COMPANY'S PORTFOLIO COVERS THE ENTIRE MIDSTREAM VALUE CHAIN AND OPERATES IN NEARLY EVERY MAJOR US SHALE PLAY
EXECUTIVE PHOTOS BY SYLVESTER GARZA
EDITOR'S NOTE: OGFJ recently talked with Bob Phillips, chairman and CEO of Houston-based Crestwood Equity Partners, about the company's business. In particular, we wanted to learn more about several interesting joint ventures Crestwood has entered into in the Marcellus (with Consolidated Edison) and in the Delaware-Permian (with First Reserve).
OIL & GAS FINANCIAL JOURNAL: It's been a busy time at Crestwood, Bob. In addition to managing your different lines of business, you have also entered into a couple of transactions that I'm sure our readers would like to hear more about. But before we get into that, talk to us a little about Crestwood's diverse business lines and how each of them delivers value to your investors.
ROBERT G. PHILLIPS: I think that's a good place to start, Don. And thank you for your interest in Crestwood. For some historical context, I started Crestwood in 2010 with my partner, First Reserve, one of the larger energy-focused private equity firms. You probably recall that in early 2010, natural gas prices were about $5.50 an mcf. Oil and NGLs were also pretty fully priced. This was long before any of us recognized how great a job the upstream industry was going to do in finding new gas, gas liquids, and oil supplies and the need for infrastructure to get them to market. It's been a quite exciting last six years since we started the company.
My strategy was to build a company like Enterprise Products, a very diversified company up and down the midstream value chain, where I had previously served as CEO. I also wanted it to be geographically diverse like El Paso, where I was president of El Paso's midstream business for a decade during the time in which we acquired Tenneco, Sonat, Valero's Texas pipeline business, and finally Coastal. We built the most geographically diverse midstream business in North America.
I wanted to parallel those strategies of value chain and geographic diversification that had worked for me in the past, and I think we've been able to do that the past six years. We've created a portfolio that really covers the entire midstream value chain, and we operate in almost every major shale play in the United States. Crestwood's portfolio is about 47% gathering and processing, 34% storage and transportation, and 19% marketing, supply, and logistics. When you look at those segments from an accounting standpoint, our cash flow is about 50% from the producer side and 50% from the customer side - and that's exactly what I envisioned six years ago.
From a product mix standpoint, we're also diverse with 40% of cash flow from our natural gas assets and services, 40% for crude oil and about 20% in NGLs. As I mentioned earlier, we're also very diverse geographically. Crestwood is in virtually every premier unconventional basin - the Permian, the Marcellus and Utica, Bakken, Powder River Basin, Fayetteville and Barnett shale plays. The Barnett, located in North Texas, is the original shale play. That's where I started the company with the initial acquisition in 2010 of some very attractive, high-quality natural gas gathering and processing assets.
OGFJ: Is Crestwood a portfolio company of First Reserve?
PHILLIPS: Yes. When we started out, we were the only midstream portfolio company in the First Reserve lineup. They are heavily invested in upstream and in services, but had not historically been a large midstream player. Since then, they have added quite a few midstream portfolio investments, but Crestwood remains the largest.
OGFJ: In September, Crestwood entered into a long-term gathering agreement with a subsidiary of Royal Dutch Shell to construct, own, and operate a natural gas gathering system in Shell's operated position in the Delaware-Permian Basin. What prompted this transaction, and how does it fit into your growth strategy?
PHILLIPS: We have been focusing on the Delaware-Permian for a number of years. Back in 2011, we acquired a dry-gas gathering system in Eddy County, New Mexico, which is on the northern tier of the Delaware-Permian. Our hope was that rich gas drilling and crude oil development would pick up in the region as gas prices declined but oil and NGL prices increased. And in fact they did. It was originally an Avalon shale play, and now like most of the Delaware Permian, it's a Wolfcamp and a Bone Spring play. We dipped our toe in the water back then, and in 2014 and 2015 we expanded the system and built our first processing plant out there. The Permian in general is the most active and prolific resource play in the country with 38% of the rigs running in the US. All of the major producers either have a position now or are aggressively seeking a land position in the Permian. Having been involved in the basin's early development with producers like Concho Resources and Mewbourne Oil Company, that are long-time acreage-holders in the D-P, and now Shell Western E&P, we were able to watch its development from the ground up.
Shell acquired Chesapeake's Delaware Permian acreage in 2012, and has had a steady but growing development program since then. They have a very large acreage position and have been delineating which zones will be the most attractive. They have made great progress on drilling and completion costs and their results have been fantastic. That's been the focus of most producers for the past year or so due to the lower prices. About a year ago, Shell concluded they wanted to concentrate their near-term development plans on an area in Loving and Ward counties, Texas. They have a significant amount of acreage there in a partnership with Anadarko. Additionally, through their partnership with Anadarko, they own a large amount of acreage in Reeves County, Texas, where BHP Billiton and other large operators have amassed some sizable positions as well.
Shell decided to outsource the gas gathering and compression system so they sent out a request for proposal to the industry. We bid, based on our local knowledge with our Willow Lake system just to the north in Eddy County, New Mexico. Shell wanted a unique gathering system which had some things in common with systems we had built in the Marcellus and in the Bakken area. After several rounds, Crestwood was selected to complete the layout of the system to meet their timing requirements, and we've been under exclusivity with Shell for about nine months now. We ultimately designed the system they wanted for gas capture, and we're now pushing that project forward and proceeding to build out that system with an estimated in-service date of July 2017.
We are very pleased with the RFP process that Shell ran because we competed very nicely based on our past experience in building out similar large-scale gathering and compression systems. Staying ahead of an aggressive producer's schedule when they want to ramp up their rig activity was a key element of the deal. We received high marks on project execution from current producers that we provide those services for in the Bakken and the Marcellus, and that was meaningful to Shell. But Shell also focuses on customer service and system reliability. And they're particularly focused on safety, regulatory compliance and environmental stewardship. I was really pleased to see that the operating principles that I built the company on, starting six years ago, had passed the test with Shell. We got very high marks for our safety program around the country, our commitment to the environment and our commitment to the communities that we operate in. We're committed to the same operating principles that a world-class company like Shell is, and this was a real stamp of approval for Crestwood.
OGFJ: How does your JV with First Reserve work? Is that separate from your portfolio company status with them? How will this add to your balance sheet strength?
PHILLIPS: The new JV with First Reserve is a separate entity from the existing portfolio investment in Crestwood. First Reserve Fund 11 is our General Partner and largest unitholder. First Reserve, the Board of Directors and senior management team collectively own about 33% of the outstanding units of Crestwood Equity Partners so we have a great alignment of interest with our public investors. Since their original commitment to Crestwood in 2010, First Reserve has continued to grow and raise additional capital to make investments in shale plays. Their most recent fund is Fund 13, which is our 50/50 partner in the new Delaware-Permian joint venture. So with the backing of First Reserve's $3.5 billion Fund 13 and Crestwood's $1.5 billion revolving credit facility, we have a substantial amount of capital availability to support additional growth opportunities in this fast-growing region.
Your readers may be interested in how we structured this JV. First Reserve has been a great partner. They've been willing to provide us with bridge capital or creative financing as well as long-term capital support when we have large growth projects or M&A opportunities. This is particularly important in the current downturn as nearly all midstream companies hesitate to go to the capital markets for growth capital today at current valuations. While we still have access to the capital markets, our equity has been deeply discounted and our cost of capital is over-inflated due to lower commodity prices, a slowdown in activity across the industry and investors' concerns about long term growth.
But our General Partner, First Reserve, came to the rescue. This gives us a lot of financial flexibility and allows us to move forward with high-return growth projects in the Delaware Permian. Getting the initial build-out capital from the First Reserve JV allows us to better manage the upfront dilution of those long lead-time investments, protects our balance sheet, helps keep leverage below our target of 4X, and improves our distribution coverage ratio as well. So the JV structure, where First Reserve's funds are invested first and Crestwood catches up later, really protects our accretion/dilution during the construction phase and during the initial volume ramp-up. Our finance team did a great job of structuring the JV capital commitment and layout in very creative in a way that moves Crestwood's capital out to a point in time when the system will be largely finished, volumes are ramping up and cash flow is accretive to our current quarterly distributions.
OGFJ: Let's move on from the Delaware-Permian to another region. Crestwood recently announced a JV with Con Edison in the Marcellus, the largest natural gas producing region in North America. The JV has an implied market value of about $2 billion. Can you tell us about this deal and how it works?
PHILLIPS: Don, I think our most significant accomplishment this year is our new JV with Con Edison in the Northeast called Stagecoach Gas Services. Most of what we do there is FERC regulated natural gas storage and pipeline transportation. These are long-term, take-or-pay type contracts for gas storage services and pipeline connectivity between the prolific Marcellus shale and the fast-growing Northeast and New England gas and power generation markets. It is Crestwood's highest quality asset in terms of cash flow stability and it's based on great contracts with credit-worthy utility customers. Con Edison is the largest customer on our Northeast platform, so this is a marriage of ownership based on critical operational services which Stagecoach provides to them and a shared vision around the long term growth of the Northeast gas markets. Con Edison relies heavily on our storage and pipeline connections to the Marcellus gas supplies, particularly in the winter when they need to withdraw natural gas supplies to meet customer demand. But it's also becoming an important play in the summer as we see a significant shift away from coal to natural gas for power generation in the Northeast.
Crestwood's primary objective with this transaction was simply to delever our balance sheet, during the current downturn, assuming we were in a lower for longer commodity price environment. We made the decision in the first quarter of 2016 to reduce debt at Crestwood by approximately $1 billion or about 40% and to get our leverage ratio to 4X or better. We looked at divestitures across our entire portfolio and ultimately decided that a plan to sell a 50% interest in our Northeast assets to Con Edison not only solves our financial challenges but better positions us to competitively participate in the long term growth of the Northeast gas markets with the largest utility partner in the region. The implied JV value of $2 billion reflects the quality of the contracts and customers, the strategic importance of the assets in the Northeast and the long term growth potential of the northeast gas market. That was a win-win strategy for both Crestwood and Con Edison.
Our finance team took the roughly $1 billion proceeds from the deal and paid down substantial debt through a very successful bond tender with the remainder used to reduce our revolver. We now have an investment grade utility partner to help us grow the business in this region and a peer group leading balance sheet to take advantage of these new opportunities. Investors took notice of the Con Ed joint venture as our unit price doubled from the announcement and our bonds moved back to par after trading at deep discounts through the peak of the downturn in the first quarter of 2016. Crestwood's bonds are now trading above par and the debt markets are open to us at a very reasonable price, as a result of this transaction, if we need access to long term debt capital.
OGFJ: Let's switch over to the Bakken for a minute. Crestwood has a large investment in Bakken infrastructure. What is your forecast for oil production there? Also, what impact will the new Dakota Access Pipeline have on Crestwood's portfolio?
PHILLIPS: Our Bakken crude oil assets are very important pieces of Crestwood's diversified portfolio. We think the Bakken shale play is still a premier crude oil play in the US and our Arrow gathering system and COLT crude by rail facility are critical parts of the midstream infrastructure for both Bakken producers and refiners that like to purchase Bakken crude. The Dakota Access Pipeline, or DAPL, will be an important addition to the Bakken infrastructure and we will be connected to it at both Arrow and COLT.
Current oil production in the Bakken is about 1 MM barrels per day down from about 1.5 MM barrels per day at the peak a couple of years ago. While production has shrunk by about 30%, due to a slow-down in drilling activity, we do believe it's leveled out. On our assets, we're seeing an increase in rig activity, volumes have stabilized and are starting to grow again. Our overall Bakken forecast is roughly 8-10% average growth over the next four or five years then somewhere around 6% to 7% annual growth over the next 10 years. With prices now settling at about $50, we expect to see a big leap in volumes in 2017.
Crestwood has about $1.5 billion invested in the Bakken. The COLT hub is the largest of the crude-by-rail facilities in the Bakken and a premier supply aggregation point, for refiners and marketers, due to the multiple pipeline interconnects and significant oil storage. The Arrow Gathering System is a three-phase system (oil, gas and water) that serves six producers in the heart of the Bakken shale play. We are seeing some incredible wells in recent months as producers are going to longer laterals and bigger frac jobs. We are expanding the system and looking at additional services such as processing as gas volumes ramp up in the next few years.
Crestwood is well positioned to take advantage of growth in volumes and DAPL will connect to both the COLT Hub and our Arrow Gathering System. Those are two of the planned five interconnects in North Dakota, origin points for access to DAPL, which we think that will give our producer customers access to the highest price market for Bakken crude. This should, over time, further incentivize drilling and development. We've had a lot of conversations with our producer customers who want access into DAPL through our facilities. We know that Energy Transfer and their partners face some legal challenges over DAPL, but we're pretty confident they will resolve those issues and move forward with the project.
OGFJ: Like many oil and gas companies operating in today's difficult environment, Crestwood made the decision earlier this year to reduce its quarterly distribution. Can you explain your reasoning and the steps that led to this decision?
PHILLIPS: I think you can tell that we've accomplished a significant strategic correction at Crestwood over the past year and a half. We've cut costs by 15-20% and improved operating margins. We've merged our two public entities through a simplification merger. We've sold assets and delevered the balance sheet. We've formed JV's with great partners to finance growth. Collectively, we've re-positioned the company to better compete in a lower-for-longer environment. With gas trading around $3 Mcf and crude at $50 Bbl, the industry is starting to heal and our outlook is improving. But we want to be conservative and make sure the balance sheet in good shape for the long run.
Part of the overall strategy review we did was around quarterly distributions or payout to our investors. While MLP's remain a yield investment for many, our yield was disconnected from our fundamentals and did not reflect the true value of our assets. We cut our distribution roughly in half in April of this year due to the headwinds in the industry and our desire to be more financially conservative. That was one of several steps we took to improve our balance sheet and to reposition the partnership to be more competitive.
We have pulled back on our capital spending in every area but Delaware Permian which will be financed through the new joint venture with First Reserve. The reduction in distributions to a more appropriate level, allows for significant retention of excess cash flow for reinvestment in the new growth projects in other areas like the Bakken. Now the next step is to make sure that our investors have a high degree of confidence that the distribution is set at a level where it will never get cut again. We feel that the new distribution level has been stress-tested by our investors and they have full confidence in our current distribution. We think this will bridge us until all these new capital projects begin to generate significant new growth and distributable cash flow over the next couple of years.
OGFJ: What criteria do you use when selecting long-term growth projects?
PHILLIPS: Project internal rate of return relative to our real long term cost of capital and accretion to DCF (Distributable Cash Flow) are always No. 1 and No. 2 in our playbook. We have become financially conservative, so we're certainly not going to get ourselves back in the position where we have too much leverage and not enough financial flexibility. Operationally, growth projects need to be in and around an area where we already operate to achieve synergies. Commercially, we see the highest return opportunities around the systems that we own and operate in the Delaware-Permian, the Marcellus-Utica, and the Bakken. While the rest of our portfolio has stable cash flows going forward, I don't see a lot of growth from a number of those areas other than potentially through consolidation. We are more focused now on areas where producer-customers have good long term development economics and we want good strong counterparties from a credit standpoint. We want to make sure that the location and the quality of the opportunity fits with our portfolio concept. Not interested in growth for the sake of growth anymore as investors won't reward that type investment in the future. Finally, we want to make sure our investment decisions create real value for our investors.
OGFJ: What impact does the improving price environment have on how you view the Crestwood portfolio and your future growth plans?
PHILLIPS: Well, we know that prices are cyclical and that serves as a reminder to Crestwood as well as our producer-customers that it's important to keep your cost structure down even when commodity prices improve. Coming off this long and deep downturn, I think everybody will be very serious this time to keep their costs as low as possible. The gas, crude, and gas liquids markets are balancing for their own reasons - oil, globally; NGLs due to US exports; and then finally gas has seen a really strong summer in power plant load and taking market share away from coal. So if we have a really nice cold winter, we can take some of the pressure off some of the recent inventory build-up and get prices back to a more predictable, long term cycle.
We are optimistic that 2017 and 2018 will show big improvements on the commodity front for our producer customers. It is also important that energy demand fundamentals continue to improve. Crestwood has a balanced portfolio across the value chain and we are diversified to protect against reliance on commodity cycles. As that happens, we'll have more options to serve our downstream customers as well.
The financial health of the industry seems to be improving, and investors have a brighter outlook. Management teams do as well. We're all anxious to see what kinds of guidance and forecasts we'll have for upstream, midstream, and downstream for 2017. But I suspect it will be based on higher prices and higher levels of activity.
OGFJ: Do you think LNG exports will be an increasing factor in the overall market in 2017 and beyond?
PHILLIPS: Yes, I do, and I'm glad you mentioned this. Crestwood has a very strategically located natural gas storage and pipeline hub facility down along the coast in South Texas near the Freeport LNG project. And that storage and pipeline system is there for the specific purpose of serving both the growing LNG market along the Texas Gulf Coast as well as the growing demand for more natural gas supplies from Mexico. We've seen a big increase in customer interest and in rates that customers are willing to pay for storage and pipeline capacity to serve LNG and the growing demand for natural gas in Mexico. And of course there is a growing demand for natural gas and liquids demand from the petrochemical industry as they expand their facilities in the Texas gulf Coast region.
OGFJ: Thanks for talking with us today, Bob.
