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Natural gas and associated investment opportunities are garnering a lot of attention from a very broad audience, according to Brad D. Nelson, managing director in the energy investment banking group at Stephens Inc.
“We believe this momentum has been building for a long time as natural gas has evolved from a local to a global commodity. We also believe the interest, demand and need for natural gas was occurring well before the Ukraine-Russia crisis,” said Nelson said.
Pre-COVID, the acronym of the decade was ESG. Post-COVID, ESG is and will continue to be front and center for the conventional energy industry. More importantly, ESG is a factor in capital allocators’ decision-making. As we all know, natural gas is much cleaner and more environmentally friendly than oil and other conventional energy sources.”
The U.S. is well set to be a major player, now and long-term, in the global natural gas industry, Nelson explained. “Generally speaking and compared to other countries, the U.S. contains one of the largest resources for natural gas in the world. In terms of reserves, the U.S. ranks fifth or sixth, but the U.S. is in the top one or two countries in the world based on production and consumption.”
“We believe this momentum has been building for a long time as natural gas has evolved from a local to a global commodity.”—Brad D. Nelson, Stephens Inc.
In summary, there are three primary reasons why people are allocating capital to natural gas, according to Stephens. First, gas is cleaner than other conventional energy sources. Second, the overall macro-economic outlook for gas is set for the commodity for the foreseeable future. Global demand is continuing to increase and supply is struggling somewhat to keep up with the pace of demand. And third, many producers and investors are able to generate money and provide healthy returns while investing in an environmentally acceptable conventional commodity.
“Private capital continues to be the driving force behind investment across the natural gas value chain,” said Nicholas Gole, senior managing director at Macquarie Capital. “While there are probably fewer investors in the space now, those of us who are still investing in the sector are seeing a lot of attractive opportunities.”
In terms of capital allocation, Gole said, “We have not seen the same level of greenfield activity outside of LNG, but there is still significant interest from private investors, particularly in the context of gas supply for Gulf Coast liquefaction expansion.
“Midstream organic growth largely targeting value chain extension with multiple fee events from wellhead to water are receiving the majority of growth spending.”
Further, he noted that “strategics are still exercising capital discipline but will be opportunistic around established assets with compelling industrial logic and definable synergies. Consolidation is also key among public strategics.”
At the same time, some banks are showing renewed interest. “While banks have stepped back from lending to the space during the downturn, it seems like some are coming back cautiously,” said Gole. “And some have decided to exit the space entirely.”
Upstream consolidation, midstream expansion
Geographically, there has been an increase in activity in basins that were marginal at lower gas prices. Takeaway from Appalachia is still constrained, which is allowing for other basins such as the Midcontinent to increase activity materially, albeit from a smaller base.
“On an absolute basis,” Gole said, “key basins close to demand, like the Haynesville and Eagle Ford, have benefited, as has the Permian, which has seen significant gas debottlenecking in recent years. On the upstream front, we expect further consolidation to wring efficiencies and capitalize on new demand-pull sources, such as liquefaction—particularly with proximity to the Gulf Coast. We also expect significant newbuild residue gas pipeline capacity connecting the Permian to emerging liquefaction hubs along the Texas and Louisiana Gulf Coast.”
In midstream, “existing capacity is likely not sufficient to accommodate growth and we expect, in addition to the recently announced Matterhorn Pipeline, several incremental Gulf Coast pipeline final investment decisions through 2030 to accommodate global gas demand,” said Gole.
Continued investment in midstream “is certainly needed,” he continued. “On the gathering and processing side, it seems that some operators are investing capital in relatively lower return midstream buildout that retains molecules across a captive system with multiple fee events, rather than pursuing step-out greenfield growth. We expect this may change if the current pricing environment continues and operators decide to divert more capital to higher return upstream capex to allow themselves the ability to still return cash flow to shareholders.”
At the policy level, capital providers are beginning to differentiate between oil and gas, in terms of carbon in addition to the existing factors. “We are certainly focused on the carbon footprint of the projects that we invest in and are looking for responsible partners with strong track records for lowering the carbon impact of their operations and looking for ways to continue to improve their overall carbon footprint,” said Gole.
“Private equity has been consistent in its investment in the segment,” said Stephen Ellis, senior equity analyst at Morningstar. “I don’t see any change this year. Public investment has picked up a little bit, especially driven by merger and acquisition activity. Geographically, the consolidation in the Permian remains the biggest and best opportunity in terms of investment for producers and takeaway.”
“While there are probably fewer investors in the space now, those of us who are still investing in the sector are seeing a lot of attractive opportunities.”—Nicholas Gole, Macquarie Capital
Today, most deals are done in cash plus a credit facility, said Ellis. “They used to be roughly 50:50 debt to equity, but these days they are usually announced as an ‘all-cash’ deal while the parties work out way to finance the transaction. That can be a combination of debt and stock. What has made the difference, both upstream and midstream, is that there is so much cash being generated. They can use that to close the deal and work out any financing later.”
As examples of both trends, he noted Targa Resources Corp.’s acquisition of Lucid Energy Group, a $3.55 billion all-cash deal, as well as Whitecap Resources Inc.’s acquisition of XTO Energy Canada ULC from Exxon Mobil Corp. and Imperial for CA$1.9 billion (US$ 1.48 billion)—again all cash.
Those structural preferences should not overshadow the fact that “banks are willing to finance gas,” said Ellis, “whether that is exploration and production or midstream. That is especially true because midstream teams are being more selective. They tend to be focusing on developments that remain with Texas, or one of the other states that are favorable to the industry, and avoiding interstate jurisdictions to the extent possible. There are a few exceptions, but pipelines generally have become hesitant to cross state lines.”
Beyond the Permian, other plays receiving investment attention are the Haynesville Shale as well as the Marcellus and the Utica in Appalachia, the latter with the acknowledgement of “chronic takeaway constraints,” Ellis added. “The Mountain Valley Line will be filled quickly.”
EQT Corp. said it expects the long-delayed Mountain Valley Pipeline from West Virginia to Virginia, the last big gas pipe under construction from Appalachia, to enter service in the fourth quarter of 2023.
War and climate change
For several years, there has been reluctance in some quarters to invest in hydrocarbons for social and environmental reasons. That has been especially true in public markets. Nevertheless, natural gas has regained some credibility as the lower-carbon bridge fuel to a low-carbon future. Natural gas has also expanded to fill the available economic space as the world scrambles to restructure its energy mix without Russian hydrocarbons.
“There is certainly no certainty as to when the war in Ukraine will end,” said Ellis, “but there is growing certainty that the longer it continues, the more the European Union moves away from Russian energy—gas, oil, even uranium—and the more structural those changes become. Even as the new plans rely heavily on renewables, there is also a reliance on gas as the bridge fuel.”
“There is very much a focus on turning flared or released gas into revenue.”—Stephen Ellis, Morningstar
That said, investors remain widely divergent on their willingness to invest in hydrocarbons, and the industry, both upstream and midstream, is widely divergent in its response to that pressure.
“I have reviewed the portfolios of the U.S. and Canadian midstream companies that I cover,” said Ellis, “which includes all the major names. About a third of them had committed to a net-zero carbon emissions policy by 2050. Another third had no program or even goal stated. And a third were somewhere in between. At the very least the sector could work on some clarity.”
For example, he noted that there has been a significant shift in the industry’s attitude about flaring.
“There is very much a focus on turning flared or released gas into revenue,” said Ellis. “The Mountain Valley Pipeline has agreed to be carbon neutral, using offsets. That is one notable effort to address the environmental issues raised by investors and the public.”
That is a sharp contrast to late 2019 when flaring in the Permian became a national issue. Williams Cos. sued the Texas Railroad Commission after the regulators allowed Exco Operating Co. to flare casinghead gas even though the Exco wells in the field were connected to Williams gathering lines.
In early 2020, Pioneer Natural Resources Co. CEO Scott Sheffield called on energy investors to sell shares or pull funding from companies that have rates of natural gas flaring.
Price decoupling: done and dusted
Another shift that has taken place quietly is how gas and oil prices have drifted apart. There was a time when producers, investors and analysts were watching for ‘decoupling’ as turning point, but Ellis noted that “with Henry Hub pricing, destination flexibility for LNG and oil-linked contracts just expiring,” the decoupling has been more evolution than revolution.
“We believe that oil and gas has been decoupled for a long time,” said Stephens’ Nelson. “Other than using a drilling rig to extract the two commodities, we believe that to be the only similarity today. Some source rock contains both commodities, but the primary supply is in very different parts of the country,” he continued.
“For oil, we think of the Permian, Bakken, Eagle Ford and Midcontinent are the key supply basins. For natural gas, the primary plays are the Marcellus, Utica and Haynseville. The same could be said for the demand side of the equation; end-use markets are very different.”
Transportation fuels and lubricants are among the major end-use markets for oil, as are numerous commodity and specialty chemicals. Power generation is a major demand for gas, as are heating and cooling. NGLs are the primary feedstocks for commodity thermoplastics.
Gole at Macquarie suggested that “to an extent, oil and gas prices have decoupled but are still highly correlated. While the U.S. seems to be the marginal supplier for each at the moment, we are now seeing overlapping but differentiated demand bases that are truly global in nature and will continue to drift independent as incremental liquefaction continues to knit the global gas value chain together.”
To that point Gole said, “We expect that more LNG liquefaction FIDs [final investment decisions] will keep long-term pricing attractive for North American producers and midstream companies while significantly reducing the spot price available to customers in Europe and Asia, relative to what is being paid today. This should make gas an important part of the energy transition for a long time to come.”