Traditionally, midstream energy companies have been successful in combining their knowledge of price differentials in various locations with their logistics capacity to move product to the right place at the right time. In fact, that strategy is critical in achieving the goal of being the preferred midstream partner supporting their exploration and production client producers as the most-efficient and reliable partner that can seamlessly gather, process and transport product to market.

The strategic acquisition of transportation and storage assets not only hedges against any trading exposures, but creates optionality in terms of the range of choices for upstream producers in getting their product to market. With greater optionality, midstream partnerships can specifically tailor their systems to meet their client’s production programs and drilling schedules.

Maximizing optionality

Logistics assets, such as terminals, vessels, pipelines, railcars and trucks allow upstream partners to optimize the value of their product, while managing the risk of loss. The key to maximizing market optionality is access to multiple interconnects to obtain the highest value at the lowest cost.

Strict regulations, greater competition and resource nationalism, for example, are only a few of the issues involving TransCanada’s proposed Keystone XL pipeline, where the need to maximize liquidity and optionality in long-term financing plans cannot be underestimated.

Nonetheless, there are risks in expanding asset operations, which include performance risk where different skill sets are required in managing various assets. Moreover, some of these assets may not be easily sold off if and when operations become technically obsolete or no longer economically viable.

Optionality has value in itself when the security of supply could be negatively impacted by force majeure events, especially in tough operating environments. With access to storage and transportation capacity, upstream producers are able to select the right time and place to sell product and maximize its value.

Investor scrutiny

The lack of optionality with midstream operations, furthermore, may hurt smaller partnership valuations. Jeff Ball, managing director at the Energy & Minerals Group in Houston, tells Midstream Business that midstream “MLPs [master limited partnerships] with fewer assets are getting greater scrutiny” from investors. Scott Joyce, senior vice president at CapitalOne, agrees, saying at the recent Deloitte Oil & Gas conference in Houston that investors are increasingly focused on “understanding the rock” upstream in smaller or single asset, developing shale plays. Such investor concerns underlie the growing trend toward midstream consolidation.

Traditional discounted cash flow models overlook flexibility on a portfolio level. Diversification in energy sources has value in reducing risk, lowering the cost of capital and improving credit ratings. Conversely, the lack of optionality may have a negative financial, as well as operational, impact on MLPs.

Market price distortions may also be eliminated or significantly reduced when additional midstream capacity is added. New pipeline construction and reversals, as well as rail capacity, have relieved bottlenecks that have caused certain products, such as West Texas Intermediate crude, to be undervalued in relation to comparable products.

Options, such as crude by rail give producers access to higher value markets that would be otherwise unavailable by pipeline and give refiners the most cost-effective feedstocks. Given the volatility of commodity markets and the difficulty in forecasting future conditions, optionality is a premium in reducing supply constraints and dealing with market uncertainty.

Also at the Deloitte conference, Byron Niles, senior vice president at Enbridge, noted that his firm is focused on “better supply chain alignment” given the need for speed to market. For example, natural gas storage cushions the highly cyclical or seasonal demand pattern for gas, acting as insurance that guarantees delivery.

Optionality, more importantly, allows a speedy response to capitalize on increases in demand and rising prices in certain markets. By directly connecting to several delivery points, shippers can access terminals and refineries without the need to contract with third parties or incur storage fees. In addition, with multiple delivery points, shippers gain additional liquidity for their product.

In terms of an unforeseeable or “Black Swan” event, the ability to change course midstream in a dynamic industry such as venture capital or energy, is invaluable.