Capital Strategies: Midstream Private-Equity Marriages

[Editor's note: This story appears in the June 2020 edition of Midstream Business. Subscribe to the magazine here. It was originally published May 15, 2020.]  

Jean Paul Getty’s formula for success was to “rise early, work late and strike oil,” and while hard work and good rock are critical ingredients of top performance in this industry, relationships also play a key role in achieving success.

This is evident more than ever in today’s private-equity midstream space. In recent years, as export markets have opened up and capital markets have tightened, private equity has aggressively targeted the midstream.

Putting the right companies with the right private-equity backers is as much art as it is economics. The differentiating factor can be the relationships between the potential partners. Private-equity firms look for experienced management teams with strong track records that they can trust to execute their business plans and deliver returns to investors. Startup midstream companies look for equity providers that invest money and resources and offer strategic guidance and complementary operations expertise.

“Personalities and values have to align,” Edgewater Midstream LLC CEO Stephen Smith said. “At the end of the day, your management team is marrying the financial sponsor.”

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That sentiment was echoed by Gregory King, managing partner at EnCap Flatrock Midstream (EFM), whose private-equity firm made an initial commitment of $400 million to Edgewater.

“The quality of the relationships we have with our management teams is paramount,” he said. “It’s easy when times are good and everything’s working right, but you have to be able to work through the tough times together. Can you make difficult decisions and move forward? Can you navigate your way through challenging price cycles like this one? These are some of the things we all think about before we form a new partnership.”

Two recent startups backed by veteran private-equity groups—a pair of “marriages” built on the backbone of geological formations and rock-solid relationships—offer a model of how the industry continues to evolve.

Taproot Energy Partners

Taproot Energy Partners CEO Kevin Sullivan had already founded at least half a dozen energy companies in his 42 years in the industry, but his call with Ben Davis, partner with Energy Spectrum Capital, in early 2018 was unlike any of his previous experiences.

“This one was totally different than what I had ever done in the past,” Sullivan said. “All of those deals were started by the management team. Whereas this time the relationship was actually developed by the private-equity people. Ben had a relationship with Carnelian Energy Capital [Management LP] that was solely involved in the upstream side. He was the instigator of bringing all the parties together: the producer, the midstream company and the money. He said, ‘We’ve got this opportunity, and let’s see if we can put it together.’”

Energy Spectrum had a prime opportunity in the Denver-Julesburg (D-J) Basin, and Davis wanted primetime partners to develop it.

“We have made it a priority in our 25 years to find good people and stick with them,” Davis said, adding that Energy Spectrum has backed some CEOs three or four times. “That’s our MO. We find good people who are smart, honest, positive to work with and know what they’re doing. We want to keep going back to the well. It was an easy call to reach out to Kevin, and I’m thankful he wanted to do it.”

Sullivan’s first step was to fill out his management team, and he knew exactly whom he would call. Rod Donovan, COO of Taproot, had worked with Sullivan when they formed Costar Midstream LLC in 2011. His 36 years of midstream experience and his familiarity with Sullivan and Energy Spectrum made him an easy choice to be the executive in charge of Taproot’s day-to-day operations.

Denver-based Taproot was officially formed in April 2018 with $18 million in backing from Energy Spectrum and an initial contract with Carnelian Energy Capital-backed Bison Oil and Gas LLC to develop 50,000 acres in and around northeast Weld County, Colo., near the Buckingham Terminal on the Pony Express Pipeline. Its multiproduct Baja gathering system, consisting of 30 miles of pipe to gather crude oil, produced water and fresh water, began operation in late 2018.

Bison has been key to Taproot’s initial success. “What really helps our business is when producers drill great wells, and those guys have been drilling great wells,” Davis said, noting the high quality of the rock in the northeast corner of the most active portion of the D-J.

“To Bison’s credit, it rushed up there and started leasing. It took them a handful of wells to crack the code, but it has really figured out how to drill good wells,” he said. “When you analyze the data, you find that the area where it is drilling has wellhead economics similar to the sweeter spots of the Permian Basin. That’s exciting.”

Taproot’s early growth has been brisk. It signed a second deal in August 2018 with Verdad Resources LLC, which provided additional acreage in the play. The Verdad deal was followed in September 2019 by an agreement with Bonanza Creek Energy Inc. for the dedication of more than 69,000 acres. Its new Rattlesnake Extension will add about 35 miles of mostly 10-inch pipe for transporting crude from Bonanza Creek’s wells to the Buckingham Terminal, with ultimate delivery to the Cushing, Okla., crude hub. In addition to the Rattlesnake Extension, Taproot also intends to construct a truck unloading and storage facility in Weld County.

Additionally, just announced in April, Taproot has acquired the dedication of roughly 60,000 acres with Mallard Exploration, a deal that pushes the company’s total dedicated acres over 200,000.

Even with his company’s early success, Taproot’s Sullivan said the D-J Basin is not without challenges in the current economic environment. “Most of our challenges arise from the upstream side,” he said. “It’s not difficult to put pipe in the ground, to operate crude gathering systems or produced water systems or freshwater systems. The challenging part is having the industry be receptive to what we’re providing.”

Sullivan said, in this case, the upstream and E&P companies struggled to get financing to drill. “Many of the startups on the upstream side are backed by private-equity companies. They get the initial funding to buy leasehold and to drill some initial wells. The theory is that after they drill those initial wells, then other types of financing will be available for them to continue their development program,” he said.

“Traditional lending sources were not open, but alternative financing methods were, and many of our producers were entering into sizable drillcos. All our producers had significant hedge positions for 2020 and 2021 production that add additional staying power. But then prices fell dramatically, and the industry slowed down. Producers have said they are laying their rigs down in this price environment. That is the challenge for us.”

As a result, Sullivan said Taproot is delaying or slowing expenditures of capex during the downturn. For example, the Rattlesnake Extension was originally expected to have between 3,000 bbl/d and 7,000 bb/d flowing by June, but now that the producer has released its rig, the volumes will not be there. Sullivan said Taproot will wait an additional six months to have the pipeline ready for operation.

“One of the great things about private equity is that it’s very patient money,” Sullivan said. “We don’t have any debt as a company, and that provides breathing room. We can wait this out. We are simply slowing down the buildout of certain sections of our pipe based on the volumes we are estimating.”

The uncertainty on the upstream side leads to difficult infrastructural decisions—such as the size of pipe on new construction—when a company is trying to estimate its volumes for the next three to five years.

“If you have the assumption that crude prices are good and you may have 100 wells per year added to your system, you would design a different system than one that you would build with interim flow where they drill 30 to 50 wells when prices are good, then shut down for 10 months when prices drop, then prices go back up and they drill another 30 to 50 wells,” Sullivan said.

“Then you’ve got an intermittent type of operation, and that’s when you start thinking about your economics. It’s cheaper to have a 6-inch pipe in the ground than it is to have a 12-inch pipe. Those are all the unknowns and the challenges you have when you’re trying to make decisions,” he explained.

Sullivan said that while the private-equity model is being tested by the current industry conditions, it is structured to withstand pricing downturns. He considers companies like Taproot as incubators.

“We are an entity that is funded to find and grow assets,” he said. “Then sometime in a four- to seven-year time frame, you’re going to monetize, liquidate and give the return back to the investors. They are patient and know that this takes time.”

Sullivan said Taproot has “accomplished quite a bit” in the past two years since the company was formed. “We’ve entered into 15-year contracts with producers that have combined to dedicate to us over 200,000 acres,” he said. “As long as we have very patient money, which we do, and producers get back to actively developing their leaseholds, we can come out of this unscathed. The producers we are dealing with basically have very low or no debt. Some of them have debt that is structured so they don’t have to worry about it until 2024.”

Energy Spectrum’s Davis said the firm utilizes a low-leverage model, avoiding the trap of companies encumbered with large debt. “The primary reason we do that is so we don’t lose control in a price downturn like this,” he said. “We are cycle-tested. We are in our 25th year as a firm, and our founders experienced the crash in the ’80s. We are not experiencing this for the first time.”

Davis explained that one of the structural advantages of private equity is that it can be patient capital.

“We certainly have investors concerned about IRR. Getting back money sooner is better than getting money back later. But they understand that this is a cyclical business and we are in it for the long haul,” he said. “When you couple that with the fact that we are relationship-driven, it makes us more patient as well. It’s about the people. It’s not about what you have done for me today. It’s about being partners and being in it for the long haul.”

Edgewater Midstream

Edgewater Midstream CEO Stephen Smith has formed a number of relationships over his many years in the industry, including a strong bond with Rob Wingo, EFM’s managing director. Their relationship began 15 years ago when Smith was an investment banker at Bank of America and Wingo worked for Copano Energy LLC. The pair reunited after Smith joined Genesis Energy LP. After Smith left Genesis in 2018, Wingo and the EFM team helped Smith assemble a management team to form what became Edgewater.

The two parties shared a common vision of the midstream sector. EFM had been expanding its scope beyond gathering and processing, and Smith’s nascent company could fit into that evolution. Smith founded Edgewater in late 2019 with chief commercial officer Brian Thompson and COO Mike Truby, and they landed an initial capital commitment of $400 million from EFM in January 2020.

“Upfront, there was a lot of socialization,” Smith said. “We wanted to understand each other’s views and be mutually aligned on value creation, strategy and overall operating philosophy. EFM’s desire to invest capital in demand-oriented midstream assets and businesses was a strategic fit for Edgewater.”

He said EFM’s managing partners have an enormous amount of midstream experience. “EFM is the premier private-equity firm in the midstream space. There isn’t a lot in midstream they haven’t seen or experienced. We didn’t have to spend a lot of time explaining the businesses we’re looking at because they understand it and have such a deep bench,” he said.

Smith added that the partners understand the challenges and opportunities and bring a host of technical and financial experience that complements the team’s experience.

EnCap’s King said the decision to partner with Smith and the Edgewater team was easy when they considered the skill sets the team brought in the areas of commercial and business development, recruiting, finance, and engineering and operations.

“At EnCap Flatrock, it all begins with people. We back outstanding teams with a demonstrated ability to execute, exceptional track records, a clear vision, great reputations and contacts, and values that are aligned with ours,” King said. “We also want to be sure that we look at midstream, risk management, value creation and overall objectives the same way. Stephen and his team brought all of these things to the table. That was very appealing to us.”

Edgewater, based in Houston, is building its business on the demand end of the midstream value chain. It focuses on the acquisition, development and operation of pipeline and terminal solutions between and in proximity to major North American petroleum trading hubs and demand centers. In particular, Edgewater aims to provide independent midstream logistics solutions to refiners, producers and marketers of crude oil, refined products and other bulk liquids.

“Our goal is to build an independent midstream logistics business that delivers value-added, integrated services to refineries, marketers of crude oil and refined products as well as other midstream companies,” Smith said.

King said those opportunities fit perfectly with how EFM’s scope has expanded since its launch in 2008.

“Gathering and processing remains an important part of our portfolio, but over the years the market has presented different midstream opportunities focused closer to demand centers. We’ve been fortunate to build relationships with seasoned industry professionals on this side of the market,” he said. “We believe the Edgewater team’s background and current strategy is well positioned to pursue a variety of these types of assets, such as transportation, storage and terminals.”

Smith said another commonality between Edgewater and its private-equity partner is its approach to embracing new technologies and environmentally sustainable practices.

“We have dedicated ourselves to going above and beyond from a social responsibility perspective,” Smith said, adding that EFM has long had an ESG policy in place. “For us, social responsibility means not only operating safely but [also] looking at new technologies that we can utilize to protect the environment. We recognize how important it is both now and in the future. It is front and center for us no matter what we do.”

Even amid the current downturn, Smith said the company is pressing forward. “It’s an exciting period for Edgewater,” he said. “We have the right team and financial partner to execute our strategy and build a successful business.”

David Klaassen is an Oklahoma City-based writer specializing in energy topics.