Midstream Game Changers

It’s no surprise that 2012 is shaping up to be a challenging year for the midstream sector. Yet, despite facing numerous obstacles, midstream companies are still doing better financially than many other industries. All of this is reflected in Standard & Poor’s Rating Services’ (S&P) midyear outlook. Putting the midstream energy sector under a microscope, the report outlines the key factors driving— and slowing down—the industry.

Broken down by S&P’s analysts during a June 14 conference call, the outlook points to the credit drivers and recent developments within the sector. It provides an overview of the factors driving U.S. commodity prices and highlights the trends shaping the future of energy.

One emerging trend is the call by politicians and industry leaders for an improved and more intricately designed pipeline network, say the analysts. A well-coordinated system would be hailed as a faster, safer and environmentally friendlier alternative to today’s railway loops and trucking systems that have been quickly built and organized where pipelines do not yet exist.

Statistics released by Bloomberg and S&P show pipeline construction took a twist in that direction in 2011. Last year, 90% of projects that added capacity to the grid were 100 miles long or less, suggesting that pipeline companies are adding infrastructure to their existing pipes, rather than constructing long-haul pipelines.

During the conference call, Nora Pickens, associate director of corporate and government ratings with S&Ps, said the trend is happening as shale gas continues shaking up formerly predictable basis differentials. Currently, the wealth of new shale-gas production is changing gas flows away from long-haul transmission service and into regional-type transportation operations. As a result, capacity demand on long-haul pipes has diminished. As the need for such space lessens, pipeline operators’ priorities are shifting.

“There’s not as much of a need to transport gas over long distances anymore,” Pickens said. “Keeping this in mind, we see the pipeline sector is shifting away from long-haul pipes capitalizing on basis spreads between producing regions—historically in the Rockies or the Gulf—and consuming regions.

“Instead, we’re seeing the greatest value is trending toward a pipe’s ability to clear bottlenecks and reliably deliver gas to end users, even during times of high demand. And so, going forward, we would expect firm transportation rates to reflect this service. Pipes that are able to provide greater operational flexibility or access to the grid will likely garner higher rates over time.”

Industry leaders have been calling for such improvements to the pipeline transportation network for some time. Speakers at a recently held pipeline summit in Bismarck, North Dakota, said such an expansion would help create a safer and more effective system. They want to pull trucks off the road and, instead, start relying more heavily on pipelines to move oil.

“There’s no single thing that I can think of that can do more to reduce the human impacts of rapid oil development than pipelines,” said North Dakota’s Governor, Jack Dalrymple, at the conference. “We are on track to have our state’s production actually handled by pipeline.”

Canadian crude

Also, crude transportation in Western Canada is experiencing some shifts of its own. Observers are noting that growing sedimentary-basin production is driving both heavy-export expansions and interprovincial growth. If statistics are any indication, the need for more pipeline capacity could swell in coming years. According to the Canadian Association of Petroleum Producers, production will hit 3.6 million barrels (bbl.) per day in 2015. That’s well above the 2.7 million bbl. per day produced in 2011 and means capacity could increase by 200,000 bbl. per day, on average, per year for conventional and oil-sands crude.

“We’d also note that this forecast is significantly higher than their 2011 forecast, I think reflecting the commodityprice environment and expansion plans,” said S&P’s director of Canadian corporate ratings, Gerry Hannochko, who addressed the topic during the company’s mid-term update. “The total cost to develop some of these pipeline capacities both within the province and outside of the province is in the multiple billions of dollars range.”

He cited Keystone XL, Enbridge Inc.’s Alberta Clipper Project and Northern Gateway, along with Kinder Morgan Energy Partners LP’s Trans Mountain expansion as examples of big-money projects that are expected to total more than $15 billion. And shipping crude from the oil sands to Alberta’s terminal areas will require billions more of investment. He warned, however, that those projects might not hit the ground as early as some hope, which might disappoint those hoping for a huge volume spike.

“On the capacity front, pipeline capacity is expected to remain relatively flat for the next couple of years with a jump in 2015 when Keystone XL is expected to come into service,” said Hannochko.

“Going out after that, we see some expansion from the Trans Mountain expansion and Enbridge gateway, which are proposed. However, we would note that there is some significant risk to some of these projects from the environmental and regulatory front. And I think what we’ve seen with Keystone XL in the U.S. is that some of these dates may end up slipping into the future.”

He added that the delay of Keystone wasn’t purely bad news, since it allowed TransCanada Corp. to spread out its capital. Had the project gone ahead on schedule, Hannochko said, it would have put a squeeze on the company’s budget.

While the Keystone pipeline is expected to provide some relief to tightening export capacity once it gets moving, the economic environment might only get worse should the project be delayed beyond 2015, said Hannochko. “The take-away from that is the capacity squeeze that could affect producers’ netbacks as Canadian differentials widen due to the lack of sufficient export capacity,” he said.

“On the environmental front, there’s significant pushback against projects both in Canada and in the U.S. Delays could become more commonplace due to long-lead times for the environmental permitting and regulatory process. One aspect that could speed projects along is that the Canadian government has introduced legislation to expedite the regulatory process.”

Crude oil slide

While bureaucratic red tape slows midstream growth, a series of factors are hurting potential crude-oil profits. Suffering largely due to concerns over demand, crude oil is also being hammered with Europe’s debt crisis, as well as slowing economic growth from China and India, said S&P’s director of corporate and government ratings, Michael Grande. All of those factors play roles in the dwindling prices.

As such, price levels are expected to remain shaky throughout the year. “In our view it probably means that crude oil prices will remain below the highs that were experienced in March at about $120 per bbl., but there will certainly be periods of volatility that will continue throughout the year,” said Grande.

The future isn’t looking any brighter for natural gas prices. “They remain very weak, and we believe they will be weak for some time,” said Grande. “Even with declining rig counts, the associated gas coming from oil and rich-gas drilling continues to increase supply, and demand really has not picked up that much.”

Overall, ethane and natural gas liquid (NGL) prices have decreased recently. Both are expected to remain low for the remainder of the year. Ethane prices are unlikely to rise because ethane is used almost exclusively for the petrochemical industry, which has hit some snags recently. Some fractionators have shut down for scheduled maintenance, while expansions and turnarounds have “taken demand out of the equation,” said Grande.

“Once that happens, coupled with the growing supply of ethane, it’s like flipping a switch,” he said. “The price is very volatile and sensitive to demand. Currently ethane prices are $0.30 per gallon, versus the average of about $0.50 this year. In our view, while demand is going to pick up a bit, the increasing supply is probably going to keep ethane prices low, but not quite as low as the $0.30 we’re currently experiencing.”

Additionally, the price of propane has been a letdown during the first half of 2012, mostly because of a mild winter, he said. Little can be done to revive its value this year, though it is likely to “pop back up” if a more seasonal winter returns in late 2012 or early 2013. Right now, propane prices sit about $0.75 per gallon, well below the yearly average of $1.15.

Meanwhile, many new projects are likely to see additional raw mix NGLs flow to Mont Belvieu for fractionation and dissemination, said Grande. Those projects, which will be coming online in 2013 and 2014, will happen while demand is increasing. However, demand is not expected to play catch up until 2015 through 2016, when the supply-demand balance is expected to level out.

Until then, the sector will remain uncertain. “You’ll continue to see some volatility,” said Grande. “You’ll see prices increase and be strong at times and then kind of fall off.”

Making the grade

In releasing its mid-year update, S&Ps also put out its latest ratings on midstream entities. The ratings are assigned based on a series of criteria and are handed out after a business risk assessment has been conducted. Marks are based on factors contained in a three-tier system. The Tier 1 factors are weighed most heavily, while the Tier 3 elements hold the least amount of sway.

“Clearly the Tier 1 factors are the most important, where we took a look at an entity’s volume flows, the degree to which they’re sensitive to commodity prices, the contracts underlying those flows, the amount of cash flows at risk from commodity price movements and then, just fundamentally, the degree and diversity an entity has,” said S&Ps Bill Ferara, director of corporate and government ratings.

“And then on the financial side, our Tier 1 factors— as you would expect—are with regard to an entity’s policy, its financial matters, the adequacy of its cash flows, its capital structure and the liquidity to deal with shortterm events.”

About three-quarters of the companies rated by S&Ps have positive outlooks. Of the companies whose ratings changed since January 1, 2012, seven were upgraded, while eight received positive outlook revisions. Five companies received negative outlook revisions, and three others were downgraded.

Ferara said most of the positive upgrades have been related to companies making long-term improvements. Many of the companies that fared less well were associated with the propane sector, which suffered from low prices and weak demand due to the past unseasonably warm winter.

Of all the companies rated, NGPL PipeCo. LLC was among those to take a tumble. It was downgraded to the B category in May 2012 due to lessening cash flows and a drop in its commodity gas-sales business. In January 2012, the Rockies Express Pipeline LLC was also lowered. It dropped to a BB grade because of its narrow basis differentials, and the fact that it’s almost fully contracted until 2019.

Energy Transfer Equity LP improved its credit score, which rose from BB- to BB, after completing its $9.4 billion merger of Southern Union. The $1.67-billion acquisition of BP’s Canadian NGL business raised Plains All American’s rating to BBB from its previous BBB- score.

Key trends

Pointing to key trends, Ferara said analysts are seeing smaller capital spending programs that are helping improve some credit metrics. Many of the major capital programs that had been stretching budgets are declining, too. However, it’s not all good news, with low gas prices and basis differentials hurting the market. “Financial leverage is often lingering at the other edge of tolerance levels,” said Ferara.

The sector has completed numerous large-scale deals during the past few months, mainly related to Kinder Morgan Inc. and Energy Transfer Equity. Observers have noted that both companies have been increasing their size and cash-flow diversity. Doing so is an effective way of improving credit quality, said Ferara.

“However, some of these deals have increased debt leverage a little bit—especially at Kinder Morgan Inc. and Energy Transfer Equity,” he said. “Those entities did, however, take actions to limit the acquisition financing at close as well as put measures in place to reduce leverage soon after the close of the transaction.”