On a stage in Midland, Texas, Mike Wichterich groused candidly about the shortcomings of the Delaware Basin’s infrastructure and how a lack of pipe has turned acreage there into an oil trap.

Wichterich, president of Three Rivers Operating Co. III LLC told attendees of Hart Energy’s November 2017 Executive Oil Conference that wells with production of 2,000 barrels per day (Mbbl/d) seem great.

“And I think, ‘OK, I need to haul that oil off. And that is a lot of trucks. And, oh, by the way, I need to move 6 Mbbl of water,’” he said, underscoring that inefficiencies add up rapidly. “It has to be piped. It can’t be trucked. That’s why we’re having all these problems.”

The need for infrastructure in areas such as the Delaware is clear and likely to be the next area of serious M&A engagement for the midstream sector— if companies can afford it, and perhaps even if they cannot.

So through late 2017, deals were dominated by dropdowns and corporate unifications. Of the top 10 announced deals, seven were fueled by dropdowns, corporate streamlining or private-equity firms’ interest in the Permian.

What’s lost
Many companies remain boxed-in by debt and the gravity-like pull of investor dissatisfaction. In early December 2017, the Alerian MLP Index—comprised largely of pipeline and gathering companies—had lost 15%, while the Standard & Poor’s 500 index was up more than 18%.

Midstream companies should see an improving economic environment in 2018. EBITDA is expected to grow by up to 10% in 2018, Moody’s Investors Service said in a December report. But while midstream operators’ access to capital markets is improving, some companies remain unable to tap markets to deleverage.

Few midstream companies have “free money left to throw at growth,” said Samir Kayande, a director at RS Energy Group. The Delaware Basin, with its resource riches and low breakevens, illustrates the larger M&A conundrum.

“It’s going to be really challenging, especially when you look at some of the larger natural acquirers,” Kayande told Midstream Business. “Energy Transfer Partners comes to mind immediately as a company that would probably love to have more assets in the Delaware Basin but probably can’t make that work with their capital structure right now.”

The opportunity and capital constraints have trapped management teams in a paradoxical dilemma.

“The Delaware is just this opportunity that probably comes along once in a generation. So regardless of how much it costs, can you really afford to not be in it?” he added.

Backstitch
In 2017, many midstream companies adopted the term “simplification” to describe their motivation for stitching their disparate affiliates into a single company.

The common thread running through the consolidating moves may have been bringing companies and investors closer to one another.

In the largest U.S. midstream deal of 2017, ONEOK Partners LP’s largest shareholder, ONEOK Inc., bought the company’s remaining interests in June for $9.3 billion. The goal was to create a single standalone company.

In a similar transaction in January, DCP Midstream Partners LP acquired the assets of DCP Midstream LLC—a joint venture (JV) between Phillips 66 Co. and Spectra Energy Corp. for $3.8 billion.

Wouter van Kempen, CEO of DCP Midstream and DPM, said at the time the deal would simplify the company’s corporate structure.

Kayande’s take is that many of the structures being combined existed because management incentives differed within each structure. Investors were forced to “tease out” whether their goals aligned with management’s, he said.

“These simplifying structures are intended to promote greater alignment between management and shareholders. And it’s on a case-by-case basis whether it does that or not,” the CEO said.

Kyle May, an analyst with Capital One Securities, agreed investors wanted answers. As distributable cash flow grows within an MLP, the general partners receive larger percentages of the cash through incentive distribution rights (IDRs).

IDR analysis
“Investors are scrutinizing the IDRs paid by MLPs to their general partners,” May told Midstream Business. “By eliminating the IDRs, MLPs lower their cost of capital.”

Other deals have materialized through the cash needs of E&Ps, resulting in dropdowns into affiliated MLPs or outright sales. In other cases, E&Ps have also used their MLPs as a vehicle to capture midstream investor interests.

“Several E&P companies have monetized midstream assets to realize the value some believe was not fully appreciated in the market, while at the same time strengthening their balance sheet,” May said.

In October, Callon Petroleum Co. sold its Delaware Basin natural gas gathering system to Brazos Midstream Holdings. The company didn’t disclose the amount of the transaction, but acquired the gathering assets in December 2016 for about $18.4 million.

President and CEO Joe Gatto said then that he expected the transaction to support plans for “robust growth across our Delaware Basin footprint.”

Other E&P dropdowns were to MLPs they control—part of a strategy that allows them to build out midstream while also owning and controlling it. E&Ps use the model to give “some line of sight to investors that want to play the midstream angle,” Kayande said, citing Anadarko Petroleum Corp. as such an example.

Companies such as Marathon Petroleum Corp., Shell, Phillips 66, Valero Energy Corp. and Noble Energy Inc. have completed or announced $5.8 billion in such deals.

In September, for instance, Phillips 66 said it would sell interests in the Dakota Access and Energy Transfer Crude Oil pipelines to its MLP, Phillips 66 Partners LP. Phillips 66 executives aim for the MLP to generate $1.1 billion of EBITDA by the end of 2018.

Theoretical M&A
By early July 2017, a deal between ArcLight Capital Partners and Energy Corp. of America (ECA) was serious enough to get the bank involved.

Several months after ArcLight approached ECA with an offer, in November the private-equity company’s new affiliate, Greylock Energy LLC, bought ECA’s 700,000 net Marcellus acres as well as ECA’s midstream assets.

Greylock—led by Kyle Mork, ECA’s former CEO—will develop the assets and likely pursue acquisitions.
“One piece of the midstream business is building out for Greylock’s upstream development,” Mork told Midstream Business. “But then the other piece is that we’ve developed experience and had good success at building midstream for third parties.”

Appalachian M&A
Mork said it’s likely for Appalachia to see continued consolidation.

Not everyone is so sure. In a September report, Bernstein analysts grappled with a recurring question they received regarding whether the sector is “on the cusp of a midstream M&A boom?”

The potential synergies for operational expenses and G&A, in Bernstein analyst Jean Ann Salisbury’s view, are not significant enough to warrant many mergers.

The competing theories for 2018’s midstream M&A outlook run generally along these lines:

  • Midstream M&A is generally not worth it; and
  • Some areas are probably worth it, but expensive.

Bernstein’s view is that the primary driver of M&A from 2011 to 2015 was the “plethora of opportunities in the midstream space” and that a lower cost of capital would allow for more competitive positioning for winning opportunities.

“In the slower, more boring future that we envision for the space, this ceases to be a driver,” Salisbury said.

Others, such as Joe Dunleavy, utilities and mining deals leader at PwC U.S., see the midstream sector as “the place to be.”

For 2017, players in all sectors have been focused on core business.

“If you don’t have scale you’re going to have a difficult time generating cash flows and meeting shareholder expectations,” Dunleavy told Midstream Business.

M&A seems poised to occur — provided West Texas Intermediate (WTI) prices cooperate. Dunleavy said sustained oil prices need to cross a “psychological $50 barrier” to create M&A activity.

Dunleavy said that if he steps back from basin-specific transactions, he sees “the private equity out there and the dry powder that they have and maybe capacity constraints as it relates to the midstream business.”

Private equity
Private equity backed some of the largest deals in the midstream sector in 2017. On the buy side, it was involved in $6 billion of announced deals.

Salisbury also noted a few areas where targeted M&A would make sense: the Permian crude chain, the Permian NGL chain and in the Rockies, either through Bakken overcapacity relief or for Niobrara takeaway capacity.

Other potential areas for midstream deals include the Midcontinent’s Scoop, Stack and Merge plays, where newer midstream and legacy infrastructure cross paths. Some older lines may be unsuitable for the higher-pressured volumes.

As for Appalachia, the region has been somewhat lethargic for deals, with about $1.1 billion in announced deals. That total doesn’t include EQT Corp.’s $8.2 billion acquisition in November of Rice Energy Inc., which included Rice’s midstream assets.

Mork said more midstream deals seem to be in store.

“As you see more upstream transactions, which I think is going to happen, I think you’ll see midstream in many cases go along with it,” he said.

The ECA-Greylock’s transaction also symbolizes a broader debate. Greylock controls the midstream and upstream sides of its business.

In a recent conversation, another Appalachia CEO said he had sold his midstream system to ultimately fund development on the upstream side.

The sale highlights the tension between capital needs and being able to control midstream assets. For Mork, that means know where volumes are flowing and that ensure they reach the right place.

“You’ve just seen different companies making different choices,” Mork said, “but certainly we really like having both sides.”

As the multihorizon Delaware is developed, deciding on building or renting takeaway is taking on even more significance.

Delaware drain
Perhaps the two Permian midstream deals that best illustrate the tension between opportunity and cost were announced days apart last year in early April.

In the first, NuStar Energy LP agreed to pay $1.5 billion to buy Midland Basin crude oil infrastructure from private-equity-backed Navigator Energy Services LLC. The deal closed in May. Later that month, Blackstone Energy Partners said it would buy gas gathering assets in the Delaware from EagleClaw Midstream Ventures LLC for $2 billion cash. It isn’t clear if the deal has closed.

Since 2015, Kayande said private equity has poured a great deal of capital and steel into the Permian.

“When you look at private equity and their exit point, for a successful business, they’re probably looking at exiting right now,” he said.

In the case of the EagleClaw deal, Kayande said it “broke every single asset valuation rule that I have.”

The amount of production flow and value on the assets was relatively small yet commanded a huge price.

He likened the transaction’s outsized cost to an option premium.

“You pay this huge premium in order to have the obligation to develop out a system that will cost you 7x EBITDA in terms of the capital you need to put in,” he said.
In her report, Salisbury raised a similar point with the NuStar acquisition of Navigator.

“Buying pure gathering from a [private-equity-backed] player is probably expensive, if the NuStar/Navigator deal is an indication, but could make sense to someone with export capacity and no upstream, like [Buckeye Partners LP] or [Magellan Midstream Partners LP],” she said.

New Permian pipeline projects were announced in 2017 and midstream companies formed JVs to share the construction cost while also de-risking the projects, May said.

“Moving associated gas from the Permian continues to draw attention as some are concerned there will be a shortage of takeaway capacity,” he said.

That need makes the Permian fertile terrain for deals or alternatives, especially as pipeline operators price tariffs on their lines.

In November, Enterprise Products Partners put a line into service between Midland, Texas, and Houston. The line adds 300 Mbbl/d of capacity from the Permian Basin to the Gulf Coast.

But Enterprise set a high interim tariff on the line for uncommitted, walk-up shippers of $6.74/bbl, said Sandy Fielden, an analyst with Morningstar Commodities Research.

“That's $2.50/barrel [bbl] more than the next-highest competitor on a comparable route between the Permian and the Gulf Coast,” Fielden said in a December report.

Consolidation when?
Kayande said consolidation among midstream operators seems to make sense, but he’s unsure it will happen yet.

“It really depends a lot on WTI. If oil prices and gas prices remain kind of where they’re at and relatively strong, there would probably be more IPO activity I would expect,” he said. “If gas prices especially start dropping off, then there may be more strategic deals.”

As Mork suggested, E&Ps are also considering their own alternatives, Kayande said. “The first question that the E&P has to ask itself is should I even have a third-party midstream company gathering and processing my oil? Because if I owned it all from soup to nuts, from drilling the well to gathering to processing, that requires more capital from the E&P side, which stinks,” he said. “But then you basically buy lower [opex] for the life of the asset.”

Due to the multiple zones available in the Delaware, E&Ps that build their own midstream would essentially build one pipe but use it multiple times, depending on the number of horizons a company produces from.

“There’s a compelling argument to be made, that ‘well wait a second, if I just own it all, I don’t have to pay someone five times as much rent,’” he said.

Midstream companies, on the other hand, will try to be competitive by offering lower rates “to the point where you’re equalized between deploying the capital yourself vs. paying a third party for it.”

For Wichterich, the Delaware Basin is “tremendously inefficient” at this point. Truck drivers earn up to $2,000 a day. Drilling crews that were efficient have been split and split again. And rights-of-way still must be purchased to lay pipelines.

“Execution is terrible,” he said. “It will get more efficient. Today it's not. Until we get the full development, it is going to take a while.”

Darren Barbee can be reached at dbarbee@hartenergy.com or 713-260-6497.

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