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'Tectonic Shift' Said Under Way in Midstream Sector

The drillbit is moving from unconventional dry natural gas activity to wetter gas and crude, but the infrastructure has yet to catch up, increasing barriers to entry for some and giving existing operators a "natural edge," an analyst with Tudor, Pickering, Holt & Co. Inc. (TPH) said in new research on the midstream sector.

As demand increased and prices rose, the U.S. natural gas pipeline and related infrastructure were expanded through the 2000s with "multibillion-dollar investments," but the same was not true for oil and natural gas liquids (NGL) infrastructure, an outdated segment that only now is beginning to be rebuilt and expanded, said TPH's Bradley Olson, vice president of equity research. He authored a 73-page report about the midstream industry.

"We believe that NGL volumes could increase by 700,000 b/d by 2015, roughly 25% higher than current levels," said the TPH analyst. "This includes production declines in the Gulf of Mexico and mature onshore basins, requiring construction of nearly 1 million b/d of pipe capacity.

Capital expenditures, merger and acquisition activity, as well as "historically low yields all indicate that North American midstream is sharing in the unconventional resource boom," said Olson. "As a result, midstream companies are leveraging existing assets and securing long-term commitments on previously underutilized infrastructure..."

It's not your parent's midstream sector, said the analyst. Midstream in the past largely was occupied by small-cap companies with "limited institutional ownership, mainly due to 50% of sector market cap being partnerships," such as master limited partnerships. "This has begun to change as investor demand has reduced public valuation penalty for midstream assets housed in a C-corp structure," such as those used by El Paso Corp. and Williams.

"This sector is not the interest rate-exposed, commodity neutral 'toll road' sector you may have been told about," Olson said. "Over the last five to 10 years, it's shown increasing correlation with crude, declining correlation with gas and less sensitivity to interest rates..." What this "tectonic shift" offers are "opportunities throughout the value chain, from upstream (gathering, trucking, processing, storage terminals) to downstream (pipelines, fractionation, storage)."

According to TPH, more than $60 billion has been spent since 1996 on large-diameter gas pipeline, and today the United States is "long gas pipe and short oil/NGL pipe...tens of billions of dollars of newbuild pipe capacity now, on average, are 'out of the money' (i.e., netbacks are worse when shipped versus sold locally.")

Examples exist across the country, he said, of midstream operators considering ways to take advantage of the "unprecedented transformation" within the domestic NGL and oil markets:

"The midstream industry exists in order to reduce differentials, but it also profits from them," Olson said. "As a result of this fact, the midstream sector is dynamic, even when production, prices, supply and demand are stagnant or even declining (as long as they don't all stagnate together)."

Performance among midstream operators since 2008 "has been broadly outstanding, with every segment generating more than 100% total returns after 18 dismal months," he said. Year to date in 2011 the sector is "reaching cruising altitude," with general partnerships stronger on their liquids leveraging, while C-corps with midstream divisions are outperforming as they prepare spinoffs, like the planned exploration and production (E&P) business spinoffs by El Paso and Williams.

As to where the growth is expected in the near-term, crude oil/condensate increases are predicted to come from Canada, the Bakken and Eagle Ford shales, and the Permian Basin, said Olson. NGL growth is likely from the Eagle Ford, the Granite Wash play and the Permian.

Meanwhile, midstream operators are positioned to participate in growth from the wellhead to the downstream delivery point, said Olson. The wave won't fuel a 2007/2008-style boom, but it may push more E&Ps out of gas plays. For instance, the July 1 New York Mercantile Exchange (Nymex) gas price of $4.32/MMBtu "is well below Nymex NGL price of over $15/MMBtu, providing a huge economic incentive for E&Ps to develop wet gas and crude."

Going forward, said Olson, "we prefer exposure to liquids volume growth, rather than prices (fee-based processing/fractionation). We believe the rapid increase in NGL volumes will cause choppiness in NGL prices, but we believe the volume growth trend is durable."

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