The 2021 Midstream Outlook

[Editor's note: A version of this story appears in the December 2020 edition of Midstream Business. Subscribe to the magazine here.]   

What a tumultuous year it was. Between an oil price crash, COVID-19 demand destruction and the change in the executive branch, the outlook for oil and gas has been reset in many cases. While much has been published and discussed about the upstream and downstream sectors, what awaits the U.S. midstream sector in 2021 and beyond?

Often on the front lines of environmental strife in the public eye due to high-profile pipeline projects—Keystone XL is about to take center stage—midstream has often proved resilient to changes in the political, social and economic landscapes. In many cases, it is positioned well to take advantage of new opportunities in the energy transition.

To get a better sense of what lies ahead for midstreamers, we went right to the source. Midstream Business held a virtual roundtable with three industry insiders—GPA Midstream president and CEO Joel Moxley, GPA Midstream’s vice president of government affairs Matt Hite and East Daley Capital managing director Ethan Bellamy—who provided answers.

Midstream Business: How will the energy transition affect midstream in particular?

Joel Moxley: The energy transition will certainly impact the midstream industry—the question is when?

Our assets and people have decades of experience and drive to adapt to changing times. We have converted gas pipelines to oil pipelines, retooled import terminals to export terminals, shifted whole plants from one part of the country to another—whatever it takes to serve suppliers and markets.

I am confident that our companies will be ready to transport renewable natural gas and hydrogen if those supplies grow to material levels. Midstream has decades of experience removing and handling carbon dioxide, so we are a natural fit if that matures as a need.

We will continue to reduce our consumption of energy and emissions of greenhouse gases to do our part to decrease our impact on the environment. But all this will have to be done in a way that creates economic value for our customers, owners and employees. I have no doubt that we will be ready when the opportunities arise.

Ethan Bellamy: Thus far, the U.S. has led the world in decarbonization, led by a potent combination of cheap natural gas from fracking and renewables. But natural gas has gone from partner to villain for environmentalists in the last decade, despite displacing coal in reliable baseload power.

The next round of decarbonization in the power sector won’t be nearly as cheap or easy, and carbon ideologues will be hard pressed to defend the Californication of the electric grid with intermittent power generation that requires offsetting capacity, expensive storage and/or power rationing. The incremental marginal kilowatt of renewable penetration will make grid management more and more challenging even with major new infrastructure spending.

Against this backdrop, with the notable exception of Texas, long-haul pipelines have run headlong into opposition. And the opposition is winning as we saw with the cancellation of the Atlantic Coast Pipeline, ongoing threats to Dakota Access and the struggle for Mountain Valley Pipeline (MVP) to complete its last 8% of mileage, among others. Without new capacity into the Northeast demand centers, that region should expect power costs to accelerate. We’ve already seen spiking natural gas prices in the winter on supply constraints, and those likely accelerate. The dirty secret in Boston, for example, is that constrained gas supplies lead to oil-fired peak generation and imported Russian LNG to satisfy demand in the coldest months. These perverse energy policy outcomes create a dirtier and more costly energy supply as ideology rather than rationality drives supply planning.

In the short- and medium-term, the opposition to new pipe may actually improve the financial health of midstream. As astute industry observers such as Simon Lack have opined, regulatory prohibitions gate capital expenditures, which reinforce the value of steel in the ground and increase free cash flow. The Marcellus-Utica appears to be headed for material constraints, which will reinforce the value of egress capacity, creating haves and have-nots in gas producers that committed or avoided firm transportation. If MVP gets blocked, we expect to see strong differential problems that likely persist into perpetuity.

In the long term, you can’t run a renewable hydrogen or renewable ammonia economy or seriously attempt carbon capture without pipelines. While not quite as versatile as railroads, pipelines remain the cheapest means of moving a ton of bulk freight.

We think the ultimate irony could come as pipeline opponents realize that to get, for example, wind-based renewable hydrogen from windmill country to cities, you’ll need the midstream. There’s a lot of simple-minded, first-order thinking going on, but not much long-term, real-world planning.

Midstream Business: What is the outlook for construction projects in 2021? Will FIDs continue to be put off, and is COVID-19 the culprit for lower expectations for demand?

Moxley: Based on recent comments from several public companies, the decrease in demand caused by COVID-19 has slowed growth projects for the next few months, perhaps into late 2021.

Bellamy: Under certain scenarios, we see a need in a few years for more gas-related infrastructure in and flowing from the Permian Basin. While there’s the need for new egress out of the Marcellus-Utica, the opposition is too great to surmount. In almost every other basin, across all three hydrocarbon streams, we see an excess of capacity.

COVID-19 is [causing] lower demand. As long as viral spread prevents air travel, jet fuel demand will remain suppressed, leaving oil prices lower.

Natural gas will benefit relatively as associated gas production declines, tightening the market, and as the call on U.S. LNG from world markets grows.

Generally speaking, with these notable exceptions, belt tightening will continue, as it should. But be on the lookout for a shift in oil demand when and if a vaccine is widely distributed allowing an exit from pandemic restrictions. If we suppress the virus and certify travel, I’d expect a surge in pent-up demand. The world is going to party when we get COVID-19 under control.

Midstream Business: With an ongoing shift toward cleaner fuels, will gas pipeline projects be looked on more favorably by a Biden administration?

Matt Hite: If the incoming Biden administration stays committed to their policy goals to accelerate the transition to renewable energy, they will likely reverse the Trump administration’s easing of rules to streamline the approval of new pipeline projects and permitting times may increase. These actions could even extend to additional review of pipelines that are already in construction or built.

This would be disappointing from an environmental perspective because the increased use of natural gas has contributed to a significant decrease in greenhouse-gas emissions over the past decade as the U.S. has developed its significant shale resources. In an odd way, increased approval times for gas pipeline projects could even slow the reduction in greenhouse-gas emissions in the future.

Bellamy: We have an ongoing debate internally, but my view is that fossil fuels will be assaulted in a roundabout manner. We won’t see a fracking ban, but we will see a death by a thousand cuts approach. For example, sand in the gears of BLM [Bureau of Land Management] permitting, a tougher approach to EIS [environmental impact statement] approval at the Army Corps, a potential lease ban on federal lands, methane regulations, a FERC that incorporates life-cycle GHGs into certification, cessation of presidential cross border permits (KXL), ramping of ESG pressure on the financial community, and increased state and local level opposition to development, transportation and consumption of fossil fuels.

From an actuarial standpoint, there’s some chance that Biden may not complete his term. A President Harris approach could usher in a much more radical view. Lastly, we still don’t know if we will have a balanced government. If the Democrats take the Georgia senate seats, we could see some extraordinary leftward shifts in energy policy.

Midstream Business: What will potential changes at FERC, Army Corps of Engineers and other regulatory bodies mean for pipelines in particular but also all of midstream?

Hite: The change of administration in the executive branch will bring new leadership to all of the federal agencies that impact midstream. While nominating and confirming new leaders will take time to accomplish, these new political appointees will be charged with implementing the president’s policies and goals.

Since one of President-elect Biden’s key policy goals is to accelerate the use of renewable energy and move away from fuels like natural gas, we can assume that all of the federal regulatory agencies will work together to achieve that objective. Current rules will be reassessed through a new political lens, which will mean that midstream operators will have to adapt to this
new reality.

It doesn’t mean that everything will be shut down; midstream companies have a long history of adjusting to change and moving forward.

Bellamy: Opposition equals oligopoly reinforcement. U.S. production will increasingly focus on exports to developing economies. In general, costs are going up, greenfield projects will become harder if not impossible to sanction, and the table stakes on operating and development are rising.

If you want to play the oil and gas game, you better come with a big stack and some good lawyers. 

Midstream Business: Are MLPs on the verge of being hip again?

Bellamy: Absolutely not. The MLP structure once had promise, but it was squandered by governance failures that awarded general partners at the expense of limited partners. There’s a great scene in the movie ‘Margin Call’ where a character played by Jeremy Irons talks about ‘fat cats and starving dogs.’ That sums it up.

There are some exceptions such as Magellan and Enterprise, but if you stuck around as a limited partner through the payout of incentive distribution rights through the top splits, then to the high-priced buyout of those rights, then onto the distribution cuts that followed, you got hosed, usually at the expense of the GPs.

This result has soured so many individual investors that it will take years of better performance to wash off the disappointment.

Of the three big remaining partnerships, Magellan is most likely to convert to a C-corporation. Insider control of both Enterprise and Energy Transfer limits the probability of a conversion. Although of those two, Enterprise may be more likely. We don’t see Kelcy Warren ever giving up the keys to the kingdom.

The industry also has some really dumb metrics—distributable cash flow and maintenance capital expenditures—that need to be put down with prejudice. These MLP legacy line items mislead investors about sustainability, because capex can be bucketed differently depending on market conditions. What was an expansion dollar yesterday becomes a maintenance dollar today if the market nose-dives.

It’s effectively a pro-cyclical indicator in an industry that strongly needs, but almost never has, countercyclical risk management. We need to use GAAP-based earnings and free cash flow and stop dangling unsustainable dividend payouts based on financial alchemy. You can’t turn lead into gold, and you can’t turn fictitious cash flow into credible dividends.

Moxley: Mr. Biden has pledged to undo many of the Trump tax cuts, one of which would increase corporate taxes for corporations from 21% back to 28%. If this happens (and there’s no guarantee that Mr. Biden will have the political clout to pull it off), MLPs would be relatively more attractive from a tax perspective. It’s unclear whether this advantage alone would be enough to bring MLPs back to ‘being hip.’

I think the companies that are MLPs today are comfortable with their structure as are their investors. Maybe some new entrants around renewable energy or emissions reduction will investigate using a MLP structure if the tax laws allow it. However, I think the firms that have converted from MLPs are pleased with their decisions, and they are looking forward, not to the past.

Midstream Business: What do you see in terms of M&A in the midstream space in the near to medium term?

Moxley: I think midstream management teams are always willing to listen to M&A opportunities. Talking about midstream M&A is easy, actually doing it is much harder.

The recent wave of upstream mergers has largely been done with stock-for-stock transaction with little to no cash being used to make the values work. Upstream companies are keeping their cash in their rainy-day funds because the future is relatively uncertain in the short term. The overwhelming driver for the combinations to date seems to be operating efficiencies and reductions in G&A expenses.

I believe public midstream companies could use the same mechanism if the parties can agree on value, which is of course the hard thing to do in this environment. Value discussions are very dependent on coming to a common vision of the future—for volumes to grow, for prices to improve, for regulatory/political changes to happen, etc. This work can happen, but both the acquiror and acquiree must be very motivated to get this done; it might take outside influences such as activist investors to
get the process started.

Of course, M&A for public companies can also mean divestments of noncore assets. There are several notable options being considered as companies look to improve their balance sheets by reducing leverage through asset sales. In the near term, public companies will likely get more support for balance sheet work than growth through M&A.

M&A in the private company space is just as difficult to achieve. The near-term outlook for midstream asset values would seem to be well below what they were 12 to 24 months ago. Are the owners and management teams of these companies ready to sell at these depressed values? I think likely not until at least the second half of 2021 unless there is some other factor to push the decision to exit.

Activity should pick up when the financial outlook for the midstream space [and] when demand for natural gas, NGL and crude oil returns as the U.S. sees the end of the pandemic, which we all hope is very soon.

It’s necessary but bid-ask remains too wide because of commodity volatility, valuation mismatches, private-equity sponsors underwater that don’t want to book a loss, and structural disincentives to disgorge assets.

Historically, midstream companies have just kept getting bigger. It will take time to convince management to give up their seats, if at all. Nobody wants to be the chump who sold at the bottom. And PE [private-equity] firms don’t want to mark to market an asset via a transaction that need not occur.

We work constantly to identify noncore assets, and there are billions of dollars of assets that industrial logic suggests should find new ownership. But that lens doesn’t capture the most important element—the human element. Personal incentives drive
M&A, best exemplified by the enormous change of control payouts we’ve seen in E&P mergers.

If conditions ripen—higher oil prices, contango, a COVID-19 vaccine—we could see activity pickup. We saw some greenshoots lately with the $2.7 billion Riverstone IMTT acquisition. That’s encouraging, but I’m not holding my breath.

Editor’s note: This roundtable interview took place the week of Nov. 9, 2020.