The weak commodities environment won’t be the death knell of shale’s success story, but the North American energy industry has hit the reset button, Jim Baker, senior managing director at Kayne Anderson in Houston, told a crowd of industry insiders in New York recently.

What happens next, Baker said, is that the sector has to recalibrate its activity levels consistent with a price environment of $50 per barrel of crude oil.

“That means a significant reduction in activity levels for domestic exploration and production; the process is painful, but unfortunately, it’s absolutely necessary for the market to rebalance,” he said.

The market’s response to dramatically lower prices has been faster than expected and the cuts have been deeper, he added. On average, North American-focused upstream companies have slashed capex budgets by 40%. In addition, the rig count has been reduced by about 40% from its peak.

The rig count proxy

“The rig count, of course, is the proxy for activity levels, and the decline in rig count is unprecedented relative to anything we’ve seen in recent history,” Baker told the crowd.

Baker’s speech kicked off the 2nd annual Capital Link MLP Investing Forum, which drew a crowd of more than 800 executives, analysts, investors and industry experts. Baker said the key takeaways for investors are to expect commodity prices to recover in the next 12 months, believe the shale opportunities today present a once-in-a-lifetime event for the energy sector—and know that Kayne Anderson is very optimistic about the long-term outlook for MLPs.

Still, he said, it’s likely the industry will see tangible signs of reduced drilling activity in the second half of 2015. Year- over-year production growth is expected to decline throughout the year.

“As the market starts to see these signs, we think that sets the stage for a slow and steady recovery. We do not believe that $50 oil works for the domestic energy industry,” he said.

A new 'normal'

Certainly as we’re all trying to figure out what the new ‘normal’ is for commodities prices, we’re of the opinion—in the intermediate term—that the new normal is somewhere north of $70 per barrel. Certainly it’s very trendy to forecast low crude oil prices, but we at Kayne Anderson are not in that camp.”

For the last 15 years, MLPs have had a can’t-be-beat record, Baker said. The sector has generated a steady re- turn for investors with regular growth in its distributions.

“Today there are over 125 MLPs with an aggregate market cap of over $560 billion. In 2000, there were 20 MLPs with an aggregate market cap of $16 billion,” he noted.

Rather, the recent downturn is just a speed bump in shale’s road to success. Baker expects activity levels to recover in 2016 when commodity prices rebound and that MLPs will spend tremendous amounts of capital during the next 10 to 20 years to facilitate the development of these domestic shale resources.

Investor preference

So what will be the impact on the midstream?

Greg Matlock, a partner at EY in Houston, said one thing the midstream sector has going for it is that it’s where the investor preference seems to be. If industry insiders were worried that equity markets were closing up, they can look to the recent IPO by Columbia Pipeline Partners LP.

“They’ve come out of this potentially volatile equity market space and for a midstream asset, they’ve outpaced, outperformed expectations and been a wild success story so far,” Matlock told Midstream Business. “You saw that with Antero’s Midstream last year; you saw it with Shell Midstream. So you’re having these strong, sponsor-backed MLPs in the midstream space that are incredible performers in the market. And it’s really where the stability and growth is in the sector—with those types of entities.”

The Columbia Pipeline Partners’ IPO has gone on to become the largest MLP IPO on record, raking in more than $1.1 billion.

Josh Davidson, a partner at Baker Botts LLP in Houston, who represented the underwriters in the Columbia IPO said the deal was actually a long time in coming. Davidson told Midstream Business the IPO actually began to take shape in 2007, but it was deferred by the credit crisis of 2008, when a lot of deals were put on hold.

But as for the size and scope of the Columbia transaction, Davidson said it’s got traction that not a lot of other new MLPs possess.


“About 90% of its revenue comes from these fixed contracts with customers, and they are long-term contracts. It’s a very steady flow of cash. That [kind of] MLP can sell in any reasonably healthy market, which we’re in. It’s not that directly impacted by commodity prices; it’s more indirectly [affected],” he said.

Dodging volatility

Matlock explained to Midstream Business that traditional MLPs have long through-put agreements that extend 10 years and beyond. There may be some short-term volatility, but so long as the counterparties to those are strong and are credit-worthy, it’s unlikely they will default on their obligations.

“They can weather volatility because these contracts are of such a length that the short-term swings in prices may not have significant impact on them,” he said. Only in certain client-specific or company-specific situations would price volatility warrant hedging the risk. “I think where you would see some volatility and companies try to hedge this risk, so it’s very client specific or company specific.

So the short answer to the question of whether cut-rate commodity prices can slam the midstream sector is maybe.
“It may have an impact for some, but not all because some of them are appropriately structured to weather the storm,” Matlock noted.

Counting ahead

Still, the issue arises whenever there’s significant movement in the midstream of whether the industry needs—or can ultimately, support— hundreds of midstream MLPs.

Matlock stands on the affirmative.

There is such a need for infrastructure. I know you have some short-term pricing volatility, but over the long term, we have an incredible asset base in this country. We have an incredible reserve base and having access to those reserves and being able to bring those to market takes a lot of capital. This is an incredibly efficient capital structure to execute on that,” he said. “The number has gone up, but so has the market cap.”

Scott Magzen, a partner at Deloitte LLP in Houston, told Midstream Business that even as the cycle placed downward pressure on E&Ps, 2014 was extremely robust for the midstream space.

“If we are going to see movement, [the second half] is when it’s going to happen. Anecdotally, the industry is holding up pretty well, and the banks are trying to work with upstream producers to give them credit extensions and lifelines,” Magzen said, adding, “A lot of people think that may start to wear thin toward the fourth quarter. If we see that, it’s going to have a corresponding impact—maybe not as clearly pronounced, but it will have an impact on the midstream because I think we’ll see producers try to renegotiate their contracts.

Even though the midstream has these take-or-pay contracts, if the credit party isn’t able to make good on the contract, it makes the take-or-pay nature worth a lot less. I think we’ll see issues with volumes that could lead to some pain in the midstream.”

Dual tracks

In some ways that differ from their upstream counterparts, midstream firms have options, whether they’re private equity-backed, sponsored by public corporations or even privately owned, Magzen said. They’ll often dual-track when they’re looking at going public, they will look at selling assets in an auction process at the same time they’re preparing their Form S-1 with the U.S. Securities and Exchange Com- mission for an IPO.

“We’ll often work with companies as they evaluate strategies, whether it’s the best bang for their buck to either sell the assets or to go public, and often they’ll find they’re still getting enough of a premium at going public to actually go public and monetize part of their investment that way,” he explained.

“That’s what is leading to a lot of the smaller MLPs out there,” Magzen added. “As they look at it—in the grand scheme of things—in the long term it might make sense to sell, and in the short term, this is the best opportunity for our business and our company. So we end up with these smaller players, and after they’ve been operating for a while, they look attractive to another MLP trying to expand into a new basin or round out a strategic area. That seems to be the natural progression of what’s happen- ing in the MLP space.”

Asset control

Another thing driving the proliferation of new MLPs—as opposed to sales to existing MLPs—is that by owning an MLP, the general partner or sponsor, more specifically, continues to be able to have some control over the asset, Magzen said. For an upstream com- pany looking to monetize investment in infrastructure that it might build for its production, by sponsoring its own MLP, the upstream company is still able to have some control over those midstream assets and ensure access to that infrastructure.

Corporate attorney Travis McCullough at Sutherland Asbill & Brennan LLP, described to Midstream Business what the industry now confronts.

“Everybody—other than people who benefit from the price drop— whose business depends on prices being at any particular level will be im- pacted by this, and the impact is going to be more and more significant and more apparent to the extent that there is a sustained drop in prices, or it doesn’t recover to levels that people are anticipating,” he said, adding that for the midstream, the impact isn’t as immediate simply because production hasn’t leveled off.

“All of that crude still needs to find a place to go, and it’s still going through contracts and arrangements with midstream companies that were probably negotiated back when prices were at a higher level,” McCullough said, adding that it’s possible some were negotiated with clauses that had some sensitivity that were built in de- pending on crude prices.

“It would be a great deal of foresight for somebody with contracts with midstream producers to have done that, but I think it’s possible somebody’s got a flexible pricing structure built in,” he added.

But, he said, assume they don’t have that flexibility. If the downturn goes on for too long, expect that producers will need relief.

“Hedges start to fall off, or prices stay at a depressed price, I think it would be natural for producers to [seek assistance]. We’ve seen that with producers talking to their service companies, and they’re asking service companies to take haircuts on pricing and amend contracts in light of the current economics,” he said.

Credit quality

Midstream companies are going to want to pay attention to the credit quality of their counter-parties. A lot of times, they’re not going to have any objective credit requirements or provisions that require a producer to deliver a given amount of collateral. The provisions, if they exist, are going to be a little bit more general and basically say something along the lines of, ‘if we get concerned about your credit quality, we can ask you to provide performance assurance,’” McCullough said.

Midstream companies are not so much worried about running out of business, but that customers might not be able to pay their bills, he said, adding, “It will have a knock-on effect, in the sense that they’re not able to collect from a producer; financing and the bills the midstream guys may have.”

A pipeline titan, such as a Kinder Morgan Inc., may have plenty of flexibility in its financing agreements and it might not have any problems. But it’s possible that some projects may have been financed on an assumption that crude prices were going to be at a certain level, and the midstream operator’s fees were going to be at a certain level.

“To the extent that the fees aren’t coming in anywhere near what the lenders thought they were going to make, those projects could run into trouble because they’re just not able to service their debt,” McCullough said.

“That’s something that could happen a little bit further down the road. I’m not sure that’s something the midstream guys are seeing right now, but if this [continues long term], you might get to a point where some aren’t able to make their obligations to their lenders because they’re not able to collect from the producers or they’re not able to collect as much—that’s for projects that already exist. A single, asset-only project or a smaller provider of midstream services might be in a different situation.”

Does it make sense?

In addition—to the extent that people have projects they are trying to finance or projects that haven’t closed and don’t already have steel in the ground—financiers might be taking another look at whether those projects continue to make sense in a period where crude is at a low price for an extended amount of time.

“People might say that doesn’t make sense right now because this product is no longer as attractive, or these margins aren’t as attractive as they were, or this particular marketplace or this region, doesn’t really need that type of thing right now, so people might be stepping back a little bit from projects that made sense when crude was much higher than they do now,” McCullough said.

Problem solving

William D. Waldrip, managing partner and founder of private equity provider EnCap Flatrock Midstream, told Midstream Business now is the time for significant problem solving, especially for those entities that may be overlevered for this type of environment.

Some companies were counting on a more robust cash flow than they are seeing now and can expect to see over the near term, so there will be requirements to come in and help restructure things, lower debt exposure and rationalize assets,” Waldrip said. “Examples might include the sale of some assets, reworking a contract in a specific way or looking at operating synergies that can be combined in a certain area.

“I don’t think we’ll see major failures. It’s more of a mending situation,” he added.

Waldrip, a longtime adviser in the private equity space, continued: “In some ways, this is a good time for midstream companies to catch their breath. We’ve had $100/bbl oil prices. We’ve had an extraordinary amount of drilling activity. It’s been very de- manding just to keep up—to get that next processing plant built, or get that major trunk-line built out on schedule, or get a terminal finished. Now we’re in a period when midstream companies can take advantage of the opportunity to take a close look at the assets they’ve built over the last few years and say, ‘Where can I take advantage of operational synergies? Where can I make improvements and optimize assets in a way that will impact my bottom line and have a positive impact in my customers?’ Before, there may not have been time to focus on those issues.”

Now, midstream companies have the opportunity to reevaluate things like fuel costs, power costs and chemical costs; how compressor utilization could be improved; or do a deep review into analyzing operating structures.

"While there may not be as many opportunities right now to grow a Mid- stream Business from a volume and a cash flow perspective, it’s possible for midstream operators to grow the value they are creating by improving efficiencies and really streamlining operating and managerial systems. I think smart midstream companies will be taking advantage of this time to develop and implement effective efficiency programs,” Waldrip explained.

Winners and losers

At Energy Spectrum Capital in Dallas, a private equity firm focused on the midstream sector of the North American energy industry, partner Ben Davis told Midstream Business that of the dozen or so active investments he’s running now, there are a variety of implications to monitor.

“We have our project in New Mexico that we’re building for Concho, called the Alpha Crude Connector, and our portfolio company Frontier out of Tulsa, [Okla.], is building that. Concho is our partner and our anchor producer, but we’ll add some other pro- ducers as we get closer to in-service date, which will be this fall. That deal is full speed ahead. Bone Spring is the main play there, and by all indications, it’s a play that does fine and returns are acceptable in this price environment,” Davis explained.

A project in the South Central Okla- homa Oil Province, or SCOOP, is being successfully drilled by Continental Resources Inc.

“I don’t like to dwell too much on the opportunities because in this environment, one person’s opportunity is probably coming as a result of one of our peer’s suffering, or someone else in the industry suffering,” he added. “But a lot of folks right now need to generate cash; a lot of E&P companies that might have, a year or two ago, wanted to put their own money into midstream now don’t. So we’re seeing some opportunities come from that.

“We like to be discreet about that, [but] our strengths are the expertise that our management teams bring to the table; their ability to build these projects, the expertise that we bring to the table as a capital fund manager that’s been doing this a long time. And the capital—clearly one of our value adds for our management teams and our producer customers is that we have capital.

“And if it needs to be built, we have the capital to do that,” Davis said. “And I think that capital is more valued by the market now than it was when everyone was generating greater cash flow than they are now.”

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