Analysts’ Midyear Outlook

The U.S. energy infrastructure sector has undergone a major paradigm shift—and that’s a good thing, say energy analysts. Historically, infrastructure has been the less exciting, slower-growth aspect of the oil and gas industry because conventional basins have been so well known. The pathways to markets were established and built out quite some time ago.

Today, new unconventional resources have risen to the fore as recent technological advances change the plays’ economics. As recently as three years ago, some of the basins were completely unforeseen. Now, companies that build pipelines, processing plants and storage facilities to support new fields find themselves with a full plate of opportunities.

Yet, during the buildout, some missteps are likely to occur, say industry analysts who closely watch the sector. Although tens of billions of dollars are likely to continue to flow to infrastructure, some operators’ execution plans could be mishandled, either by overpaying for pipelines or by getting caught up in bidding wars for projects, which would reduce returns to investors.

Also, while the overall midstream sector continues to look promising, the playing field is somewhat uneven. For example, storage operators are not as likely to see the same growth potential as gas processors and liquids transporters. During the past ten years, the energy industry saw a massive storage buildout, particularly along the Texas and Louisiana Gulf Coast, and the demand for new storage has fallen. Previously, gas storage was used to smooth out the highs and lows of gas exploration and production. Now, because unconventional developments exhibit lower exploratory risk, the demand for that economic mechanism has lessened. Supply can be turned on at will, and demand is easier to forecast.

Pipeline buildouts, on the other hand, are booming. Both newbuilds and expansions are in play. The heavy emphasis is, and will continue to be, focused on oil and natural gas liquids (NGLs) transportation—for two reasons. First, the U.S. experienced a major gas-pipeline buildout from 2004 through 2008, which somewhat diminishes the current demand for long-haul gas infrastructure.

Second, and until recently, the directional flows of oil, NGLs and petrochemical products had not changed for decades. Declining liquids supplies from production basins were delivered into the same set of decades-old refineries and petrochemical complexes and, because no significant refineries have been built since the 1970s, the infrastructure layout was fairly stagnant.

But that has changed. Unconventional plays are giving up increasing amounts of liquids. The Bakken play of North Dakota, new developments in the Rocky Mountains, the reemergence of the Permian Basin and the excitement of the Eagle Ford are driving the growth of new liquids supplies in places where they had been declining and where there is no endemic demand. In fact, as new liquids lines are built, some small liquids-storage facilities will be required at origin and destination points, prompting at least some lift to the liquids-storage sector.

Meanwhile, there is no doubt that gas processors are in the limelight. Many operators have announced new plans for processing capacity to remove liquids from rich-gas streams to meet pipeline specifications and, just as importantly, to serve the petrochemical communities’ growing appetite for less-expensive NGLs for feedstock.

The disconnect between natural gas and oil prices, sometimes as high as 22 to 1, has encouraged petrochemical producers to switch from oil derivatives (naphtha or gas oil) to more economical NGLs (especially ethane). Consequently utilization of gas-processing assets has increased. Forward-strip prices indicate that the differential between crude and natural gas prices will persist, thus driving more processing capacity buildouts with little risk for the near-term.

However, while a significant portion of processing investment is targeted to areas with an obvious lack of capacity, the danger of an overbuild looms on the mid-term horizon if buildout exuberance continues to run unchecked.

Overall, the midstream future looks bright, say industry analysts, despite various regulatory, environmental and tax-code challenges. Most obstacles can and will be overcome as energy transportation remains a small cost of the overall energy matrix with considerably inelastic demand.

KAYNE ANDERSON

Recapping the first half of 2011, the pipeline master limited partnership (MLP) sector began the year with “plenty of momentum,” says David LaBonte, senior analyst and partner for Kayne Anderson Capital Advisors LP.

“The Alerian MLP Index posted total returns of 62% and 27% in each of the past two calendar years,” says LaBonte. “Through the first four months of 2011, the index delivered a 7% price return, and then hit its all-time high, on April 28, of 390.”

“Our analysis indicates that MLPs should be able to achieve distribution growth of 6% annually for the foreseeable future.” --David LaBonte, senior analyst and partner, Kayne Anderson Capital Advisors LP.

Yet, May saw a selloff of equity in the sector, although the sell off “does not suggest a change in the positive underlying fundamentals” of the sector, LaBonte says. The three main drivers to the selloff were falling commodity prices, fears of a change in taxation and dividend cash or trades.

Commodity prices fell amidst concerns of a global economic slowdown, which triggered a broad-based energy selloff. A correction in commodity prices followed. For example, West Texas Intermediate oil price peaked on April 29 at about $114 per barrel, then slipped to about 14% to $98 per barrel, due to easing tensions in the Middle East and a strengthening dollar.

Meanwhile, fears of changes to the energy tax code, especially concerns of new taxes for partnerships and limited liability companies, have had detrimental effects on the sector. Specifically, the U.S. treasury department is considering a reform proposal to begin to tax partnerships with more than $50 million in annual revenue, although such a change would be difficult to achieve before the 2012 elections, says LaBonte.

In May, the sector saw increased activity in dividend cash and trades. “The month following quarter-end tends to be the strongest,” explains LaBonte. “This is due to MLPs declaring distributions and investors and competitors buying up MLPs in advance. Therefore, January, April, July and October tend to have the strongest returns. The months that follow, such as May, generally exhibit a reversal of that dividend cash or trade.”

Overall, the sell-off in May made MLPs appear cheap, with the average yield trading up to 6.5% from 5.9%, which, LaBonte says, represented a good buying opportunity.

“The primary drivers of growth for the midstream sector are new expansions and green-field projects that support the development of unconventional resources and the petrochemical industry’s preference to use more natural gas feedstocks, at the expense of gas oil and naphtha, for ethylene production. Our analysis indicates that MLPs should be able to achieve distribution growth of 6% annually for the foreseeable future.”

U.S. BANK

The commercial debt market agrees. “In our view, the outlook is very positive for the midstream sector,” says Mark Thompson, senior vice president and division manager for the Energy Industry Division of U.S. Bank. “There is a tremendous need for infrastructure around the active oil and gas development plays. In fact, we believe the small, private-equity-backed midstream companies will be the major beneficiaries of the recent activity.”

Gathering and processing companies will be the big winners, he says, and less so for storage companies. “We really have not seen much activity during the past two years in the building of new storage capacity. But we are seeing a lot of activity among the greenfield gathering and processing projects.”

“Many small midstream companies follow the same build-and-flip model that we’ve seen in small, equity-backed producers.” --Mark Thompson, senior vice president and division manager, Energy Industry Division, U.S. Bank

Despite the uneven distribution of opportunities, Thompson doesn’t see any general slowdown of activity ahead. “We are watching a number of companies gearing up to build new or expanded midstream projects,” he says. “The companies are following the new plays, particularly the Bakken, where casinghead gas-gathering systems need to be built to gather the gas from new oil-development areas, and in the Eagle Ford play, where producers are exploiting the liquids-rich gas envelope.”

Recently, in the Northeast, U.S. Bank participated in a deal with Caiman Energy LLC, supporting its active buildout project in the Marcellus shale play. “We are seeing a lot of midstream development there, in both the dry- and wet-gas areas,” he says.

Also, although the bank hasn’t seen new opportunities recently to participate in development of the Haynesville, Fayetteville, Barnett or Woodford shales, it has watched many midstream companies embark on new in-fill projects and some consolidation in those plays.

“Many small midstream companies follow the same build-and-flip model that we’ve seen in small, equity-backed producers,” he says. “Because of their agility, equity-backing and access to bank capital, they can negotiate producers’ contracts, assemble the necessary rights-of-way and materials, build their systems and get them up and running rapidly, and then sell them to larger companies down the road.

“Of course, the big guys like DCP Midstream Partners LP, Kinder Morgan Energy Partners LP, Energy Transfer Partners LP, Enterprise Products Partners LP and Williams Cos. Inc. have been very active as well, but we have noticed that many independent producers tend to prefer to deal with independent midstream operators,” he says.

Growth drivers

Thompson lists the growth drivers of new projects as the availability of private-equity and bank capital, high-yield debt, good projects and strong management teams. Yet, such fertile grounds can be spoiled by low gas prices and a reluctant demand market that will not justify producer activity, he says.

“One of the challenges in some of these areas like the Marcellus is the impending oversupply of ethane. Petrochemical activity is fairly weak and is almost non-existent in that part of the country. That’s certainly a well-publicized situation, but we can see a scenario where gas liquids produced in the Bakken and Eagle Ford could also struggle to find a home. That would adversely impact liquids prices and those plays.”

Favorite names

Some of Thompson’s favorite names in the investment-grade space include DCP Midstream, Energy Transfer, Kinder Morgan and Williams, due to their dominant positions in their areas. “We also like private-equity backed companies with quality projects like Caiman Energy in the Marcellus, Bear Tracker Energy LLC and Hiland Operating LLC in the Bakken, and Arrowhead Pipeline LP and Southcross Energy LLC in the Eagle Ford.”

“Also, one of the things we’ve notice is that, since the SemGroup Corp. collapse in 2008, a number of banks have really de-emphasized, or even exited, the midstream segment,” he observes. However, Thompson says U.S. Bank recognizes the SemGroup event “for what it was” and continues to focus on midstream by committing about 25% of its energy portfolio to the sector. The remaining 75% is devoted to independent exploration and production companies.

WELLS FARGO SECURITIES

Michael Blum, energy analyst for Wells Fargo Securities LLC also has a positive outlook for the midstream industry, and with good reason, he says.

“The fundamentals for most midstream companies are excellent right now. High crude oil prices and new technologies are opening up a whole new set of domestic oil shale resources in areas with inadequate infrastructure. This is creating a tremendous opportunity for new investments to build gathering lines, pipelines and storage to handle new supply from emerging shales such as the Eagle Ford in South Texas, the Bakken in North Dakota and an old but re-invigorated field, the Permian Basin in West Texas.”

The wide differential between crude oil and natural gas prices has caused a structural shift in the U.S. NGLs markets, he says, with the petrochemical industry consuming ever greater amounts of ethane and propane at the expense of naphtha, an oil-derived product. Because U.S natural gas prices are so low, relative to crude, the U.S. now has world’s third cheapest feedstock for ethylene, making its exports competitive globally.

“We’re forecasting annual growth-capital investment, by the MLP sector as a whole, of $15 billion in 2011 and an average of $10 billion annually through 2014.” --Michael Blum, energy analyst, Wells Fargo Securities LLC

“And several petrochemical companies have made announcements about adding new plants on the Gulf Coast, which would add to total NGL demand,” he points out. “For midstream players, processors, NGL-pipeline providers and fractionation owners, there’s been a tremendous increase in demand for these midstream services and we see this continuing for some time.”

From Blum’s view, the one area of midstream that looks to be weak for some time is natural gas. Because the U.S. is oversupplied with natural gas, and because it has added so much new pipeline and storage capacity across the country, the nation has largely eliminated the bottlenecks in its supply, causing basis differentials to collapse, seasonal storage spreads to narrow and volatility to decrease.

“This has put pressure on natural gas pipeline and storage earnings and we don’t see that reversing anytime soon,” he says.

Yet, the relative strength and weakness is “product specific” and “very regional and location specific” he observes. For pipelines tied to strong areas of demand like the Southeast, or connected to growing supply basins like the Marcellus shale, the outlook is good. The same is true for processors in areas with NGL rich production with active fields. But for pipelines tied to areas of conventional production or processors in dry gas areas, his outlook is less positive.

Is there a slowdown ahead? “We don’t really see a slowdown in the sector for the foreseeable future,” says Blum. “As an example, we’re forecasting annual growth-capital investment, by the MLP sector as a whole, of $15 billion in 2011 and an average of $10 billion annually through 2014. And those numbers are likely to grow. Once this new wave of oil and NGL shales are developed, we could see things slow down a bit, but that’s a number of years down the road.”

Growth drivers

Blum sees the main driver of growth as the development of new shales for oil and NGLs, evidenced by acquisition activity as the oil majors divest midstream assets and E&P independents look to monetize their midstream assets to re-deploy into shale development.

Yet, a shift in commodity prices could alter the growth trajectory, he warns. “If the spread between crude and natural gas prices narrowed, this would impact the demand for NGLs, for example. Another risk we see is regulatory—as several proposals out there could slow the pace of drilling development.”

Favorite names

Blum’s favorite names in the space include Enterprise Products Partners. “It has a leading position in Mont Belvieu, the hub for NGLs, and a superior asset base tied to most of the major NGL supply regions in the country. Cash flows are primarily fee-based, and growth is visible. Enterprise is spending $5 billion over the next two years on infrastructure projects tied to NGL development.”

El Paso Pipeline Partners makes his list as well. “The El Paso pipelines are all under long-term contracts in premium markets like the Southeast. And there’s visible growth tied to El Paso Corp., the parent company, which is moving its pipeline assets to the MLP over time. We're forecasting a three-year compounded annual growth rate in the distribution of 15%.”

Blum also highlights Buckeye Partners, a refined-products pipeline and storage operator. The business generates mostly fee-based cash flows so it’s low risk, he says, and there’s visible growth in the distribution because Buckeye is benefitting from increasing storage demand and acquisition opportunities.

STANDARD & POOR’S

William Ferara, director of the integrated gas team for Standard & Poor’s (S&P), characterizes his outlook for the midstream sector as “stable to slightly positive.” About 75% of S&P-rated companies are listed as stable.

On the positive side, Ferara lists strong NGL and crude prices as support for the midstream industry, but the optimism is offset by an “absolute level” of low natural gas prices and basis spreads.

And more conflicting factors are and will be affecting the sector, he says. “Overall demand is relatively flat throughout the sector in a somewhat stagnant economy,” he observes. “But the external financing conditions are strong, both on the equity and credit sides, and the interest rate environment in which the companies are borrowing is very favorable. Liquidity is generally adequate.”

“The uptick in capital spending is focused on the shale plays. Attractive debt financing rates are helpful.” --William Ferara, director of the integrated gas team, Standard & Poor’s

Ferara sees companies increasing the size of their capital-spending profiles, “which give us some pause,” he says, because that capital will be spent in the near term although cash flows won’t be received until projects are completed.

Nonetheless, S&P has seen the sector’s credit metrics improve during the past year because cash flows from projects completed in 2007 through 2009, when market conditions were more favorable, have increased, he says. The projects include the Rockies Express Pipeline, the Midcontinent Express and a handful of others. “The uptick in capital spending is focused on the shale plays. Attractive debt financing rates are helpful.”

Growth drivers

The growth outlook is strongest for gas processing operators, says Ferara, due to the strong NGL environment. “Processing volumes are somewhat favorable, but it is basin-dependent. So processors in wet-gas basins are viewed more favorably.”

S&P’s outlook for gas pipelines is driven by regional basis spreads, volumes for power generation and home-heating demand. Yet, due to the stagnant economy, Ferara has not seen material changes in total volumes.

“Regarding power-generation demand, there are very high reserve margins throughout most of the U.S., so we are not seeing a material increase in gas-fired power-generation demand. That will be driven by a turnaround of the economy.”

Conversely, Ferara has seen a recent recovery in the demand for refined products. “But that pick up is working off a base from a few years ago when demand fell off due to the economy. It is not quite back up to the levels of five years ago.”