[Editor's note: A version of this story appears in the May 2018 edition of Oil and Gas Investor. Subscribe to the magazine here.]

When private equity (PE) wants to invest in your sector, you know you’ve moved up in priority on the logistics supply chain. No longer are you almost an afterthought, an unspoken sector where it’s assumed whatever’s necessary will “get done.” There’s always trucking, the traditional solution, but what happens if needs spiral upward?

Yes, we’re talking water, an area where water sourcing includes more recycling, and demands on handling produced water are rising to new orders of magnitude, according to some observers.

Often underestimated in energy production, water plays an important role. First, mainly freshwater is sourced and pumped downhole along with proppant in the hydraulic fracturing process. After the well is completed, a quantity of flowback water is then recovered. But of far greater consequence is the ongoing volume of produced water that accompanies oil and gas production over the life of a well.

Each Fountain Quail ROVER system is capable of recycling 10,000 bbl/d of clean brine.

The Permian Basin, expected to be by far the largest driver of U.S. production growth over the next several years, exemplifies the upward scale of opportunities unfolding in water management. As producers mostly move into full-field development, with pad drilling and batch completions, ramping production means wider sourcing of freshwater for fracking and, even more, mounting needs for water disposal.

Historically, water disposal was relatively straightforward, in that water could typically be reinjected into a play’s largely depleted conventional zones. However, reinjection of produced water is not feasible with the tight rock characteristics of unconventional reservoirs, which account for roughly two-thirds of Permian Basin production—and are expected to take an even greater share going forward.

Water-To-Oil Ratios

Produced water accompanies, of course, both conventional and unconventional production. The former generally has a produced water-to-oil ratio (WOR) of 12 or more barrels of water for each barrel of oil, more than twice that of unconventional wells. The latter have a significantly lower WOR, but absolute water volumes are much larger due to far greater well productivity and a rapidly rising well count.

What PE sponsors see unfolding is the sheer volume of water-related needs arising from this trend of increasing well productivity and well count in large-scale developments in the Permian Basin and other U.S. oil and gas plays. Add in an arid environment, as exists in the Permian, and the prospects are appealing for a variety of PE-backed projects across the water management sector.

“It’s unquestionably a growing market,” said Joel Fry, principal with Tailwater Capital LLC, which has backed Goodnight Midstream LLC with several rounds of private equity, including an $80-million commitment in 2016. Based in Dallas, Goodnight describes itself as an oilfield water midstream company. Its chief operations are in the Permian and Williston basins.

Obviously, any estimate of future needs for produced water disposal is tied to production levels and an assumption as to the blended average WOR for both conventional and unconventional sectors.

Taking the Permian as an example, the U.S. Energy Information Administration (EIA) said crude output topped 2.9 million barrels per day (MMbbl/d) in January. As for an average weighted WOR, if conventional production is conservatively given a 12:1 ratio (and weighted one-third of output), and unconventional production is given a 3:1 ratio (and weighted two-thirds of output), the estimated Permian WOR comes out to around 6:1.

“If you assume a water cut on those barrels of 6 to 1—sometimes more, sometimes less—that implies over 17 MMbbl of water that need to be handled daily,” said Fry. “And some projections call for that 2.9 MMbbl/d of crude output to increase to 5.5 MMbbl/d in the not-too-distant future. Apply any reasonable water cut to that projected level of production, and we feel confident that a very significant amount of water infrastructure must be built to accommodate the growth.

“I don’t believe all producers are fully prepared for the potential bottlenecks,” Fry continued. “A lack of water handling means a higher cost of production in the near term and, potentially, production being disrupted in the long-term if Permian infrastructure is not built out. Goodnight is looking to get in front of producer’s needs and help ensure that this doesn’t happen.”

Higher Ratios In Delaware

A research report by Credit Suisse estimated the average water cut in the Delaware Basin at 3:1. The southern Delaware is said to be wetter, at 3.5:1, while the northern Delaware is the opposite, at 2.5:1. Within the southern Delaware, the highest WOR is 4.8:1 in Culberson County, Texas, for wells in the sixth month of production. The Midland Basin is less differentiated, and less wet overall, at an average 2:1.

The Credit Suisse report predicted Permian crude production will rise by close to 700,000 bbl/d per year during 2018 to 2020. This is expected to result in a need for somewhat more than 2. MMbbl/d per year of incremental water disposal capacity. In turn, this translates into a need for roughly 120 incremental saltwater disposal (SWD) wells per year “at a cost of about $350 million, above the historical run rate.”

Measuring Permian disposal needs in terms of SWD wells reflects the many years in which the industry has relied largely on trucking to transport produced water to nearby, predominantly in-basin SWD wells. But recent trends have shown a growing use of pipeline infrastructure, which in some cases is designed to access SWD wells in the Central Basin Platform.

“Trucking will continue to play an integral role in water management,” said Fry. “But I believe the longer term, more cost-effective means to handle water is pipeline infrastructure. If you can provide a solution that both saves producers money and is more reliable, that’s a win-win strategy for midstream water businesses.”

Whether it is by truck or by pipeline, water management planning is gaining attention.

“I think producers are increasingly becoming more aware of solving produced water infrastructure needs upfront, but that’s been a very recent change,” observed Fry. “E&Ps have been intently focused on securing frack water and sand, but more attention needs to be paid to the infrastructure required to handle produced water. It’s critical if the industry is to hit its growth targets. And that infrastructure simply doesn’t exist today.”

Expenses incurred in handling produced water make up the largest component—about 40%—of total operating costs in the Delaware Basin, according to a review by Tailwater of more than 50 wells in the basin.

In addition to cost concerns, assuring production flows is a key factor as output ramps up in the basin.

“It’s fundamental to unconventional energy,” emphasized Fry. “For producers to earn their oil and gas revenue stream, they must have a water solution to ensure they can produce. We all need to consider what happens when the water comes out of the ground. My biggest question is: ‘At what point does it start to disrupt productivity?’”

Tailwater’s relationships with Goodnight—its sole platform in the water space—began as Goodnight was building a reputation for constructing best-in-class water pipeline systems in the Bakken Formation in North Dakota, according to Fry. With an established base of customers, plus positive referrals, Goodnight was able to expand and apply its knowledge base to the needs of clients in West Texas, according to Fry.

Long-Haul, High-Pressure Disposal Lines

Noteworthy are two recent pipeline projects underway by Goodnight. Both reflect, in part, producer unease over the possibility that traditional shallow SWD wells may communicate with productive oil and gas zones. These concerns have accelerated trends to drill more deep Ellenburger SWD wells or, in Goodnight’s case, to offer long-haul, high-pressure water disposal lines as an alternative.

A project with Callon Petroleum Co. (NYSE: CPE) involves building and operating a produced water pipeline that will connect operations in Ward County, Texas, to SWD wells in the Central Basin Platform. The shallow, porous, depleted formations in the CBP will “provide the ideal disposal reservoirs for the millions of barrels of salt water the Delaware Basin will produce in the decades to come,” according to Callon.

Also in the Delaware, Goodnight itself launched an open season for producers to enter into long-term contractual commitments for a high-pressure pipeline with an initial capacity of 200,000 bbl/d of water. The Llano Produced Water Pipeline, which is anchored by an unnamed key producer, will transport produced water from central Delaware to Goodnight’s SWD system in the Central Basin Platform.

The Llano project is due to be placed in service in the fourth quarter of this year. Multiple receipt points are planned along the route with each able to accept produced salt water of 50 psi. In the Eunice area of the Central Basin Platform, the Goodnight SWD system will “utilize the depleted oil fields on the Central Basin Platform as a superior geologic alternative for sustainable disposal of produced water into multiple formations,” said Goodnight.

“Goodnight is asking producers to commit to space on the Llano line and support the growth of this project as a more cost-effective alternative to trucking barrels out of New Mexico,” commented Fry. “Given the fact that the Ellenburger is not uniform across the Permian, Goodnight’s strategy has been to take the barrels away from producers’ oil wells and transport them to the CBP [Central Basin Platform].”

Third-Parties

According to Fry, an increasing number of producers are letting third parties handle their water issues.

“These producers are focused on drilling and producing tremendous oil and gas wellbores—that’s their core competency,” he observed. “As a result, opportunities are increasing for third parties to come in and take on the water management role.”

CSL Capital Management is a Houston-based private-equity sponsor focused primarily on the oilfield service sector. CSL was founded in 2008 by Charlie S. Leykum and provides growth capital to firms that operate in various segments of the oilfield service and equipment market, including proppant, pressure pumping and chemicals. Matthew Kondratowicz, a CSL managing director, joined the firm in 2011.

CSL provided an equity commitment in 2016 to Fountain Quail Water Management LLC, whose two main markets are the Marcellus-Utica and the Permian. More than 50% of its operations are in the Marcellus-Utica, according to Kondratowicz. Fountain Quail specializes in treating and recycling flowback water and produced water that is generated in oil and gas plays as well as logistics, disposal and water supply.

With a background in environmental services, Kondratowicz is quick to describe water management as a “very dynamic area” and one with sharp regional differences. Unlike the Permian, the Marcellus-Utica has the advantage of plentiful surface water but the challenges of a mountainous terrain. It also faces obstacles in terms of regulatory issues and more densely populated areas than in West Texas.

“Sourcing water is relatively easy; delivering it to the pad site is much more challenging,” said Kondratowicz, citing complicated geography, rolling hills and rights of way. In addition, the geology doesn’t lend itself to ease of wastewater disposal. Pennsylvania has only a handful of commercial SWD wells, and Ohio’s roughly 200 wells can accept produced water at rates of only 3,000 to 4,000 bbl/d vs. 15,000 to 25,000 bbl/d at a typical SWD in West Texas.

Fountain Quail’s operations in the Northeast tend to have “more of a full-cycle solution: deliver the water, treat the water, dispose of the wastewater,” according to Kondratowicz. “Our Northeast business does treatment and recycling, but also logistics for water supply via pipelines and water disposal by trucks. We do it all, because we can offer a differentiated position in all those service lines in the region.”

“Trucks Are The Pipeline”

Even in the water sector, regulatory and permitting procedures for pipelines can face lengthy delays.

“It is just as hard to build pipelines for water in the Northeast as it is for natural gas, so we like to say the ‘trucks are the pipeline,’” said Kondratowicz. “We operate a fleet of trucks up there, and we use more long-term contracts, more volume contracts, features that start to look more like a midstream-type business. If we can get trucking assets under a ‘midstream pipeline-type contract,’ it works.”

In addition, he indicated little sleep is lost over concerns that the trucking business may be displaced by pipes: “If you do the math, it can be two to three times more expensive per mile to build pipeline infrastructure in the Northeast vs. Texas or New Mexico.”

In the Permian, Fountain Quail’s business is focused heavily on treatment and recycling, and the company has been selective in the projects it pursues.

“While disposal wells may straddle the line between midstream and services, as a services-focused fund we at CSL have opted not to build pipeline infrastructure in the Permian, because then you’re building 20-year assets that are mostly valued on a yield basis,” said Kondratowicz. “Instead, we’ve gravitated to the treatment side, where we can partner with different parties developing infrastructure as the provider of the treatment portion of the project.”

The “All-Of-The-Above Solution”

In terms of handling produced water in the Permian, the challenge is “there’s a tremendous amount of water coming, and it’s going to require an ‘all-of-the-above’ solution,” said Kondratowicz. “Recycling is going to be part of it, and fixed infrastructure—pipelines to disposal wells—is going to be part of it. It may also mean pipelines to centralized treatment facilities, which we’ve also discussed with customers.”

As an example, he cited three large Permian operators whose collective water-handling needs come to about 2 MMbbl/d of produced water from “just one corner of the Delaware.”

With a typical water-hauling truck carrying 100 to 120 barrels, he continued, “There are not enough trucks in the U.S. Permian producers are all moving toward pipeline. And in the relatively flat, sparsely populated parts of West Texas and New Mexico, where there’s a pretty mature market as regards rights-of-way for infrastructure; that makes a tremendous amount of sense given such a concentrated resource.”

Kondratowicz noted that recycling is increasingly becoming standard in some parts of the oil patch. Recycling can address not only costs but also the issue of reliability of supply, he added. “If you think about the most expensive water for an E&P, it’s the water that doesn’t show up on time to complete a well. If you have a frack fleet and a couple of million pounds of sand waiting, and there’s no water to do anything, that’s a very expensive barrel.”

“Control Over Destiny” With Recycling

Securing water can in some cases entail operators having to source water from multiple different landowners. If a producer is able to supplement or meet a portion of its needs from its own produced water, the E&P “has some control over his own destiny by recycling,” Kondratowicz said. While recycling today typically accounts for only a modest amount of water needs, some operators target meeting 100% of their needs with recycled water within the next two years, he added.

Among services offered by Fountain Quail is its ROVER system, which is designed to recycle produced water into clean brine that can be reused in hydraulic fracking. In addition, the company has developed a suite of other treatment solutions that can provide basic on-the-fly treatment all the way up through high-level desalination that allows for surface-discharge-quality water.

“Fountain Quail offers a fleet of mobile treatment assets that basically follow the frack fleets and set up in an area where a customer has ongoing development,” he said. “They’ll set up there for anywhere from three months to a year and a half and will act as a recycler, pulling water from the produced water, flowback water and other sources. They work on providing the logistics: to aggregate, treat and return.

“These are not large centralized treatment assets; it’s really a frack-support type of service, where Fountain Quail’s main contact is the completions engineer. And at some point he’ll look at their development plan and say, ‘We need you guys to pick up and move 100 or 200 or 300 miles away and set up shop there for a period of time.’”

Not At A Transient Issue

Are there any short-term solutions to the challenges faced by the Permian in terms of water-handling?

“We don’t see the challenges related to water going away any time soon. It’s not a transient issue that’s going to be solved overnight,” commented Kondratowicz. “This is a space that is very much maturing and becoming central to planning as opposed to an afterthought. And that’s why there are opportunities today and will continue to be for many years.”

Gerrit Nicholas is a co-founder and a managing partner of New York-based Orion Energy Partners. The company focuses on middle market energy infrastructure businesses and recently agreed to provide a $75 million credit facility to fund an expansion of water infrastructure in the Permian Basin. In February, it closed its Orion Energy Credit Opportunities Fund II and now manages in excess of $1 billion of investable capital.

Orion Energy’s recent $75 million credit agreement was signed with Midland Basin Partners LLC (MBP), led by CEO Jason Roberts. The new facility is expected to help drive the expansion of MPB’s existing water supply platform in the Permian. MPB provides water sourcing—mainly brackish water for fracking—as well as transportation and storage solutions to producers operating in the Midland Basin.

“We’re a private-equity fund that invests in the form of debt as opposed to equity,” said Nicholas. “We like to make loans where we’re the only lender in the capital structure, and so we rarely lend with anyone in front of us. We make senior secured loans. Depending on the underlying quality of the collateral, we may also want to ‘stretch’ and do what we call a stretch senior, where you might add a mezzanine component.”

The funding offered by Orion Energy is often suited to companies that have yet to gain scale and enjoy established lending arrangements, according to Nicholas.

“It’s generally the case that there aren’t a lot of lending options when we’re being considered,” he said. “We tend to compete against equity investors as opposed to other lenders. We’re generally a lot less expensive—meaning less dilutive and less controlling—than a typical PE investor would be, and that’s what makes our capital attractive.”

Less Dilutive And Controlling Capital

With a senior secured position, including hard assets as collateral, Orion Energy targets “low- to mid-teens returns,” made up by a cash coupon enhanced by some form of equity kicker to boost overall returns when upside is realized in an investment.

Working on sourcing freshwater for fracking, MBP has been “very successful in entering into land agreements for surface rights so they can be the go-to supplier of water if producers, including many of the majors, aren’t interested in doing it themselves,” said Nicholas. Payback on building wells and pipes to deliver water is often “very quick—measured in a few years.”

Orion Energy’s recent agreement with MBP is its second deal in the water management sector, following a 2017 agreement to fund $100 million to Produced Water Transfer (PWT) in the Haynesville/Cotton Valley. But whereas MBP is focused on supplying brackish water for fracking, PWT is focused on the disposal of produced water and flowback water.

Does Orion Energy have an appetite for further investments?

“We absolutely have interest in getting deeper into the space,” said Nicholas. “Given our current views on the U.S. water sector, we’re looking for a number of opportunities with PWT, both in the form of new developments and acquisitions. And the same goes for MBP on the supplied water side. They’re getting opportunities all the time to expand and acquire or merger, and we are their capital provider.”

Chris Sheehan can be reached at csheehan@hartenergy.com.

[Sidebar Story]

Third-Party Migration

“The water business is growing much more rapidly than any other part of the midstream,” said David N. Capobianco, CEO and managing partner at Five Point Capital Partners. Five Point has midstream water operations in the northern and southern Delaware Basin, as well as in the Eagle Ford and in the Arkoma. WaterBridge is its pure-play water midstream operation, but several other of its midstream portfolio companies have oil, gas and water operations.

“Three pipes in a ditch is the way all midstream development will be done from now on,” Capobianco said, “but there still remains a meaningful transition from spot market water handling to permanent water management infrastructure. For the past few years producers have been like race cars speeding around a race track toward a wall at the end of the track. They have known the wall was there, but had no strategy relative to what they were going to do when they got there. ... but now it is in sight. The wall is the mass water management challenge they face as they ramp up production. We have crossed the tipping point, or the moment when the need for a permanent solution is no longer a luxury but a necessity.”

In many ways the development of the water segment of the midstream is following the path of the hydrocarbon midstream. “Originally, producers built out their own infrastructure, and later divested,” Capobianco noted. “Over time, I would expect that the lion’s share of water management infrastructure will be owned by independent third-party companies.”

Capobianco reckons that within a few years “almost all midstream operators will have water operations of some kind. It will be impossible to avoid if you are a midstream business.” The form the water midstream will ultimately take remains unclear. “It could end up like a utility, with large companies managing an array of local operations,” Capobianco said. “There is not really an existing model. Unlike oil and gas, the water molecules are not going to move very far.”

—Gregory DL Morris

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