORTH AMERICA

RICCARDO BERTOCCO AND WHIT KEUER, BAIN & COMPANY, DALLAS
MILE MILISAVLJEVIC, BAIN & COMPANY, HOUSTON

The boom in oil and gas production in the US from 2009 to 2014 fueled an infrastructure supercycle in midstream, with more than one hundred companies building out the gathering lines, processing facilities, and pipelines that bring crude oil or natural gas liquids from the wellhead to distribution centers or refineries.

Steep price declines in oil and gas have helped bring that chapter to a rapid close-although it was reaching its limits even before oil prices began to drop last summer.

Now, as oil and gas producers reconsider new investments and, in some cases, draw down production, midstream operators are also adapting their expectations and plans.

Many midstream companies are taking immediate action to lower costs and defer capital expenditures. But executives should not lose sight of the opportunity this downturn presents to establish and extend leadership positions.

Experience in other sectors in oil and gas, including exploration and production and oilfield services, as well as in other industries, shows that downturns create extraordinary threats and opportunities, often reshuffling the leader board. Bain research found that during the 2001-2003 downturn, leaders across industries grew their earnings 4.5 times faster than their peers, compared with only 1.5 times faster during the subsequent economic growth cycle through 2008. The gains or losses built during these periods tend to endure, with major gains more likely to be sustained through the next boom cycle.

However, many midstream companies will have to rethink their equity sources and modify their cash distribution models to take advantage of these opportunities. Historically, equity has been a key source of M&A financing for midstream companies. As companies grew using MLP models, their investment distribution rights drove outsized profits for their general partners. Now, this model is becoming a financial burden for some of the largest midstream companies. As the portion of income that is passed out via investment distribution rights grows, the cost of equity increases and the company becomes less competitive. Research suggests these distribution rights can account for as much as 2% in the cost of equity difference.

With those caveats in mind, we see three groups of players that should be preparing for this next phase: established leaders, financially strong competitors and followers.

Established leaders can extend their strong strategic positions, but even they will probably face some challenges in the capital markets as they try to fund transactions. They should consider deals that build scale in a basin by expanding up or down the value chain, then integrate those acquisitions to provide a more comprehensive end-to-end solution for their customers, the E&P operators. Leaders should also take a long-term view of oil and gas prices, laying the groundwork for growth by building up a portfolio of assets across several regions that could be profitable with $60 to $70 oil. Finally, they should pursue entity-level transactions-that is, buy whole companies or complete operational units to build scale and reduce total costs per unit of production through lower procurement and administrative costs.

Financially strong players may not be as competitive in their basins, but they have access to low-cost capital and other capabilities. These companies can take advantage of this consolidation wave by establishing leadership positions, acquiring new assets that let them build scale at chosen points along the value chain. They may find opportunities from E&Ps or other midstream companies that are shedding assets to shore up their balance sheets. At the same time, they can build stronger relationships with customers by identifying customers' key needs, establishing trust and expanding their offerings to deliver more complete solutions.

Followers, the third group, include companies that need to strengthen their strategic positions by focusing on their core assets, reducing costs and shedding fringe positions-which will help shore up the balance sheet and improve cash flow.

Executives should remember that experience matters a lot in M&A, and those who develop a repeatable model for implementing their deal strategies generally come out winners. This means developing a deal thesis, a detailed rationale for the agreement and terms of success. Successful dealmakers conduct the proper financial, commercial and technical due diligence and then rigorously manage synergy targets.

In the current price environment, executives instinctively focus on cost reduction. It may be difficult to draw back from the moment's price fluctuations and look at the bigger picture. But long-term success in midstream depends now on shifting course and taking advantage of this moment to improve strategic position for the years ahead.

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