MIDLAND, Texas—On a stage in the heart of the oil patch, Mike Wichterich groused candidly about the shortcomings of the Delaware Basin’s infrastructure and how a lack of pipe has turned acreage there into an oil trap.

Wichterich, president of Three Rivers Operating Co. III LLC, told attendees of Hart Energy’s Executive Oil Conference in November that wells with production of 2,000 barrels per day (bbl/d) seem great—at first.

“And I think, ‘OK, I need to haul that oil off. And that is a lot of trucks. And, oh, by the way, I need to move 6,000 barrels of water,’” he said, adding that the inefficiencies add up rapidly.

“It has to be piped. It can’t be trucked. That’s why we’re having all these problems.”

The need for infrastructure in the Permian Basin and related consolidation is likely to be the next area of serious A&D engagement for the midstream sector—if companies can afford it and perhaps even if they cannot.

After years of acquisitions, few midstream companies have “free money left to throw at growth,” said Samir Kayande, a director at RS Energy Group.

The Delaware, with its resource riches and low breakevens, illustrates a conundrum for companies that want to buy.

“It’s going to be really challenging, especially when you look at some of the larger natural acquirers,” he said. “Energy Transfer Partners comes to mind immediately as a company that would probably love to have more assets in the Delaware Basin but probably can’t make that work with their capital structure right now.”

The opportunity and capital constraints have trapped management teams in a paradoxical dilemma.

“The Delaware is just this opportunity that probably comes along once in a generation. So regardless of how much it costs, can you really afford to not be in it?”

Road To Nowhere

Perhaps the two Permian midstream deals that best illustrate the tension between opportunity and cost were announced days apart in early April.

In the first, NuStar Energy LP (NYSE: NS) agreed to pay $1.5 billion to buy Midland Basin crude oil infrastructure from private-equity backed Navigator Energy Services LLC. The deal closed in May.

Then funds managed by Blackstone Energy Partners LP and Blackstone Capital Partners LP said they would buy gas gathering assets in the Delaware from EagleClaw Midstream Ventures LLC for $2 billion cash. It isn’t clear if the deal has closed.

The EagleClaw deal, Kayande said, “broke every single asset valuation rule that I have.” The amount of production flow and value on the assets was relatively small yet still commanded a huge price.

He likened the transaction’s outsized cost to an option premium.

“You pay this huge premium in order to have the obligation to develop out a system that will cost you 7x EBITDA in terms of the capital you need to put in,” he said.

The high-cost deal for a gas-gathering system also illustrates concerns in the Permian stretch beyond transporting crude oil. New pipeline projects were announced in 2017 and midstream companies formed joint ventures to share the construction cost while also de-risking the projects, said Kyle May, an analyst with Capital One Securities.

“Moving associated gas from the Permian continues to draw attention as some are concerned there will be a shortage of takeaway capacity,” he said.

Bernstein analyst Jean Ann Salisbury said that with private-equity in control of a large amount of infrastructure, the Navigator deal may also foreshadow the difficulty of deal making.

“Buying pure gathering from a [private-equity] backed player is probably expensive, if the Nustar/Navigator deal is an indication, but could make sense to someone with export capacity and no upstream, like Buckeye or Magellan,” she said in a September report.

Overall crude gathering operations in the basin are fragmented. Plains All American Pipeline LP (NYSE: PAA), Enterprise Products Parnters (NYSE: EPD) and Energy Transfer Partners (NYSE: ETP) control about 31% with most of the remainder in the hands of private equity or upstream E&Ps.

Fragmentation: Permian Basin Crude Gathering Since 2015, private equity has poured a great deal of capital and steel into the Permian, Kayande said.

“When you look at private equity and their exit point, for a successful business, they’re probably looking at exiting right now,” he said.

However, while consolidation among midstream operators seems to make sense, Kayande said he’s unsure it will happen yet.

“It really depends a lot on WTI. If oil prices and gas prices remain kind of where they’re at and relatively strong, there would probably be more IPO activity I would expect,” he said. “If gas prices especially start dropping off, then there may be more strategic deals.”

Rent Or Own?

In November, Enterprise Products put a line into service between Midland and Houston. The line adds 300,000 bbl/d capacity from the Permian Basin to the Gulf Coast.

Enterprise set a high interim tariff on the line for uncommitted, walk-up shippers of $6.74 per barrel, said Sandy Fielden, an analyst with Morningstar Commodities Research.

“That’s $2.50/barrel more than the next-highest competitor on a comparable route between the Permian and the Gulf Coast,” Fielden said in a Dec. 4 report.

Enterprise, Energy Transfer and Plains All American all collectively control 80% of the takeaway capacity being built in the Permian.

The Permian remains fertile terrain for midstream deals, but it also raises a serious question for E&Ps: should they just build out infrastructure themselves?

Due to the multiple zones available in the Delaware, E&Ps could essentially build one pipeline but use it multiple times—depending on the number of horizons a company produces from.

“There’s a compelling argument to be made, that ‘well wait a second, if I just own it all, I don’t have to pay someone five times as much rent,’” Kayande said.

Midstream companies, on the other hand, will try to be competitive by offering lower rates “to the point where you’re equalized between deploying the capital yourself versus paying a third party for it.”

For Wichterich, the Delaware Basin is “tremendously inefficient” at this point. Truck drivers earn up to $2,000 a day. Drilling crews that were efficient have been split and split again. And rights-of-way still must be purchased to lay pipelines.

“Execution is terrible,” he said. “It will get more efficient. Today it’s not. Until we get the full development, it is going to take a while.”

Darren Barbee can be reached at dbarbee@hartenergy.com.