Increased organic capital spending, greater commodity price volatility, changing ownership structures and developing regulatory policy are expected to continue to have an impact on credit ratings in the midstream energy sector for the remainder of 2006 and into 2007, Standard & Poor’s Ratings Services said Thursday in a new industry “report card.”

S&P noted that acquisition activity has been high in the sector with Plains All American Pipeline LP recently buying Pacific Energy Partners LP for $2.5 billion, Regency Energy Partners LP paying $350 million for TexStar Field Services LP’s gathering assets and Enterprise Products Partners LP’s acquisition of a South Texas gathering system from Cerrito Gathering Co. for $325 million.

“Heightened demand and the scarcity of assets for sale have resulted in soaring prices, with trailing [earnings before interest, taxes, depreciation and amortization] multiples in the 12x to 13x range,” S&P said. “A permanent shift to higher acquisition multiples could dampen credit quality, if the acquirer is burdened by the extra debt used to finance the transaction and simultaneously fails to realize its cash flow targets in the expected time frame.

“As a result, some midstream companies have renewed their focus on organic building rather than buying often forming joint ventures with their competitors to achieve growth.” S&P noted that Oneok Partners LP is working with Boardwalk Pipeline Partners LP and Energy Transfer Partners LP to build a $1 billion 1 Bcf/d interstate pipeline that will extend 560 miles from North Texas to a connection with Texas Gas Transmission in Cohoma County, MS.

In May, Energy Transfer also said it would go ahead with a $360 million expansion of its Texas intrastate system, including the addition of 157 miles of 36-inch pipeline and 92,700 horsepower of compression to its proposed 42-inch pipeline in East and North Texas. The 950 MMcf/d expansion will bring the system’s capacity to 2.3 Bcf/d and will bring the total construction cost of its pipeline system to $895 million.

However, S&P noted that organic growth projects can “strain balance sheets (albeit temporarily) given the time lag between capital spending and cash flow generation, and the risk of additional delays in obtaining rights of way or regulatory approvals.”

BP plc’s decision to shut down a portion of its Alaska pipeline because of corrosion drew attention to pipeline maintenance issues prompting the Department of Transportation to propose a rule that would require pipelines that operate at low pressures in sensitive areas, such as Prudhoe Bay, to comply with the more rigorous safety standards of high pressure pipeline systems. While such a change to regulations could have a positive impact on credit ratings because of safety improvements, they also could lead to higher operating costs, S&P noted.

The credit rating agency also warned that lower commodity prices could affect some midstream operators with price-sensitive segments. “For example margins for percent-of-index gathering segments are calculated at a percent of the natural gas index price, so they would weaken as natural gas prices decline. In addition, percent-of-proceeds processing margins decline when commodity prices are low. In contrast, keep-whole processing margins fall when natural gas liquids prices are low and natural gas prices are high.

“These risks can partially be mitigated through hedging programs, conditioning language, or plant bypass capability,” S&P said. “Furthermore, midstream operators with a large proportion of fee-based operations are not as exposed to commodity prices, although they can indirectly be affected as sustained lower prices could lead to less drilling activity and lower volumes.” Interstate pipelines are least exposed to commodity price changes, S&P noted.

The agency also predicted that there will be more initial public offerings (IPO) by midstream holding companies because of the lucrative distribution rights of the general partners in master limited partnerships (MLP). Holding companies have been hitting the market at high multiples reflecting “investors’ expectations of accelerated incentive distribution growth.” S&P said, noting the recent IPOs by Valero GP Holdings LLC, Atlas Pipeline Holdings LP and Buckeye GP Holdings LP.

“While these IPOs do not by themselves affect the credit quality of the MLPs, we remain concerned that the [general partner] could aggressively expand the MLP or enter into higher-risk business segments to the detriment of MLP bondholders to meet the typically high-growth expectations of holding company investors.”

Another issue that could impact midstream credit quality is the rate decision in the Kern River Gas Transmission case, S&P said. “The FERC’s Kern River decision to set a 9.34% rate of return was much lower than the rate many in the pipeline industry had anticipated,” S&P noted. “In fact, the outcome is significantly below the 15% rate of return that Kern River had requested, and even below its pre-existing 13.25% rate of return.” S&P noted that the Interstate Natural Gas Association of America has urged FERC to change its pipeline rate-setting methodology to include MLPs in its proxy group. Historically, pipelines have been awarded ROEs of 12-14%. “If the Kern River project is any indication, lower than expected returns on new pipeline investments could cool infrastructure capital spending,” S&P warned.”

For a copy of the report titled “U.S. Midstream Energy Companies Poised to Increase Maintenance and Organic Growth Spending,” call (212) 438-9823.

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