?Pipeline infrastructure constraints are slowing the growth of domestic production in key areas, despite record additions of pipeline capacity in 2007. Proposals to build new pipelines and expand the existing ones abound, but the constrained credit environment is causing cancellations and delays for projects scheduled to come online in 2009 and 2010.


Not all planned pipeline developments will proceed, nor are all needed. Pipeline-capacity additions during 2009 will be adequate to meet industry needs, although producers will be more selective in the projects they are willing to back.


The rapid growth of unconventional production during the past couple of years and the resulting regional pipeline constraints have propelled infrastructure- development plans to levels not witnessed in many years. Projects that were scheduled to begin operation in 2008 add a record 47 billion cubic feet (Bcf) per day of deliverability and 4,407 miles, according to the Energy Information Agency. By a Barclays Capital estimate, more than 18 Bcf of daily capacity and 1,500 miles of that have already been completed.


Against the backdrop of increasing concern over the depth of the economic recession, pipeline-infrastructure development has become a favored investment choice for some energy companies. Pipeline operations enjoy a steady income stream backed by firm shipper commitments and are less exposed to the fluctuations in the price of gas.


While pipeline owners do obtain some income that is based on the volume of gas shipped, and that volume of transported gas does vary with the ups and downs of demand, this is dwarfed by the income swings that gas producers face.


For this reason, among others, several integrated energy companies have recently announced a shift in capital commitments away from E&P and toward opportunities in the midstream space. With domestic gas supply strongly on the rise and near-term demand trends nearly flat, the need for new pipeline capacity is clearly greater than the need for incremental production growth.


This is particularly acute in regions that are leading in unconventional-gas production growth, such as East Texas, Louisiana, Arkansas and the Rockies, where insufficient take-away capacity has caused slumps in regional prices and, in some cases, has even forced producers to shut in production and slow plans for growth.


The development of pipeline infrastructure is likely to benefit from its relative safety in a recessionary environment, as integrated energy companies focus on midstream projects. However, new pipelines and expansions are also likely to face increasingly tougher times in securing binding commitments from gas producers for new construction.


During the past couple of years, growing production volumes, rising gas prices and easy access to capital allowed producers to ramp up spending. With gas prices now on a downward trend and tougher lending terms constraining debt-capital access, many producers are being forced to scale down spending.


Although securing pipeline capacity to bring future production to consuming markets is certainly a priority for producers, entering binding agreements for upcoming capacity ties up scarce capital, and could be particularly challenging in the current credit market for highly leveraged, high-yield producers.


The credit crunch and lower natural gas prices will also affect the timing of production growth. However, the relationship between capital spending, drilling rates and production is not linear. While capex cuts are averaging 17% to 20% across the producer community, production estimates have been lowered only marginally as producers cut spending only in areas that do not affect near-term production. Areas with proven success, such as the Barnett and Haynesville shales, are likely to be the last to suffer.


In fact, the largest infrastructure additions planned for 2009 have already secured financing, and some are already under construction. Plans for further expansions in 2010 face greater risks, but their development hinges not only on credit availability, but also, and more importantly, on the pace of production growth, which will ultimately determine the magnitude of the capacity additions needed.


Meanwhile, the economic downturn could be a blessing in disguise, as it will likely drive costs lower. Steel prices, an important cost component for pipeline construction, have already experienced a remarkable pullback, with the London Metals Exchange’s three-month price for steel billets down some 70% from its high in June 2008. Regional assessments point to a 38% decline in U.S. prices over the same period—a smaller, but nevertheless substantial, decline.


Overall, the underlying need to build more pipelines remains, despite a slowing economy and the expected moderation in the pace of production growth. We believe the pipelines needed to de-bottleneck areas of growing supply will be built, as key pipeline projects for 2009 are already under construction, energy companies divert capital to forthcoming pipeline projects, and wide basis differentials spur enough credit-worthy producers to support these pipes.


—George Hopley, Biliana Pehlivanova and Michael Zenker, analysts, Barclays Capital

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