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Moody's: Basis Collapse, Low Prices Threaten Pipelines

While the waters are calm now, some North American natural gas pipelines could face rough sailing as transportation capacity pricing power is eroded by new development and long-term contracts roll off, according to an analysis by Moody's Investors Service.

"Our stable industry outlook is solidly positioned today, given the generally robust financial performance that gives the sector substantial capacity to absorb some of the business risks inherent in some negative emerging trends," said Moody's Vice President Mihoko Manabe, author of the report.

However, "execution risk and financial weakening related to construction projects are likely to extend into the next decade. New pipeline capacity coming into service has often had a riskier credit profile than pre-existing pipes, resulting in some new ratings that are below the sector's 'Baa2' historical average. Expansion of existing systems could also dilute incumbent pipelines' credit quality, and lead to ratings downgrades," said Manabe.

Collapsing basis differentials figure large in Moody's outlook for the industry. Some of the pipeline construction that has been spurred by regional pricing discounts, especially in the Rockies and East Texas, is helping to eliminate bottlenecks that have emerged in recent years, Manabe said. Discounts are also disappearing as new capacity comes online. Narrowing of price differentials across the continent has been noted by other analysts as well (see NGI, Sept. 21a).

"The historically discounted Rockies gas price that inspired the construction of [Rockies Express Pipeline] is now more on par with the Henry Hub benchmark," the Moody's report said. "The bottlenecks that created pricing discounts and spurred pipeline construction are easing, and discounts are disappearing as new capacity comes online."

As many of the new pipelines have been supply-pushed projects, they have a greater exposure to gas producer credit quality, noted Moody's. "As an example, Midcontinent Express Pipeline (recently rated 'Ba1' senior unsecured) [see NGI, Sept. 21b] has transportation commitments that begin to step down after five years, which effectively reduces the shippers' exposure to the potential decline in some of the reserves it serves," Moody's report noted. "Such a contract structure is unknown among the traditional pipes, which serve utility customers. Unlike utilities that can pass their gas costs through to their ratepayers, [exploration and production (E&P) companies] are price-sensitive by nature. Their cash flows and drilling activity will adjust rapidly to gas prices."

Moody's said some of the weaker E&P companies that have underwritten pipeline projects could become strained in the near term as favorable hedges roll off and cash flows reset to the currently low gas price environment. Further declines in gas prices could reduce E&P borrowing bases, leading to a liquidity crisis, Moody's noted.

"Over the medium to long term, some of the new high-cost shale plays could prove unsustainable if gas prices remain below the $4-5/MMBtu level necessary to make the plays economically viable," the report said. "Although E&Ps will be committed with firm contracts at the beginning, they will not likely renew if the price outlook does not support drilling activity or if the play's performance falls short of expectations."

While producers deal with low gas prices and oversupplied markets, "pipelines still enjoy long-term contracts with utilities that tend to be more concerned about ensuring customer supply than with finding the cheapest deal possible," said Manabe. "Utilities have been the beneficiaries of cheaper, more plentiful gas and more transport options, and recent changes in North American gas flows have not affected the utilities' gas procurement practices to date [see NGI, Sept. 28]."

This should keep the gas transmission sector's cash flow relatively intact over the near term, but the Moody's report points out that as these long-term contracts expire, older pipelines could experience tougher competition in renewing their contracts. "We are concerned that the spate of new pipelines slated to come online over the next three years could aggravate today's oversupply situation and add further competitive pressure to existing pipeline systems," said Manabe.

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