Tuesday, August 21, 2018

Energy midstream undergoing transformative shift

Report provided by Salient Capital Advisors LLC

When it comes to crude oil and natural gas, boring is better… except when talking about the notable changes occurring within the midstream industry today. Then, we can say that “exciting” is a good thing.  Energy midstream is currently undergoing a transformative shift between two mutually-exclusive models. 

Graphic: Bloomberg, Salient Capital Advisors LLC, July 2018. For illustrative purposes only. Click image to enlarge.

On the one hand, there is the traditional, high-yielding Master Limited Partnerships (MLPs) with a General Partner (GP) that serially issue equity to fund growth projects. In return for a higher-yield, MLPs have expected to have ready access to capital whenever it was needed. On the other hand, there is the new model, in which midstream companies have prioritized a simplified corporate structure, reduced cost of capital, and self-funding of equity needs.

One of the primary ways in which these changes are being expressed is through the corporate structure. In short, MLPs are complicated. MLPs can be prone to misalignment of incentives between investors and management, and cash payments to GPs through Incentive Distribution Rights (IDRs) can place a large cost of capital burden on the MLP. The new midstream model, in contrast, is about better shareholder alignment and reduced cost of capital.

Click image to enlarge.
To achieve these goals, many MLPs are consolidating, simplifying, or converting into a C-Corp structure. Not including the potential for Initial Public Offerings (IPOs) or buyouts, the graphic included here shows just how much these potential changes could affect the makeup of the marketplace over the next several years.

Why should our friends and partners at TEXPERS care about these changes? One reason why these changes are so significant is because they are partly designed to increase the appeal of midstream to a broader investor base, namely, institutions. Eyeing midstream companies’ simplified structures and greater visibility into their future growth potential, institutions have been making up an increasing source of outstanding midstream ownership.  Only a few years ago institutions owned roughly 30% of the space. Today that figure is about 50%, and we believe that trend will only continue, according to recent PricewaterhouseCoopers LLP and Wells Fargo Securities LLC partnership reports.

Another reason we feel these changes are so important is the increasing capital needs of energy midstream. In a recent report, the Interstate Natural Gas Association of America (INGAA) has illustrated the need for $55B-$70B in midstream infrastructure spending every year for the next 20 years. This level of potential spending is substantial, and, in our view, midstream companies will need healthy balance sheets and large institutional partners to fund the necessary growth projects.  We believe that those companies that adopt the new model are a better fit for the future of the industry and have the potential to thrive in this environment.

The final reason why these changes are so important is that, in our view, they improve the investment outlook for the space. As suggested above, we believe there will likely be some winners and losers over the next few years as the transition to the new model progresses, but, as evidenced by a positive macroeconomic backdrop and quarter-over-quarter earnings beats, the future appears bright for those who can navigate their way through.  

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Salient or TEXPERS. 

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