The Reality Ahead

For those of us whose years of high school orchestra are well behind us, a popular form of musical composition involves the introduction of a harmonized melody, or theme, which a composer will then repeat in altered forms while maintaining the theme throughout. Though the energy market isn’t exactly Carnegie Hall, a host of industry experts are echoing that practice, trading in Chopin’s piano notes for a message on the future of midstream.

And what sort of piece is Variations on a Theme, composed by the U.S. midstream?

While the fortissimo score of a year ago may have featured loud cymbal clashes and triumphant brass, the energy orchestra has pulled back to a mezzo-piano that is likely to continue for much of the next year, with a few soloists continuing to wow the audience until the next crescendo.

Pricing in the lower register

Analysts expect that prices should be generally better than they were during the first half, but nobody should get their hopes up for $60+ crude barrels in the near future. In addition to the current global crude surplus—magnified by OPEC rejecting its usual swing producer role—the prospect of sanctions lifted from Iranian crude exports will likely continue to stifle crude prices.

“Iran’s oil minister said recently that Iran could put 500,000 bbl/d [barrels per day] on the global oil market within one week of lifting sanctions and 1 million bbl/d on the market about 30 days after lifting sanctions,” John Edwards, director of energy logistics and infrastructure MLPs at Credit Suisse LLC, told Midstream Business.“Combined with stubbornly high U.S crude oil production, crude oil inventories tracking about 25% over the average of the last five years and upcoming refinery turnaround season, it adds up to depressed crude oil prices for the near term.”

As the hope for a swift return to year ago prices fades away, the reality ahead is leading those in the energy space to take a closer look at the implications of the new price environment.

Investors are pushing out the time frame in which a substantial commodity rebound is expected,” Jeffrey Birnbaum, midstream MLP analyst with Wunderlich Securities, told Midstream Business. “The slower recovery puts additional pressure on the balance sheet of any company that is substantially levered, which as the cost of equity goes up debt go up, makes it harder to finance additional capex projects even if they can contract them in this weaker commodity environment.”

On the upstream side, that means r ally examining acreage to find the most economic areas in the portfolio and focusing on those. The midstream side then follows where the upstream leads, with the added advantage that companies can shield themselves from low oil prices via favorable contract structures.

“Generally, commodity weakness makes contract structure all the more important in our space,” Kristina Kazarian, equity analyst at Deutsche Bank AG, told Midstream Business.

“We expect the worst-positioned names to start to lose further steam in the second half of 2015, and that could mean they’re seeing the direct pressure from [percent-of-proceeds] or keep-whole contracts,” rather than the more price-protected, fee-based contract structure favorable to midstream operators,” she said.

NGL lag

On the natural gas side, the forward curve is around $2.80 to $3 per thousand cubic feet (Mcf) for the second half, according to Sunil Sibal, senior analyst with Global Hunter Securities. From the gas price forward curve and crude prices, he can project NGL prices.

Currently, the common theme among NGL components is oversupply, with the two most common NGL components—ethane and propane—dragging down the overall barrel.

“We are severely oversupplied in the ethane market right now, and some of that starts to get relieved only in ’17, as the big petrochemical projects come online on the Gulf Coast,” Sibal told Midstream Business. Before those ethane crackers come online further down the road, the prospect of exports looms to help the oversupply situation, in the form of Sunoco Logistics Partners LP’s Mariner East project. Mariner East’s design allows for ethane produced in the Marcellus and Utica shales to be exported to European markets.

That project is expected to start up in the second half of this year, so that should provide some relief on the ethane prices,” Sibal said.“Basically right now, they have been trading at a severe discount to natural gas prices, and I think that will bring that discount a little bit closer.

“As these petrochemical projects come online on the Gulf Coast, what it does is basically brings ethane at close to parity with natural gas from ’17 onward,” he added.

The oversupply story continues with propane, which is much easier to export. Exports are ongoing but facing a headwind due to a shortage of very large gas carriers (VLGCs), which carry large volumes of U.S. propane over longer distances to destinations like Asia.

Because we are short of the ship capacity, the ship rates have been pretty high, and, as a result, U.S. propane exports have been somewhat disadvantaged in the Asian markets,” Sibal said.

On that front at least, a bright spot lies ahead in the second half of 2015 as new VLGCs are scheduled to enter the market. Around the same time, winter heating demand will likely pick up and relieve some of the pricing pressure.

Investor reviews

When looking ahead to the end of the year, most investors aren’t seeing the warm glow of propane. While the midstream is insulated from commodity prices compared to upstream operators, investors don’t seem to be making much distinction between the sectors, with low prices dragging down investor sentiment in the midstream.

“We always believe that a lot of what happens in midstream is driven by what is happening in the upstream business,” Billy Lemmons, a managing partner at private equity firm EnCap Flatrock Midstream, told Midstream Business. “As the industry looks forward, a lot of energy professionals continue to believe that meaningful price improvement is going to take some time. Having said that, midstream continues to be a very attractive space for those that understand it well. For example, our companies are stepping in to help their customers by serving as problem solvers, near both supply and market nodes. Where we see supply and demand mismatches, there is an opportunity to help ensure that the right types of hydrocarbons get to the right markets in the right amounts.”

Additional concerns relate to investor views of the midstream as yield-type investments, especially for those midstream companies within the MLP structure, which tend to give out attractive quarterly distributions. The Alerian MLP index yield as of July 30 was at almost 7%, compared to about 4% for other high-yield investments like utilities and real estate investment trusts.

However, according to Sibal, there is a growth component that goes hand-in-hand with this view of MLPs.

“Right now, I think investors are dialing back the growth because frankly, we have been in an era as the U.S. has been expanding production pretty rapidly over the last five years,” he said. “So in the current commodity price environment that high production growth has to take a hiatus. We will probably still be growing production but at a more tempered pace than what we have, so that’s going to impact ultimately the need for the infrastructure and how quickly the midstream MLPs can grow distributions.”

That isn’t to say that investors are negative on the entire space, though.

“Most investors we talk to are positive on specific names, but acknowledge the backdrop of the space moving against them,” Deutsche Bank’s Kazarian said. What’s causing the overall caution in the space is likely a number of factors, she said, including concerns over commodity prices, rising interest rates and other factors such as fund flows.

Rates to move up an octave

In a move unlikely to have much actual impact on MLPs, but that may further damage investor sentiment, the Federal Reserve may be ready to raise interest rates during the second half of the year.

“I think the fed wants to move,” Beth Ann Bovino, chief U.S. economist with Standard & Poor’s Ratings Services, told Midstream Business. “They’ve got their finger on the trigger and they’re ready to shoot it, but they still have to make sure the economy is stable. I expect them to move in September. With inflation low, they will likely take their time thereafter.

“They are concerned that keeping this incredibly excessive accommodation in the markets causes investors to take undue risks,” she added. “I think that they’ll probably have a lookout on what happened in the energy sector.

“You’ve seen a significant amount of speculative-grade bond activity in the energy market. You’ve seen a lot of more speculative-grade businesses in energy getting loans. Well now, what will happen when you have basically the drop in oil prices and interest rates rising? You can see much more of a squeeze there.”

When it comes to the effect of rising rates on MLPs,“part of it is perception and part of it is reality,” Birnbaum said. While entities with weak growth prospects may feel the rise in rates somewhat, companies with strong organic growth prospects or substantial drop-down availability from sponsors will likely not be affected nearly as much.

For those that are affected, the cost of capital will go up and could set up some fairly substantial hurdles for projects.

“On the MLP side, there’s been concern because MLPs on the equity side at least tend to be a yield-type investment, and yield investments tend to be hurt in a rising interest rate environment,” Peter Molica, senior director of corporate ratings with Fitch Ratings, told Midstream Business. Overall though, he said “MLPs, relative to some other yield investments like REITs or utilities, should be better-insulated for a rise in rates because of the growth profile that a lot of them provide.

“Their yield is really yield-plus-growth, and that plus-growth part of the equation should provide some cushion even in a rising rate environment.”

Companies set their tempo

Midstream companies have been doing what they can to further pad that cushion.

“A lot of the bigger players in this sector over the last year or so have trimmed out a lot of their debt,” Sibal explained. “What that means is their cost of capital, interest payments that they’re making every quarter, have already been fixed at 4.5% to 5% rates.

“So the cost of doing business is not going up as a result of the higher interest rates.”

This isn’t a permanent solution, as eventually debt will have to be refinanced, and if low commodity prices extend to that date, those companies may be more pressured. However, it does buy companies time for prices to rebound.

Regardless of any interest rate protection midstream companies enjoy, there are concerns that rising rates could present the appearance of a larger impact, thus sparking an asset sell-off and damaging investor sentiment.

“While a very modest increase in interest rates is not going to have a meaningful impact on revolving credit facilities or on valuations, my bigger concern is that it has a much more pronounced impact on sentiment, and is just one of the many things I look at as potentially causing a reversal in the bull market,” Ethan Bellamy, senior analyst with Robert W. Baird & Co. Inc., told Midstream Business.

Tough crowds in the equity market

That investor hesitation is being felt in the equity market.

“The equity marketplace has clearly been difficult, particularly for the small and mid-cap players,” Eric Kalamaras, CFO of Azure Midstream Partners LP, told Midstream Business. “It’s been a little bit more favorable for the larger caps, or for those that have very strong growth stories.”

One cause behind the difficult equity marketplace could be that there is simply too much paper being offered compared to fund flows in the space. “Funds flows are down significantly from the last three years with respect to the ETFs [exchange traded funds] and ETMFs [exchange traded managed funds],” John Edwards, director for energy logistics and infrastructure MLPs at Credit Suisse LLC, told Midstream Business.

“If that’s indicative of the sector as a whole, it would look like fund flows are down, paper issuance in terms of debt and equity is about the same as last year—it’s only slightly lower—so you’ve got that issue, and of course you have the commodity price headwinds, that’s been an issue. You put all that together, and that’s helping to contribute to sagging equity prices this year.”

The equity market can be a tough place for large cap companies as well, Christopher Sighinolfi, senior vice president, U.S. equity research with Jefferies LLC, told Midstream Business.

“Companies that have needed equity, regardless of the reason, have been punished by the market,” he said. That“speaks to a lack of enthusiasm by investors for new issuance in the space, which is a departure from the last several years.”

This played out in mid-July when Sunoco LP financed a portion of the $2 billion dropdown deal with its parent company Energy Transfer Partners LP through a public equity issuance, he said. The dropdown was, according to Sighinolfi, “well telegraphed in advance.”

“They have a dropdown story they have been telling that will continue through the end of next year,” and only about $250 million of the total transaction was funded through a public equity issuance. Though the transaction was “articulated as accretive by the management team,” he said, “stock was down 8% the day they announced it. I think in total since that news, it’s down 15%, but by early August it had rallied for a decline of about 9.5%.“It speaks to, I think, a lack of appetite from investors to deploy new capital into the space.”

A warmer reception

When a company needs to finance a deal, they may be better served in other markets, Kalamaras said.

The bank market is pretty widely available to midstream companies for the time being, but will likely tighten as the banks begin to more closely evaluate their portfolios.

“They will be taking a harder look, but that market is still pretty readily available,” he said.

“The leveraged finance and credit, debt markets, those are a little bit more challenging, but capital is still available there for the right stories.” If a company is leveraged, “pretty much it’s going to be difficult anywhere you go,” Kalamaras added.

The right story is going to involve a clean balance sheet and solid growth prospects, he stressed.

“Really there are not a lot of great places to go in the credit markets where you can get good risked returns and predictability of payback at a good credit profile, so those names are being valued,” he said. “If you can match that criteria, you’re going to be rewarded in that marketplace.”

On the other hand, “If you can’t, it’s going to be challenging, and I expect it to stay that way really through the rest of the fall and the winter,” Kalamaras said. “Credit markets will probably get more difficult, certainly on the upstream and services side. The midstream side will probably be OK for now, but it could get pressured here over the next six months.”

M&A hits a high note

A substantial increase in M&A activity could help faltering equity markets. So far, 2015 has been a big year for acquisitions, and that’s likely to continue.

“We thought over time as the basins matured, as the growth profiles matured, there would be an opportunity for consolidation,” Jefferies’ Sighinolfi said. “I think you’re starting to see that. I think that’s been accelerated by what’s transpired on the commodity price front, and so you’ve seen a lot of activity over the last nine months.

“If you think about the bid that Energy Transfer made for Williams, for example—I think that process will continue.”

“What we see is that there’s going to be an increasing consolidation trend,” Kalamaras said.

“I think you started to see it over the past year or two, and that was in a more bullish environment. That really exacerbates itself in a weakening commodity price environment, where everyone starts feeling more exposed about where their position really lies, particularly when you start constraining some capital sources, so what we’re expecting to see is a fair bit more consolidation and really more merger activity, if you will, on a corporate or partner to-partner side.”

During the last downturn in 2008 and 2009, industry observers expected consolidation that never really materialized, Kalamaras said.

“I think the reality was, there wasn’t as much private equity capital on the small portfolio company side to initiate that and valuations were difficult to make work, just because of the disconnect at the time, on the public side,” he said. “I think now we’re seeing much more willingness from private equity sponsors to initiate in those conversations, create a bigger portfolio suite of assets, protect their investment. And then they can try to grow off a bigger asset base.”

Many companies may find consolidation enticing, as “size and scale really matter in the space, to the extent that you see other names kind of scaling up historically; you’ve seen it kind of spread throughout the space,” Molica said.

Scaling up

One example of corporate-to-corporate capitalization on the opportunity to scale up was the merger between MPLX LP and MarkWest Energy Partners LP. According to Kathleen Connelly, director of corporate ratings with Fitch Ratings, the merger was “another example of how many players in the MLP space are looking for ways to grow, they’re looking for size and scale; they’re looking for opportunities to grow their distributable cash flows, and yes, diversify as well.

“And many times, some of these transactions have been driven by an opportunity to try and reduce cost of capital, so that projects get done with better returns as well,” she added.

However, such consolidation is easier said than done—particularly when parent companies of MLPs are taken into account.

“Part of the complexity of the MLP sector is that many companies aren’t companies unto themselves,” Birnbaum said. “Many smaller MLPs have sponsors that are distinct—some of whom are E&Ps, some of whom are refiners, some of whom are private equity funds or business development companies, and in a lot of ways, it depends on the goals of the sponsor of an MLP and what its motivations are to really understand where the MLP might be headed.

“To the extent that you have a sponsor that doesn’t think there really is a path forward, you could see increased consolidation, but to the extent that that sponsor feels like they can kind of help their MLP ride out the storm, there’s an incentive to hold out because the economics are generally going to be better,” he added.

Infrastructure encore

“There’s still a tremendous demand for infrastructure,” Edwards said. “Capital spending numbers, while they look like they’re not going to be quite as high as 2014, probably down slightly, but it looks like it will probably be the second-highest capital spend number after 2014, so it’s still very strong.”

“That said, there are areas where midstream capacity appears to be adequate with current combined planned expansion projects, such as in the area of crude oil pipelines.”

Those numbers may come down more in 2017, but “longer term, obviously the U.S. has become one of the largest energy producers and we don’t see this changing,” Kazarian said. The biggest drivers for continued infrastructure buildout will likely be increased demand for both crude and gas.

“The themes that impact this are gas-fired power generation driving incremental infrastructure needs, LNG exports and further expansions to connect pockets of supply across North America that remain pipeline constrained,” she said. Particularly constrained areas requiring further buildout include the Permian, the Marcellus and Utica and western Canada.

“While projects coming online over the next five years will alleviate some of these issues, and some of it’s obviously price-dependent, we think there will be further pipeline buildouts associated with those regions,” Kazarian added.

The pipes are calling

The Northeast particularly is in “extremely short supply,” according to Edwards.

“We saw natural gas prices spike severely up in that area last winter, electricity prices spiked because they couldn’t get enough gas to the area to where it was needed,” he said. Kinder Morgan Inc.’s announcement that it would move ahead with its Northeast Direct project will help alleviate some of the supply issues, and it and other proposed projects should find success in infrastructure expansion, he said.

Expansion of gas pipelines to Mexico is also required, and the willingness of the Mexican government to work with private U.S. companies makes this a compelling area of expansion, Molica said.

“The willingness of these Mexican governmental entities to take what looks to be essentially 100% of the capacity on the pipeline makes those projects pretty attractive,” he said. “You have an investment-grade counterparty ready to take 100% capacity on the pipeline into their country.

“So clearly, the Mexican government believes there’s a need for natural gas, and I think U.S. companies are more than willing to be partners on these projects and develop these pipelines into Mexico.”

In addition to piping North America, the oversupply of natural gas and NGL has created an energy future with a major export focus. The buildout to support that future is an enticing prospect for midstream operators.

How much is needed?

When it comes to infrastructure needs, “I’m more biased toward export markets as we have overshot indigenous demand, but even there we probably have too much supply relative to global needs, particularly as China softens,” Bellamy said. “With the exception of crude oil, which we still can’t export at least for the time being, I think we will saturate global markets in LPG and run up against crude-linked pricing and competition on LNG in the Pacific.

“Light processing of condensate looks like a lucrative but risky business with a binary future—you mint money now, but a change in crude oil export policy would gut the value of those assets overnight.

“Remarkable strides in U.S. E&P capital efficiency will lessen but at different rates for different basins. I expect U.S. producers to continue to do more with less, mainly because a lot of operators are scrambling to keep their jobs. Either they make up on volume some of what they have lost on price, or it’s hit the bricks,” he added.

Many operators are hoping to capitalize on the opportunity for export—likely more than export demand will actually support, according to Azure’s Kalamaras.

“I think what the industry is waiting to see to some extent are how many liquefaction facilities are you really going to get, and what that really looks like at the end of the day,” he said. “There are a number of development projects that have been announced but have not started yet, and some that have started are coming to completion, albeit slower than planned. Some of this is obvious from a gas perspective, because those liquefaction plants are happening.”

“The question is, how much of the transport market is really going to get utilized to dispatch those supplies?

That’s the question that is yet to be fully answered, and that will then dictate the natural gas side in the U.S., how much additional infrastructure is put into play to facilitate that international marketing.”

Staying upbeat

So what are good indicators that a company will remain in tune and play on while the downturn lasts? Generally, analysts and investors are looking back to the basics of the company when prognosticating likely outcomes.

In the midstream, it doesn’t get much more basic than pipelines, and Edwards said those assets are likely to help companies while prices remain pressured in the reality ahead.

“The assets that will hold up the best are more of your traditional long-haul pipelines,” he said. On the other hand, “the ones where you’ve got more commodity-type exposure, obviously margins have been pressured significantly, and those margins are going to continue to be pressured for some time.

Analysts at Deutsche Bank expanded further to include crude logistics assets, assets making up the NGL infrastructure chain and demand-driven assets. Meanwhile, assets feeling the most pressure will be those that are supply-driven and closer to the wellhead, like gathering and processing assets.

“We prefer companies with large sponsors that can help them not only finance or fund projects, but also support them from a volume standpoint,” Kazarian said.

Crude Export Ban Likely To Linger

In what could be a game changer for midstream in the U.S., momentum is growing in the U.S. Congress to lift the ban on exports of U.S. crude oil.

If and when the export ban is lifted, “that leads to another 2 million or 3 million barrels per day of production, and that would be a whole other level—and layer of infrastructure—that we would need to accommodate that,” Ethan Bellamy, senior research analyst at Robert W. Baird & Co. Inc., told Midstream Business. “The single best thing that could occur for the U.S. midstream business is the elimination of the crude export ban because it would absolutely ignite production, development,” Bellamy said. “I think we would see a short-term spike in WTI [West Texas Intermediate] toward Brent, but ultimately U.S. production growth would drag Brent down, benefitting the U.S. energy sector as it takes global market share through volumes while moderating global prices.

“I’m increasingly optimistic about this policy change, because which politician wants to fire U.S. oil and gas workers so that the Ayatollah Khamenei can fill his coffers? This would be a ludicrous and unsustainable policy outcome.” he added.

However, though there is talk of lifting the ban in both the House and Senate, “I’m hard pressed to see either chamber moving forward to make a legislative change at this time,” John Kneiss, Washington, D.C.-based director of Stratas Advisors, a Hart Energy company, told Midstream Business.

According to Kneiss, lifting of the ban faces two major obstacles for congressional approval:

First, “we still are, of course, a substantial importer of crude oil;” and

Second, “the underlying concern if such changes were adopted and turned into law, and there’s an increase for whatever reason in the price of [gasoline], elected officials don’t want to get the hit for that.”

“Longer term, as we move back to the normal for global crude markets, the next Congress—the 115th Congress—may look at it more closely,” Kneiss said, but he remains very doubtful that any changes will occur in the next 18 months. Supporters of lifting the ban “likely aren’t at a majority in the House at this point, though many members in the House would support it.”

While the prospect of lifting the ban is tantalizing, experts caution that other obstacles would arise with removal of the ban.

“When a lot of people look at it, they look at it on a siloed basis. I think instead there are a myriad of factors that actually impact policy and affect decision making,” Deutsche Bank AG analyst Kristina Kazarian told Midstream Business.

“One of the bigger things we need to think about is the Jones Act. If we lift the export ban but don’t change the regulations here, it would likely be cheaper to ship crude to Europe from the Gulf Coast than to the U.S. East Coast, which makes no sense as a U.S. government policy prescription,” she said. “We would need to make corrections for that, because, in theory, if we’re going to open this portion of the market, we should really open up the entire market.

“Further, there are other issues to consider such as pipeline permitting between the U.S. and Canada and renewable fuel blending requirements. Changing crude export policy on a standalone basis would clearly have broader consequences and in my view necessitate an overhaul of U.S. energy policies.”

It’s likely that if the export ban is lifted during the next few years, some midstream companies will be able to quickly reposition their current assets to get crude to export markets.

“I think there are a lot of companies who are positioning themselves such that they have assets in place that could be dedicated to that use if they get the clearance to do so,” Christopher Sighinolfi, senior vice president with Jefferies LLC, told Midstream Business. One such company is likely Enterprise Products Partners LP, he said.

Enterprise “was one of the early recipients of approval from the Commerce Department last year to export condensate, and they were doing that from the Gulf Coast,” Sighinolfi said. “If you look at an acquisition they made of Oiltanking … that company in a nutshell runs terminaling operations in the Gulf Coast that Enterprise was already utilizing as a customer, but by acquiring that company, now Enterprise can decide best use of those assets within the aggregate portfolio of things Enterprise operates in the Gulf Coast.

“So we take a look at that company, and this is sort of a microcosm of what you’re likely to see the effort to be from other companies.”