As Midstream Wobbles on IRA and ESG, a New Trend Opens Up for Sector

As enthusiasm for the Inflation Reduction Act (IRA) and ESG take a back seat in the midstream sector, midstream players are turning to a new trend—asset-backed securitization.

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IRA expectations downgraded

When the IRA debuted, there was significant interest from the midstream sector in the potential tax credits available for carbon capture and sequestration (CCS). But the enthusiasm has dimmed.

“We haven’t seen much benefit on the traditional midstream side of the business yet,” said Mike Mayon, managing partner at Energy Spectrum.  The primary beneficiaries in midstream will be CCS projects, but “those are proving tough to permit and contract,” he noted.

Most companies simply can’t afford to pursue such projects at a large scale because they tend to be expensive and take a lot of time to yield a return, said Nick Dhesi, partner, Latham & Watkins. For that reason, they remain in the realm of the very large players like majors or supermajors, he said.

“There’s going to be a lot of waiting and seeing rather than new projects starting up,” said Dhesi.

Beyond carbon capture, hydrogen infrastructure holds promise for midstream, noted Phill Segal, an energy research analyst at VettaFi. “The hydrogen industry, which is also seeing benefits from the IRA and additional DOE incentives, could also present opportunities for midstream around storing and transporting hydrogen,” he said.

ESG takes a back seat

“ESG as a whole is getting less attention now than it was a year ago, when it was more of a peak topic,” said Nick Dhesi, partner, Latham & Wakins. “The reality is that energy is outperforming as an investment opportunity … and because of that, investors are focusing on performance in addition to ESG.”

ESG remains a stronger focus among some pockets of capital. European institutional investors that have looked at the U.S. midstream still have “really robust, rigorous requirements around ESG,” Dhesi said. It is still important to have a narrative ready to address ESG-related questions, he said.

Midstream could get a new tool

In recent years, asset-backed securitization (ABS) has garnered some attention in the upstream space as E&P companies have used the new mechanism to monetize producing assets by placing them in special purpose vehicles and aggressively hedging them against commodity price risk.

Now, advisers say, ABSs could also be applied to the midstream sector.

“Securitization is a financing tool that applies well when you can apply it against assets or portfolios that have predictable cash flows,” said Anuj Bhartiya, senior managing director, Guggenheim Securities. Through hedging, upstream producers have been able to create predictable cash flow streams. “I think the midstream sector certainly has assets that are more infrastructure-like with long-term contracts that generally lend themselves well to securitization.”

ABS “absolutely” has a role to play in the midstream, said Daniel Allison, partner at Sidley Austin. For the first deal to get done, a number of factors will need to align “just right,” such as medium- and long-term contracts and investment grade—or close to investment grade—counterparties.

Upstream consolidation could actually streamline the introduction of ABS, Allison said. Following a merger, midstream companies could end up with a major or supermajor as their sole client. That would satisfy the counterparty risk question, and all that would then be needed is to tie the securitization to predictable cash flows, he said.

Some upstream ABSs already have been structured to include value for midstream gathering cash flows, said Victor Mendoza, managing director and head of oil and gas ABS at Donovan Ventures. Investors in production-backed ABSs are “getting more comfortable understanding oil and gas reserves,” and so with the proper long-term contracts and creditworthy offtakers, a midstream-focused ABS is possible, he said.