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After a long hiatus, investors are returning once again to the midstream sector.
In a difficult year for markets, the Alerian Midstream Index (AMNA) in 2022 was up 32.9% as of Oct. 31, compared to a 17.7% decline in the S&P 500 over the same period. The gains follow years of underperformance by midstream. But turbulent macroeconomic conditions, including soaring inflation and a hawkish Federal Reserve, have investors looking for safe havens. In many respects, midstream fits the bill. Just look at the average 6.07% yield for companies in the AMNA index, more than triple the return demanded by investors in the typical S&P 500 company (see Figure 2).
Midstream is the focus of East Daley Analytics, and we see exciting opportunities on the horizon. The Russia-Ukraine war has boosted global demand for U.S. energy products while helping solidify political consensus around the primacy of energy security. Midstream also has a critical role to play in the energy transition; infrastructure will be needed to move products such as hydrogen and renewable fuels or to capture and transport CO₂ emissions for burial underground.
Yet viewed a different way, the relatively high yield for midstream companies also reflects hesitation by investors. Recent market history likely colors their perception. Midstream overbuilt through prior commodity cycles, leaving companies highly levered when oil prices fell in 2015 to 2016 and 2020. This debt has dragged on sector performance when commodity prices have rebounded. While we see a growth story ahead for midstream, the market seems to lack conviction.
Another factor that potentially inhibits investment is the complexity of the midstream business. Something as simple as the rates that companies charge for services can be complicated by a high degree of opaqueness.
While investors can readily follow fluctuations in commodity prices, these price changes often don’t correspond to the rates charged by midstream operators. Gathering and processing (G&P) assets in particular are a locked vault when investors try to assess future cash flow. Since most G&P systems don’t cross state lines, they aren’t subject to federal oversight. This results in fewer disclosures on volumes, rates and performance compared to other assets, such as interstate pipelines. G&P system operators also rely on bilateral contracting with producers and use varied structures to set rates. These factors make apples-to-apples comparisons of assets difficult.
“Rising oil and gas prices is good for midstream” is a common investor axiom, yet only certain G&P systems directly benefit from higher commodity prices via percent-of-proceeds (POP) or percent-of-liquids (POL) contracts. Lower confidence in future cash flow results in a higher discount demanded by investors for capital provided to midstream companies.
Wide variance in service rates
To bring greater transparency to markets, East Daley Analytics is undertaking a broad study of G&P system rates. We maintain asset-level financial models for over 1,000 assets owned by public companies. From this asset pool, we’ve identified 200-plus G&P systems for which we can confidently assess rates. We’ve created a G&P rate methodology based off our balanced public asset models. Using first-quarter 2022 (1Q22) results, we can calculate an average G&P rate for these systems.
Gross margin/volume = blended rate ($/Mcf)
Our investigation finds wide variance in the G&P rates assessed from basin to basin. Figure 3 presents estimated 1Q22 G&P rates in basins targeted for liquids. On the high side is the Denver-Julesburg (D-J) Basin, where operators received an average of $2.59/Mcf for G&P services in 1Q22. On the low side is the Anadarko Basin, where we calculate an average $0.74/Mcf rate for G&P services. In other words, producers in the D-J in eastern Colorado paid 250% more on average for midstream services than their counterparts in Oklahoma, just one state over.
What can explain these huge differences in midstream service costs? Several factors influence G&P rates. Barriers to entry is one factor that can limit the amount of competition for midstream services within a basin. In the D-J Basin, two companies, DCP Midstream and Western Midstream, are the dominant providers of G&P services, while basins such as the Permian and Anadarko have dozens of companies competing for business.
A second factor is the relative sophistication of producer counterparties. If midstream service costs trend too high in a basin, well-capitalized operators (ie, majors and large independents) may opt to build their own gathering systems.
A third factor is the dominant contract structures (ie, postage rates versus POP contracts) used in a basin, which can influence G&P rates when commodity prices are unusually high or low.
Nevertheless, it is easy to see why investors would need to tread carefully when putting money to work in Midstream. Picking the winners while avoiding the landmines can be hard work given the limited information in the public domain.
About the Author: Rob Wilson is vice president of analytics at East Daley where he manages a team of energy analysts covering commodity markets and its impact on midstream asset financial performance.