M?idstream mergers and acquisitions (M&A) activity is off to a robust start in 2011, with 11 announced transactions worth $1.5 billion. This compares to 13 transactions worth $1.2 billion in the same period in 2010 (excluding the $12-billion Williams Partners LP restructuring) and 88 transactions worth $47.4 billion for all of 2010.

Looking forward, the midstream M&A market is likely to be influenced by the following trends: reduced cost of capital for master limited partnerships (MLPs) generally and greater access to both the debt and equity capital markets; high levels of activity from private-equity firms; asset sales or joint ventures by exploration and production (E&P) companies to free up capital to fund drilling; increased competition for assets; and the continuation of MLP-related party transactions, although without the high level of general partner buy-in transactions seen in 2010.

Lower cost of capital

Today, MLPs are enjoying a lower overall cost of capital. Equity yields are down across all subsectors compared to the previous three years, with yields for some MLPs at or near record lows set in 2007. The credit markets are readily available to both investment-grade and high-yield issuers. As such, 2011 should see increased competition for midstream assets.

The overall reduction in MLP cost of equity capital has, to a certain extent, eliminated lower-cost equity as a competitive advantage. That means MLPs with cheaper equity due to one or more factors, including stability of cash flows, a strong sponsor, a dominant market position or large market capitalization, are increasingly relying on synergies to remain competitive. Larger MLPs should be able to use their asset footprint to drive additional synergies, while smaller MLPs will likely focus on in-market consolidation or accept reduced economics to expand into new businesses or geographies.

Private equity

Private-equity firms continue to be active in the midstream sector. Multiple firms raised dedicated midstream funds during the past two or three years and, with the credit markets providing more overall leverage per dollar of equity invested, these firms possess substantial purchasing power. In addition to backing more than 20 management teams primarily focused on smaller packages of assets or greenfield developments, private-equity firms are investing in platform businesses, such as Riverstone Holdings LLC’s recent transaction with USA Compression Holdings, and First Reserve Corp.’s purchase of Quicksilver Gas Services LP’s general partner to form Crestwood Midstream Partners II LLC. In addition, these firms will likely continue to monetize a number of midstream portfolio companies in the M&A market.

E&P rationalization

E&P companies will continue to rationalize midstream assets, and those with large development plans will consider divesting midstream assets or executing midstream joint ventures to fund drilling budgets. A further decline in natural gas prices could accelerate this trend, although not in the high-growth areas where producers believe it is critical to control midstream assets to avoid delays in executing their upstream strategies. E&P companies that have built sizeable midstream operations may also opt to follow the likes of Williams, Quicksilver and Chesapeake Energy Corp. and form their own midstream MLPs.

NGLs, gas storage and refined products

With producers focusing on liquids-rich natural gas production, midstream companies will continue to pursue NGL transportation, fractionation and storage assets. Given recent successful natural gas storage MLP IPOs and the ensuing multiples paid for storage assets in the M&A market, despite deteriorating underlying economics, a number of storage assets will likely be monetized in 2011 at high valuations. Given their stability of cash flows and relative scarcity, refined products pipeline and storage assets will continue to receive high valuations.

Related-party transactions

Finally, drop-down transactions from sponsors such as Anadarko Petroleum Corp., Chesapeake, DCP Midstream LLC, El Paso Corp. and Spectra Energy Corp. to their respective MLPs will continue, but overall activity will likely be down compared to 2010 in terms of total dollar volume. This reduction in volume will be driven primarily by an expected reduction in general partner buy-in transactions, which accounted for $14.8 billion of activity in 2010. In addition, although Enterprise Products Partners LP recently offered to acquire the 42% of Duncan Energy Partners LP it does not already own, the total value of such transactions will likely not match 2010, when the Williams Partners restructuring alone accounted for $12 billion of the total dollar volume.