In recent years, midstream master limited partnerships (MLPs) relied on acquisitions to fuel growth, but the trend has clearly shifted. Organic growth is now the name of the game for virtually all of them.

Analysts expect this to continue in 2007 and beyond. Some say this is good, but the focus on organic growth concerns others. Merrill Lynch analyst Gabe Moreen favors organic growth for the midstream sector because the acquisition market has become increasingly competitive, driving up multiples for midstream assets.

"An organic-growth strategy provides attractive returns and project economics and allows an MLP to expand its asset base while avoiding the competitive acquisition market," Moreen says.

The acquisition market has become heated as a result of the proliferation of MLPs, with the increased private-equity interest in midstream energy assets also paying a role, Moreen points out. "Almost all MLPs have been active in the third-party acquisition market," he says.

"However, we think the recent decline in third-party acquisition activity is a trend that may continue as a result of the overall competitiveness of the market, as well as the larger asset footprint that MLPs have within certain asset classes such as refined products pipelines and terminals."

Moreen believes many acquisition opportunities remain in the midstream sector, but the higher multiples may reduce the attractiveness of returns on acquisitions. "The current range for acquisition multiples is nine to 10 times EBITDA (earnings before interest, taxes, depreciation and amortization). This is significantly greater than just a few years ago, when MLPs routinely paid between six and eight times EBITDA," he explains.

Organic projects often provide better returns than acquisitions, with many MLPs having a growing slate of attractive organic-growth opportunities that will likely offer high returns and allow them to avoid making acquisitions, he adds.

However, this organic-growth strategy concerns RBC Capital Markets energy analyst Mark Easterbrook. Speaking at an RBC Capital Markets MLP conference in November, Easterbrook said organic growth can strain balance sheets and bring additional risks in commodity-price volatility and changed ownership.

Organic growth also concerns Standard & Poor's Ratings Services. "Given the stretched financial credit-protection measures that can result from organic spending, the growth project's business-risk characteristics can become increasingly pivotal for a company's overall credit quality," says Standard & Poor's credit analyst Plana Lee.

In December, at Wachovia's fifth annual MLP conference, which drew a record 400 fixed-income and equity investors, organic growth was the prevailing theme. "Without exception, each presenting company stressed its focus on organic growth and noted that returns on internal projects are greater than returns from acquisitions," says Wachovia analyst Yves Siegel.

"Overall, our MLP universe is projected to spend $8.3- and $9.3 billion on organic projects in 2006 and 2007, respectively. This is up from $5.7 billion in 2005."

For one thing, buyers aren't in an acquisition mode because of a dearth of assets in play, while most owners are holding onto their cash producers. "It all boils down to that there just aren't many high-quality assets on the market these days," says Alan Armstrong, president, midstream, Williams.

In addition to growing organically, Tulsa-based Williams is also focused on investing in existing facilities and systems. "We're bringing in new power lines, replacing equipment-spending money in ways that provide reliability assurance for our customers and repeat business for us," says Armstrong.



Ample capacity

Aside from the buy-or-build avenue to growth, the midstream sector is expected to see another good year in 2007, although few expect a repeat of last year's performance, when natural gas liquid (NGL) prices and fractionation spreads broke records across the board.

"Last year was a blowout year for many, so it would be a strange thing that this would be repeated in 2007 at that level," Armstrong says. "We should still have a good year. As long as the economy stays in check, we won't see a dampening in NGL prices. Demand is still good and should remain so this year."

Jim Teague, executive vice president, NGLs, at Enterprise Products Partners LP, says fractionation spreads should remain robust this year. "It revolves around two issues: the gas-to-crude relationship and petrochemical performance," he says.

"If the petrochemicals are performing well with strong run rates and strong demand, then typically there is a pull for the [NGL] products we produce...If the gas price relative to crude is as it is today, then that enhances the desirability of petrochemicals to use our products."

Last year, NGLs were a preferred feedstock for petrochemical plants because of favorable gas-to-crude ratios. "If gas is selling higher relative to crude, then it makes the crude-derived feedstocks, such as naphtha, more competitive," Teague says.

He remains bullish on petrochemical demand this year, citing a recent Hodson Report that shows U.S. petrochemical plants running at about 90% capacity. As long as gas prices remain attractive relative to crude, NGLs should remain a preferred feedstock.

Enterprise relies on a portfolio of contracts to mitigate risk and engineers its new processing plants to have a high level of flexibility in terms of extraction rates. Teague says this keeps Enterprise competitive in both high- and low-fractionation-spread environments.

Most regions have ample gas-processing capacity for the foreseeable future, he adds. One area that is gaining more capacity is the Rockies, and Enterprise is becoming much more active there. Early last year, Enterprise's only presence in the Rockies was the Mid-America Pipeline, which is used to evacuate NGLs.

The first phase of its Meeker gas-processing plant in the Piceance Basin, expected to be operational in the third quarter, will have the flexibility to produce 35,000 barrels per day when run at full extraction. But if NGL margins are falling, production can be tuned down to dew point at 3,000 barrels per day. This is to allow Enterprise to mitigate the keep-whole risk when margins aren't there and to maximize profits when margins are there.

"Today we're building a 750-million-cubic-foot-per-day processing plant in the Piceance Basin, anchored by a dedication (of gas production) from EnCana, and a second 750-million-cubic-foot-per-day plant for a total of 1.5 billion cubic feet per day of processing capacity in the Piceance that we didn't have last year," he says. "We're also building a dew-point plant, anchored by a dedication from ExxonMobil."

In addition, Enterprise is building an adjacent cryogenic processing plant that will serve gas producers in the Jonah and Pinedale fields of Wyoming. Expected to begin service in fourth-quarter 2007, it will have capacity to process up to 650 million cubic feet of gas per day.

For producers, the driver is the deliverability of their gas to market.



Caution ahead?

Meanwhile, Standard & Poor's cautions that lower commodity prices could adversely affect some midstream operators in price-sensitive segments. "For example, margins for percent-of-index gathering systems are calculated at a percent of the natural gas index price, so they would weaken as gas prices decline," S&P reports in a recent analysis of the sector.

"In addition, percent-of-proceeds processing margins decline when commodity prices are low. In contrast, keep-whole processing margins fall when NGL prices are low and gas prices are high."

These risks can be partially mitigated through hedging programs, conditioning language or gas-plant bypass capability, the agency adds. "Furthermore, midstream operators with a large portion of fee-based operations are not as exposed to commodity prices, although they can indirectly be affected as sustained lower prices could lead to less drilling activity and lower volumes."

Williams is unique in that it is less susceptible to short-term swings in gas prices. Many of the gas processors that make up the midstream sector are exposed to volatility in fractionation spreads, Armstrong says.

Williams is more exposed to fluctuations in crude prices, he says. Many pure midstream companies benefit when gas prices are cheaper relative to crude because the NGLs extracted from the gas stream prove to be of higher value as a petchem and refinery feedstock.

Williams' midstream unit may make less money when gas prices are more expensive relative to crude, but the company as a whole still benefits because the E&P side makes more money when gas prices move up $1 or more, Armstrong says. "Just the reverse happens when spot gas prices decline, as we saw in the third quarter of 2006. We are almost perfectly in balance as a company in 2007. Said another way, we are selling as much gas as we are buying after hedges are considered."

Like other midstream companies, Williams relies on hedging to mitigate risk. Wachovia's Siegel points out that, as midstream operations move closer to the wellhead, commodity exposure increases, both in terms of price and volume risk. To mitigate this risk, midstream companies with processing assets are hedging 60% to 70% of their price exposure going out several years.

"However, volume risk can't be hedged and is less of an issue if assets are situated in regions with growing production," Siegel says.



Fee-based contracts

Many producers have shifted to fee-based contracts for processing their gas, where there is no price risk to the processor-it receives a fee based on gas volumes processed. But in a low commodity-price environment, this can produce a "looming risk" for them.

"With fee-based contracts, producers are forced to process and produce liquids, even if the market is not asking for it," Armstrong says. "The decision to process can be based on the processor's economics, which may include the benefit of downstream fees to be collected."

A reliance on fee-based contracts could force excess NGL supply on the market, he warns. A wider variety of contracts, including keep-whole and percent-of-proceeds, works to keep the market in balance, ensuring that the NGL market does not build excess supply. "This will force the market to discipline itself very quickly," he says.

For Williams, keep-whole contracts work best to ensure that both producer and processor receive the full economic benefit, he says. "Keep-whole is a much better model for Williams because it allows us to balance our overall commodity risk."

For the pure midstream players, Armstrong expects more fee-based contracts because they offer a more certain rate of return.

Processing capacity is pretty much in balance in regions where Williams operates, he adds. Prior to hurricanes Katrina and Rita, there was excess Gulf Coast capacity, but the storms cleared out some older, less efficient plants, and this excess capacity won't be coming back.

Instead, the trend toward replacing damaged plants with higher-efficiency, new plants is continuing. Some plants are only now being fully restored to pre-storm capacity.

In fact, Williams and Williams Partners, along with DCP Midstream Partners (formerly Duke Energy Field Services), own Discovery Producer Services LLC, which includes offshore gas pipelines and a large processing facility in Louisiana, with a design capacity of 600 million cubic feet of gas per day.

While Armstrong remains fairly bullish on short-term NGL demand, the long-term picture concerns him. "Petrochemical capacity is moving overseas at a very fast pace. This presents a major concern-if petrochemical demand is not there, NGL demand will not be there."

Too, the fact that there is no new construction of petrochemical plants should be a major concern to the industry, he warns. "NGL production stands to increase, but demand from the petrochemical sector is flat."



John Hart is editor of Gas Processors Report, a 23-year publication of Hart Energy Publishing. He can be reached at 713-260-6423.



DEFINITIONS

Gas processing removes natural gas liquids (ethane, propane, butane, isobutane, ethane and natural gasoline) from a well's gas stream, which is mostly methane. NGL processors have four types of contract to do this.

Fee-based: No price risk to the processor, since it receives its fee based on the amount of gas processed, on a dollar-per-million-Btu or dollar-per-Mcf basis.

Keep whole: Calls for the processor to remove the NGLs from the gas stream for its own account, but it is required to pay back to the customer (producer) a sufficient amount of gas to keep the producer whole on a Btu basis. This exposes the processor to changes in the price ratio between NGLs and natural gas.

Percent of liquids: The processor retains a portion of the NGLs as its fee for processing the raw natural gas, which it then sells at a profit or loss. The producer retains title to or receives the value in Btu content associated with the remaining percentage of NGL mix.

Percent of proceeds: The processor receives an agreed-upon percent of the net proceeds of the sales value of the NGLs and lean gas leaving the processing facility.

Fractionation is a process in which, once the NGLs are removed form the raw gas stream, they are heated and separated into NGL products: ethane, butane, isobutene, propane, pentane and natural gasoline. Energy costs are thus a large component of the cost of fractionation. Sources: Raymond James & Associates and Merrill Lynch.

Comments