The market loves opportunities to exploit variations in valuation, and such arbitrage opportunities are frequently to be found in the energy sector. With times tough, what E&P wants to ignore a step-up in valuation that may be made possible by carving out midstream assets, through a spin-off or outright sale, even if valuations are a far cry from levels of just a year or two ago?

With the collapse in crude prices, valuations have swooned in both the E&P and midstream sectors. And within midstream, made up of assets largely held by master limited partnerships (MLPs), it is hard to argue there has been much differentiation. Valuations for natural gas and crude-oriented MLPs have both tumbled.

In terms of how much midstream valuations have fallen, a sense of near disbelief was apparent in a recent energy note put out by energy specialist investment bank Tudor, Pickering, Holt & Co. On midstream valuations being “taken to the woodshed,” it was “hard to rationalize the large-cap midstream space being worth approximately $70 billion less than a week ago,” commented the TPH note after a late-September sell-off. “Key question on everyone’s mind is, ‘What am I missing?’”

But as much as valuations may have fallen, the midstream sector still offers E&Ps having any significant midstream assets an arbitrage opportunity. At a time when many E&Ps are suffering financially, midstream assets may be overlooked or undervalued if they are obscured within an E&P structure. These hard infrastructure assets, often backed by long-term contracts, are traditionally valued at higher metrics than those afforded to their E&P counterparts.

How much of a higher valuation uplift can potentially be captured?

Brandon Blossman, managing director with coverage of midstream equities at Tudor, Pickering, Holt, noted that the gap between mid-cap E&Ps, trading at about a 7 multiple of 2016 Ebitda, and midstream equities, trading at a 10 or greater multiple, offered a better-than 3 turn uplift in valuation.

“Obviously, you can argue there is an arbitrage between where the assets are getting valued within an E&P company and what they might be valued in a midstream company,” said Blossman.

“Even though the MLP market is beaten up, there is still a valuation arbitrage,” said Ethan Bellamy, senior research analyst with R.W. Baird & Co. covering the midstream space. “It still makes a lot of sense to disaggregate MLP-qualifying midstream assets from an E&P company, because MLP investors will always pay more than E&P investors for those midstream assets.”

In addition, the lower beta of midstream assets should mean, other things being equal, that they hold their value better in a downturn. “If midstream assets made up 10% of your net asset value [NAV] a year ago, they ought to be more than that now,” Bellamy said. “The relative contribution today of your midstream assets is going to be a bigger component of your overall value.”

In terms of strategic alternatives, Bellamy identified a few of the key factors weighing in favor of or against a spin-off (typically into an MLP) or an outright sale of midstream assets. The latter has the advantage of usually being “cleaner” and delivers upfront cash—albeit with potential tax consequences—sooner. With a spin-off, the ability to participate in the continued growth of the midstream assets is retained, with no risk of losing prioritization of wells. In addition, taxes on a gain on the sale of assets are not incurred all at once, he noted.

In better times, of course, E&Ps were able to look at a possible midstream monetization as just one of a range of options to raise capital.

In November of last year, Pioneer Natural Resources Co. announced it was pursuing a divestiture of its 50.1% interest in its Eagle Ford Shale midstream business, shortly after closing a common stock offering that brought in proceeds of about $1 billion. Pioneer went on to close its midstream divestiture in July of this year, selling the Eagle Ford assets for $2.15 billion (100%) to Enterprise Product Partners LP. The other 49.9% owner of the assets was Reliance Holdings USA.

Other transactions in late 2014 included Antero Midstream Partners LP, spun out of Antero Resources Corp. in an IPO raising more than $1 billion, and Shell Midstream Partners, spun out of major Royal Dutch Shell, which also raised about $1 billion in its IPO debut. Earlier this year, Hess Corp. announced the sale of a 50% interest in its Bakken midstream assets to Global Infrastructure Partners, for $2.675 billion, in what was rumored to also foreshadow an IPO.

Amid the robust capital markets before the current downturn, a recipe evolved for potential issuers seeking to access the capital markets to gain greater financial flexibility.

“The dream scenario,” as typified by several Marcellus producers, was to spin off a midstream MLP, while retaining the general partner (GP) of the MLP and thus control of the assets, said Blossman. This would enable the E&P to retain a reasonable ownership position in the MLP and a known cash-flow stream from the assets. The MLP would offer the benefit of a tracking stock and provide a means of raising incremental capital periodically over time. Ultimately, the strategy would provide for taking the GP public at an elevated multiple reflecting the growth record notched up by the MLP.

Different goals today

Those were the days. E&Ps with midstream assets today typically have more modest goals—funding a capex outspend, for example, or adding much-needed liquidity—in the current depressed crude price environment.

In terms of outright sales, in the third quarter Matador Resources Corp. sold Delaware Basin gas gathering assets to a subsidiary of EnLink Midstream Partners for $143 million, buoying liquidity to more than $500 million. And WPX Energy agreed to sell its Van Hook gathering system in North Dakota for $185 million as part of a $400 million to $500 million divestiture target.

Bonanza Creek Energy Inc. also plans to monetize its Rocky Mountain Infrastructure LLC subsidiary by the end of this year. While final terms were not available at press time, an outright sale by Bonanza Creek could generate an estimated $60 million in proceeds, while freeing up $40 million of capex otherwise earmarked for infrastructure needs, according to Capital One Securities.

In late September, Sanchez Energy Corp. monetized its midstream assets by dropping its major gathering and processing assets into an MLP it had previously spun out, Sanchez Production Partners LP. The assets, including 150 miles of gathering lines, as well as processing units, compression facilities and eight stabilizers, brought in $345 million, significantly more than the $200 million price tag one analyst expected. Pro forma, the sale boosted liquidity for Sanchez to $918 million, up from $572 million previously.

Predictably, a much larger E&P like Anadarko Petroleum Corp. can draw more than the arrow of periodic asset sales from its quiver. In June, Anadarko raised around $130 million through an offering of 2.3 million shares it owned in Western Gas Equity Partners LP (WGP). The latter MLP was formed by Anadarko to hold not only its significant limited partnership interests in its midstream MLP subsidiary, Western Gas Partners LP (WES), but also its GP interest and incentive distribution rights in WES.

In addition, Anadarko completed an offering of 8 million “tangible equity units,” or TEUs, each with a stated amount of $50, raising net proceeds of $387.1 million. The TEUs are comprised of a senior amortizing note, paying equal quarterly payments equating to a 7.5% cash payment, coupled with a prepaid equity purchase contract providing for the delivery of common units in WGP.

Anadarko has made clear that while its basic tenet is to keep capex in line with cash flow, it may rely upon its midstream asset sales to help finance projects, such as in Mozambique, and thus minimize any outspend. “We see Western Gas, and our monetization efforts there, as the source of capital that will fund what we do with the equity portion of the development in Mozambique,” explained CEO Bob Walker on the company’s second-quarter conference call.

Balance-sheet destiny

But most E&Ps have fewer options. And their cushion of financial safety is usually determined by the strength of their balance sheet.

“Your destiny is your balance sheet,” commented Bellamy. “Selling assets is the main card to play right now. The pool of potential buyers hasn’t evaporated, but E&Ps have to be prepared to accept less than they were going to before. At the right price, there is the money. If you have a clean balance sheet, you can do what you want. If you’re five times levered, then the banks are telling you what to do.”

For E&Ps with limited options, monetization moves are typically triggered by the specifics of the assets in their portfolios and the degree to which the E&Ps have a need to fund an outspend in the near term, according to Blossman. Assets are generally sold for a nine to 12 multiple of forward Ebitda, he said.

“Generally, 10 times forward Ebitda is the sweet spot for deals getting done,” said Blossman. “In some cases, it’s been able to do deals at higher levels, around 12 times Ebitda, where the assets being sold have a good line of site on some organic growth and thus command a higher multiple.”

A common view is that, with plenty of private equity sitting on the sidelines, active midstream buyers are going to be more weighted to private equity than to public companies, whose now lower valuations and reduced access to the capital markets have severely hampered their ability to raise capital and transact deals that would still be accretive.

For a private equity purchaser, typically looking for midstream returns in the mid-teens, threshold economics work in buying assets at roughly a 10 multiple of forward Ebitda, said Blossman. Assuming some haircut for maintenance capital needs, this translates into an unlevered return of nearly 10%. If the purchase is funded 50% with equity and 50% with debt, with the latter borrowed at 5%, he calculated a 15% rate of return.

“For an infrastructure fund, that’s probably in the ballpark,” commented Blossman. “That’s not a bad return during the holding period, particularly if banking on an improved macro energy outlook and a higher exit sale price.”

The contract terms supporting the midstream assets are important as well. “The contract has a lot to do with the value of the transaction, over and above the assets themselves,” said Blossman. “What you’re paying for the gathering and processing sets the value, irrespective of the assets.”

In addition, contract duration and counterparty matter. As an example, a 20-year, take-or-pay contract with a counterparty that is rated investment grade could be 65% debt financed, he noted.

As part of a dropdown of water assets, valued at $1.05 billion, Antero Resources Corp. in September entered into a 20-year water services agreement with subsidiary Antero Midstream Partners LP covering the parent’s properties in West Virginia and Ohio. Under the agreement, Antero Resources will pay a fixed fee per barrel of $3.69 in West Virginia and $3.64 in Ohio for fresh-water deliveries to the well site.

The agreement also provides for minimum volume commitments by the parent that are set at rising levels in each of 2016, 2017 and 2018. In addition, the transaction includes earn-out payments, totaling $250 million, potentially to be paid to Antero Resources at the end of 2019 and 2020, contingent upon specific average threshold volumes being delivered by Antero Midstream in 2017-2019 and 2018-2020.

According to Bellamy, Antero’s prior decision to spin out—rather than sell—its midstream operations provides an example of the synergies to be achieved by a “high-growth-rate E&P, which is now lowering its lease operating expense by having extensive in-house midstream infrastructure. Without that water system, their well economics wouldn’t be nearly as good. They’re really doing it right.”

Antero Resources’ dropdown of its water business assets was done at a multiple that allows for continued distribution growth, creating a “virtuous circle,” and keeping returns in-house, said Bellamy. “They had the scale to do an MLP in the first place,” he recalled, and by placing the midstream assets into a separate vehicle, “they got the most efficient owners of those assets to give them the highest value for those assets.”

In addition, Antero now has “a currency that helps them finance the midstream growth and doesn’t burden the E&P returns. They get a higher valuation on the midstream assets than they would have received in the E&P, because E&P investors don’t want to pay up for midstream assets,” he said.

“And, ultimately, because Antero management owns the GP of Antero Midstream in a sidecar vehicle, they’re incentivized to make sure it works,” Bellamy added. “So I wouldn’t be surprised to see them take the GP of the MLP public in the same way as with Western Gas Equity Partners.”

Market sentiment

As for public equity markets, the prospective dearth of deals reflects an understandably low level of market sentiment, given the sell-off in the MLP sector.

“Most market participants feel there is very little depth in terms of raising fresh capital on the public equity side,” said Blossman. “The large, overnight deal, raising $1 billion, is not currently possible on the public equity side. The concern for those wishing to issue equity in any size is that there are practically no takers for deals, almost irrespective of valuation.”

It’s as if the capital markets have hit an “air pocket,” he said. “It’s not so much a question of valuation; it’s more a question of availability of capital. There are short-lived periods in the capital markets when it doesn’t matter how attractive a deal is, there is just no incremental capital available for it.”

So what is the template for the few deals that can get done? Mainly they are smaller, private deals, according to Blossman. “In the current environment, you’re only going to push out what you have to push out, because valuations are certainly not as favorable as in recent times.”

While market receptivity is somber as regards raising public equity for midstream deals, Blossman is reluctant to rule out a swing in sentiment. Given shifts in capital flows, “you have to remember that two weeks can make a world of difference.”

Moreover, Street chatter has pointed to some E&Ps coming closer to finalizing preparations for the spin-off of their midstream operations. This process could—subject to market conditions—pave the way for transactions later this year and into 2016.

“The process of getting the midstream entities structured up within organizations to be able to send them off on an independent track—getting the legal entities and contracts in place, for example—has taken the E&Ps a lot longer than they expected. But they’re getting to the culmination of that process,” said Blossman.

“I don’t think the E&Ps will be worried so much about timing it perfectly,” he added. “It will to a large degree be determined by the appetite of the capital markets to provide new money to the space.”

If such transactions come to fruition, either via an IPO or sale, “asset prices will have to be lower due to the MLP market sell-off that has raised the cost of capital across the sector,” commented Bellamy. “If you’re an E&P trying to sell midstream assets, you may still have a materially positive asset arbitrage potential, but the absolute value you are going to receive is going to have to take a haircut relative to the valuations your bankers were showing you in 2014 or even the second quarter of 2015.”

Bellamy also raised a red flag in terms of market pressures building up in the MLP sector ahead of an eventual thawing in the now-frozen public equity markets.

“The longer low oil prices and volatile equity prices prevent the market for new and secondary equity issuance from functioning, the more tension will build in the MLP sector’s equity needs. I’m increasingly concerned by multiple issuers all trying to run through the same narrow doorway at the same time, which would really mute MLP returns,” he warned.

How does Blossman see the potential return of capital markets unfolding?

Investment bankers will attempt to test the temperature of capital markets, but issuers are unlikely to try to time the market, he ventured. “It will be a little bit opportunistic. For issuers, it won’t be so much that they can get the best price today, but rather that they can be assured of a price today.”

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