Low Gas Prices Support Midstream M&A Activity

The number of midstream merger-and-acquisition (M&A) transactions has been growing in the past few years, and much of this activity has been driven by the emergence of the master limited partnership (MLP) structure in the midstream. But now, M&A activity related to MLP creation has eased, and we believe low natural gas prices instead are supporting midstream M&A activity as dry gas producers divest their assets in order to raise cash.

Recently, gas producers have been looking for sources of extra cash as their operating cash flow plummets with the natural gas price. With the Henry Hub spot price just over $3, dry gas producers are operating at a loss and are forced to cease gas drilling, focus on cost reductions in order to preserve margins and, most importantly, develop liquidsrich projects focused on natural gas liquids (NGL) and unconventional oil. Midstream asset disposition has emerged as an answer to the cash-deficit problem for producers looking to invest in liquid-rich projects.

The accompanying chart—Midstream Transactions by Producers and Other Sellers—shows the number of M&A transactions involving midstream gas assets grew steadily between 2008 and 2011. While the total number of transactions was increasing, so was the percentage of deals with gas producers as the seller.

Transactions were represented by four types of deals: sales of assets, sales of interests in assets, asset spinoffs into MLPs and joint ventures. However through third-quarter 2012, the market witnessed a decrease in the overall number of midstream transactions. The number of deals contracted by about 50% compared to 2011 numbers. In 2011 and 2012, producer sales of midstream assets represent 37% of total midstream transactions. It is fair to say, as the M&A market for midstream gas assets is cooling down, gas producers are driving the number of transactions by continuing to monetize their assets through spinoffs and divestitures.

However, not only are the producers accounting for a growing number of transactions, they are also raising more funds. We used a peer group of 27 predominantly gas producers to analyze M&A activity in upstream and midstream. The peer group consists of North American upstream companies, whose reserves are mostly represented by dry gas plays and who own midstream asset inventory. According to our research, the total value of transactions has been steadily increasing since 2009 at an annual compound growth rate of 140%, as noted in the accompanying chart, Midstream: Total Value of Transactions. This trend signifies the growing importance of midstream asset divestiture as a source of funds.

The liquids shift

Let us take a look at two examples of producers that used midstream asset sales to fund their shift to liquids-rich plays:

In 2011, Quicksilver Resources Inc., primarily a gas company with a reserve mix of 77% natural gas, 22% NGL and 1% crude oil as of year-end 2011, announced it would target more oil projects going forward.

The company planned to spend around $370 million on capital expenditures in 2012 with about 50% going toward liquids-rich plays. It has been investing in oil prospective acreage in West Texas and was expecting to scale down drilling and completion activity in the gasprone Barnett shale in 2012.

Quicksilver went through two midstream transactions in 2011. One was the sale of its Quicksilver Gas Services LP. This midstream subsidiary was sold to First Reserve Corp. for $1.03 billion. Another midstream transaction was entering into partnership with Kohlberg Kravis Roberts & Co. LP for its pipeline and compression facilities. This deal helped Quicksilver Resources raise $125 million cash. Prior to 2011, Quicksilver Resources also used midstream asset disposition to raise funds. In 2009 midstream asset dispositions amounted to $130 million. The same year, Quicksilver Resources made one upstream transaction, selling an interest in upstream assets for $280 million.

Producing assets

So why aren’t producers raising funds through producing- asset sales and farm-outs instead, as they have in the past? There are two key conditions that have reduced the attractiveness of producing asset monetization.

First is with the underlying commodity prices, disposing of upstream assets in a period of declining gas prices would require selling reserves for substantially less than the long-term price view would warrant. Further, many firms that joined the shale gas expansion late would have to sell for less than what they paid for assets.

The second factor is the growth and development of a robust midstream sector over the last 10 years. Until recently, there was only a small and relatively illiquid market for midstream assets. Most assets were owned by producers or large pipeline companies.

However, the advent of the MLP structure enabled pure-play midstream companies to raise capital and grow the segment as an industry sector in its own right. This has created a ready market to acquire these midstream assets from producers.

The impact of underlying commodity prices originates with low gas spot prices and an expectation of prices staying low near-term, reflected in declining NYMEX Henry Hub gas futures. This trend contributed to low gas reserve valuations and thus unattractive sale and farm-out dynamics.

Given these low price and valuation dynamics, producers are deciding to hold off on selling their gas reserves and proceed, instead, with midstream asset sales. The accompanying chart—Upstream: Total Value of Transactions—illustrates the declining value of upstream dry gas transactions. (For the purpose of this analysis we excluded mergers and 100% acquisitions in upstream. These types of transactions include the transfer of ownership of the entire company. The purpose of this analysis is looking into ways existing companies raise funds.)

In 2009, total value of transactions involving sale of gas reserves declined almost 60% while the Henry Hub gas price dropped 55% compared to 2008. We believe this level of total transactions value was below the portfolio turnover and was caused by liquidity issues companies were facing after the financial crisis.

In 2010, there was an 85% spike in total transaction value motivated by a 20% increase in gas prices that year. However in 2

11, the value of transactions declined by 20%, followed by a further decrease through third-quarter 2012.

Usual turnover

We believe the total value of upstream transactions at the end of 2012 was a little over that of 2009. This level of M&A activity represents usual upstream portfolio turnover. These transactions are a part of the normal business cycle.

The emergence of the midstream MLP, further supported by private-equity players seeking to aggregate and grow fee-based assets with an eventual MLP initial public offering, has created an opportunity for producers to monetize a significant portion of non-producing assets to fund drilling and production. The factors that have influenced midstream M&A activity will continue shaping the market going forward. These factors will influence the decision on both sides of the investment table—sell-side and buy-side.

On the sell-side, producers will continue to divest midstream assets while the market price of gas and, subsequently, reserves, stays low. However, this will be limited by the finite number of midstream assets owned, companies’ financial needs and appetite for new projects.

Timing becomes of the essence as more and more producers divest midstream assets by creating MLPs or outright sales to others. For potential buyers this means a decreasing number of individual midstream assets for sale.

Buy-side decisions, on the other hand, will be based on midstream risk/return dynamics and strategic objectives. Midstream buy-side is represented by three primary types of players: MLPs, private equities and infrastructure funds. MLPs will continue to buy assets in order to diversify their portfolio and create growth for general partners’ incentive programs. Private equities and infrastructure funds will continue to invest in midstream assets as long as interest rates stay low and midstream assets support yields above corporate bond rates.

Emergence of MLPs stimulates deals on both ends, with sellers raising more funds in transactions due to growing EBITDA multiples and buyers earning higher returns on their investments. All of the factors lead us to believe that there is a lot of potential for M&A in the midstream sector.

So what are the implications for various players in the industry? And how will this trend change the traditional operating models and market dynamics for midstream players going forward?

To answer these questions, we must look at the implications for producers and then evaluate how midstream companies can work with the producers to resolve their issues.

A place for midstream

Producers own midstream assets because this guarantees that they will be able to get their product to the customer. Historically, producers have invested in midstream themselves in order to exercise greater control over these crucial assets. Development of midstream capabilities by producers was dictated by necessity.

Today’s North American midstream landscape allows producers to divest those assets at a lower risk to their operations. This is made possible by the number and sophistication of North American midstream players that have the capabilities to ensure operational reliability for producers.

The latter, however, does not apply to geographies outside of the U.S. and Canada. Those markets don’t have a developed midstream market, thus producers engaged abroad must keep these capabilities in house.

Helping producers

Midstream companies have evolved. They have adopted a fee-for-service business model limited to their existing footprint and adjacent regions. This model is distinct with little shared risk and collaboration with producers.

Going forward, the industry must adopt more collaborative models to support producers’ need for capabilities and address their service level concerns. Collaborative models can also be used by midstream companies to break footprint constraints to future growth. Long-term collaborative relationships can provide an entrance to new geographies.

As low gas prices continue driving companies to monetize non-producing assets, there is one thing businesses should be aware of: Asset divestiture is not only a financial decision; it is a strategic initiative with an impact on business in the long run.

When divesting midstream assets, producers need to consider all associated risks and work closely with midstream companies to mitigate these.