With the industry’s collective anxiety rising with every rig that is stacked, it might be time to recall that energy investing is not just about swimming upstream.

“We’re actually expecting to see an uptick in midstream M&A activity because it’s an asset class where there are a lot of E&P owners of their own midstream assets,” Duff & Phelps Managing Director Jim Rebello told Midstream Business during an interview with three of the financial advising firm’s senior executives. “They can get a better value for their midstream assets than they can for their exploration and production assets. So when you’re trying to decide on, ‘how am I going to rationalize this asset base?’ the pieces where you can get a better value will be those in the midstream space. E&P companies with controlled MLPs likely to complete an increasing number of dropdown transactions.”

“Absolutely,” agreed Jim Hanson, Duff & Phelps managing director specializing in transaction opinions, MLPs and private capital raising for companies in the energy sector. “The last three years have all been active for dropdowns in the MLP world. This is a good source of growth if the sponsor is an E&P company or a bigger midstream company.

“It’s a great way to continue the growth trajectory of their MLPs,” he told Midstream Business. “I also think we’re going to probably see some bifurcation within the MLP sector, even in the midstream, where some companies that are closer to the wellhead or maybe a little less diversified could see some impact on volumes, whereas some of the more diversified, bigger companies that are more fee-based, will see a little less.”

Would-Be Wizards

There are a number of variables at play—swift drop in commodity prices, midstream buildout—but the relatively recent proliferation of the retail investor into oil and gas stocks triggers a round of rattled nerves, as well.

“In the last three years, you’ve really seen the retail investor dictate the structure of the market,” Dave Herr, Duff & Phelps’ managing director and energy lead, financial reporting and valuation advisory services, told Midstream Business. “Retail investors are no longer buying the integrated oil and gas company at the same valuation that they ascribe to something that is a basin-specific E&P or gathering play. Retail investors put a premium value on the ability to invest exactly as much as they want in a specific basin.”


Duff & Phelps managing directors Jim Hanson, left; Dave Herr and Jim Rebello.

Oil’s reign of $100-plus per barrel (bbl) might have made them see themselves as financial wizards. But how will these investors, new to the ebbs and flows of the energy business, react to $50/bbl oil? Especially if low prices persist as expected?

“That desire of the retail investors has actually created less financial stability in companies, particularly in some of the recent IPO’s in the upstream space,” Herr said. Things can get dicey, he explained, when single-basin E&P players drop down their gathering systems in an MLP.

“Those captive MLPs are where you’re going to potentially see bifurcation,” Herr said. “If you’re a single-basin play relying primarily on a single upstream company, that is now cutting back severely or totally ceasing drilling activities, the rate at which those commitments are going to be met and certainly the ability of that MLP to deliver the distributable cash-flow growth is severely diminished.”

Herr expects the downturn to result in a shakeout in the market.

“Where we saw a lot of the MLPs trading in a similar range, I think you’re going to see a separation of those that have a more sustainable long-term platform and those that were a function of the market dynamics of the last 36 months,” he said.

Rebello, Houston-based energy lead for mergers and acquisitions, stressed that the sky has not yet fallen and that the next couple of months, at least, appear to be manageable.

“Timing is an important part of this,” he said. “Volumes are expected to grow—most analysts are saying at least through mid-year, maybe into the third quarter. A lot of these MLPs in single basins won’t feel the effects until the rig count in those basins begins to fall. The difference is drilled wells vs. completed wells. There’s a big inventory of uncompleted wells. I don’t want to be all gloom and doom and say this is all going to come apart between March and June. Every company is going to be different, and it’s going to be a slow bleed as the decline curves begin to play themselves out.”

Increased efficiencies

Much depends on where a company operates, he said, even if it is a single-basin entity. Companies that are working in basins’ sweet spots won’t feel much pain, at least not yet.

“The Capex budgets don’t immediately get chopped all at once,” Hanson said. “People are continually re-evaluating and slowly taking off projects. The science projects come off first, then you get to some of the less core areas.”

“What’s ironic is that, as you start to peel some of these off, you actually get increased efficiencies,” he said. “I’ve heard people say, ‘why can’t you just have these efficiencies in a good market and really increase your production?’ In a good market, the E&P companies are more apt to look on the fringes and look for new technologies and things like that. It’s not quite as dramatic as people think. You could expect to see some increase in production over the next several months.”

The larger midstream players, the ones that have diversified their assets and locked in long-term agreements for output, will be fine, Herr said. “The MLPs that have been created as dropdowns from those single-basin plays? They’re likely to get punished in the market if they can’t deliver consistent distribution growth.”

But the sector will rebound.

“Ultimately, we need more pipeline capacity,” he said. “It’s just maybe not as much or as fast as was initially thought.”

Contact the author, Joseph Markman, at jmarkman@hartenergy.com.