Distributable cash flow shortcomings, unsettling court rulings, skittish investors: They all add up to challenging times for the Midstream 50 and other midstream firms. Yet the intrinsic value of the sector—along with excellent capital appreciation opportunities in the near future—remain. A long-time participant and observer of the midstream’s financial side, Olsen recently joined BP Capital, the investment house founded by legendary oilman and financier T. Boone Pickens, to manage the firm’s midstream-focused Twinline MLP Fund. He took time to visit with Midstream Business to give his views on those challenges as he predicted attractive investor returns ahead.

MIDSTREAM Considering the broad financial market, where do mid- stream issues fit into portfolios now, given the weak overall performance of the oil and gas sector?

OLSEN What we’re seeing is the underlying interest rate environment is, obviously, still very depressed, so there’s a lot of attention on yield-oriented securities—like what most midstream securities are.

However, there are certainly con- cerns about the creditworthiness of companies in the energy industry right now. It’s a period of time where you’re seeing great investor concerns. You’re seeing a lot of outflows, especially from the retail sector that has historically dominated midstream investing. But at the same time, you’re seeing a rotation from those retail investors to more institutional-type investors, such as en- dowments and pension funds. Investor interest in the midstream remains high; certainly price dislocation has brought the group to investors’ attention. But that interest level comes from a different group than we’ve seen historically.

MIDSTREAM What can midstream executives do to differentiate their fee-based firms from upstream producers that have greater commodity price exposure?

OLSEN I think what you’re seeing today—the reason why that’s such a tricky question—is frankly because there’s a lot of investor concern. It’s not just about fee-vs.-commodity exposure, there’s concern about whether the E&P companies can pay those fees. They have credit issues themselves. In 2008 and 2009, there wasn’t widespread concern about the creditworthiness of producers. In 2008 and 2009, the argument for mid- stream was always, “Are you commodity or are you fee?” If midstream companies showed themselves to be fee-oriented, investors were satisfied with that.

What’s different this time around is that we’re seeing that a fee-based structure is not sufficient because people are concerned about the credit quality of those fees as well as the risk that vol- umes may substantially decline over the next year or two. In this cycle, it’s not as easy as saying, “Hey, we’ve got fee ex- posure.” You also have to explain who your typical customer is. That is kind of invasive and intrusive into a midstream business, and I think midstream exec- utives are finding that they’re probably giving more disclosure about their customer base than they ever have in the past and probably more than they frankly have ever felt comfortable doing.

MIDSTREAM Investor sentiment toward MLPs seems to have improved in recent weeks. Is this a result of bet- ter category differentiation or are mid- stream stocks still in lockstep, given slightly improving crude prices?

OLSEN I think investor sentiment and crude prices are connected. What we’ve seen is just a reaction to commod- ity prices. We have seen a pretty broad- based recovery in companies that are well positioned and have very strategic assets. But we have also seen meaningful appreciation in companies that con- tinue to have issues with a $40, $50 or maybe even a $60 crude price.

In my view, I think that what we’ve seen so far has been driven by commod- ities. It has not really been differentiated between the quality of different mid- stream companies.

MIDSTREAM You mentioned ear- lier that institutions have a growing interest in midstream MLPs. Do you see this as a major trend?

OLSEN Yes, absolutely. From where we sit and the fundraising that we are privy to, the amount of interest—the request for proposals—coming from universities and pensions is very pro- nounced, investors that have historically not looked at midstream.


MIDSTREAM With some strongly dislocated yields, distribution sus- tainability is a major question now for many MLPs. What’s your view?

OLSEN If you take a bird’s eye view, and without getting fixated on any specific company, we have had very high levels of capital spending. And as a result of lower volumes and lower com- modity prices, in many cases the proj- ects that were built in 2013 and 2014 are not delivering the returns that they were originally expected or forecast to deliver. So what we have now is a situation where indebtedness is at historically high levels and, in many cases, compa- nies are having trouble paying their div- idends out of cash flow from operations. It raises the question of, do you address the debt issue by issuing a bunch of new common or preferred equity? That’s an option that some companies are facing. But you know, that raises the question of, have you really protected the divi- dend long term or have you just bought yourself some time by addressing the debt issue by raising new equity?

When I look at where companies are right now with regard to their payout policy, there are plenty of companies whose payout is objectively too high un- less we assume a dramatic oil price re- covery. So the question is, do you dilute yourself with an extensive equity issu- ance today and protect yourself against debt issues that maybe endanger the dividend further down the road, or do you just cut the dividend, put yourself on a more stable footing and begin to grow the payout on a more sustainable basis going forward?

MIDSTREAM Will the MLP struc- ture need to change and, if so, how? For example, what is the role of incen- tive distribution rights (IDRs)?

OLSEN That’s a great question. When you think about it, an IDR by its very nature assumes growth. It assumes that the MLP will grow so that the IDR can grow at an even more accelerated rate. And when you think about that nature of an IDR and why it has gone away from many companies, it’s at companies that were paying out a significant IDR where cash flows were shrinking for
two or three years. The IDR becomes a fixation for investors and it becomes a source of uncertainty.

I think in a lot of cases, companies whose payouts were a little bit too aggressive are rightly reconsidering. Or in the case of Targa and Kinder Morgan—even Williams before the Energy Transfer acquisition came up—they were getting rid of their IDRs because the company was not growing and the IDR was poised to fall even faster than the company’s overall payout. So I think what we’re seeing structurally is in some cases companies are, frankly, doing away with IDRs for the reasons I mentioned.

But I think another structural change that we’re seeing is companies believe that C corp investors can value a com- pany more on the basis of earnings and cash flow regardless of what the payout policy is, while MLPs are valued more or less on the actual cash payout. I think what we’re seeing is that some of these companies that are converting to
C corps want to have the flexibility to pay out less of their cash flow without seeing a huge valuation hit.

Getting rid of IDRs or converting to C corps are really two strategies dealing with the same problem: shrinking cash flows and declining growth.

MIDSTREAM What about MLP alternatives? Will we see more conventional corporate structures or real estate investment trusts in the midstream?

OLSEN I don’t know about REITs, that’s a structure that just has not been used widely. On the C corp side, I think the answer is probably yes, we will see more. I think a year or two from now the percentage of midstream assets housed in a C corp will be greater than today for two reasons. One is, there will be some conversion to C corp for tax reasons as well as companies want a different investor base. I think the other reason that I’d highlight is that some of these C corps that aren’t paying out all their cash flow will eventually be in a better position to acquire MLPs.

And being a C corp, you know, you have tax benefits in buying an MLP, as we have seen with the Marathon Pe- troleum acquisition of MarkWest and the Kinder Morgan buyout of its own MLPs. So yes, I think we will see more C corps. I don’t think we’re going
to see MLPs go away, but I do think C corps will become an increasingly important player in the overall mid- stream landscape.

MIDSTREAM Private equity seems to be the financing choice for a lot of midstream players now. Will we see a surge in IPOs when prices turn around?

OLSEN What we’ve seen so far is that private equity has been more interested in taking minority stakes in existing companies rather than trying to take the assets over themselves. And I think, quite frankly, the track record of private equity control of private equity-spon- sored companies in midstream has not been a good one. That’s just factual.

Companies coming out of private equity stewardship have generally not done as well in the public market and have not been positioned as well to thrive in challenging markets. So rather than trying to take all the risks associated with being the owner or the sponsor, what private equity is doing now—and I think makes more sense— is they’re providing the lender of last resort-type role where they provide relatively expensive preferred equity capital to MLPs that don’t want to tap the common equity market.

And I think it makes sense because I think by injecting that private equity, they show the common equity market that things are really not so bad. They put a floor underneath MLP valuations and they set up these companies to at least participate in a recovery. We’ll see, as the cycle continues, if the private equity firms begin to buy entire compa- nies or buy more assets outright. But so far, we’ve just seen them involved in a financing role rather than in any kind of controlling role.

MIDSTREAM How will the growing volume of exports alter the midstream?

OLSEN Between 2013 and 2015, we saw a massive growth in U.S. exports, to the point where we went from being an importer to now we will probably ex- port, in the next couple of years, 5% to 10% of our total energy production.

Now, some of that export growth is going to be because of the LNG con- tracts and the LNG facilities that are already planned and underway. But I think when you look at the economics today, the economics for exports are actually much weaker than they have been over the last several years and that just has to do with lower prices, which means that export arbitrage necessarily shrinks. The number of dollars that you can charge to export a barrel of $100 crude is necessarily higher than what you can charge for $40 crude.

I think, frankly, as we move forward, the export projects that are planned already will still be completed, but I don’t necessarily expect a lot of new export project announcements. Maybe there will be a few more projects, maybe exports to Mexico will see a few more projects, and eventually I expect to see LNG projects resume again. But for the time being, a lot of those export growth projects—unless they have already been committed to—are going to be on hold.

MIDSTREAM There have been recent court rulings that many say jeopardize the traditional contractual relationship between producers and midstream operators. What is your viewpoint on the issue?

OLSEN There has been a lot of discussion about some very specific contracts associated with bankruptcies in the past few months, Sabine Oil & Gas you know, and that has really dominated the headlines in the midstream industry. What are bankruptcies going to do to investor sentiment in the midstream space?

The only comment I would offer is that in the U.S. right now, we have import contracts, 20-year LNG import contracts, that have basically never been used and these contracts have been going for years. They’re expensive, they were never used and never canceled. And on the other end of the spectrum, we have private E&P companies that are going bankrupt and are renegotiating their contracts. And in that spectrum, those examples are probably the most secure to the least secure cash flows.

I think when people really do fun- damental analysis on the midstream group, they will find that the average cash flow is much closer to that 20-year contract than to a small producer in a certain part of a basin somewhere in the U.S. And so I think the bankruptcy risks, while they’re real, affect a smaller percentage of the midstream companies than I think is currently priced into the market today.

MIDSTREAM What are your short- and long-term forecasts for the midstream?

OLSEN One thing I feel very good about is that if you buy a high-quality portfolio of midstream assets today, that over the next three years you’re going to see meaningful capital appre- ciation. Every historical indicator of value just screams the same way, and that is midstream assets are very cheap today. And while there are certainly uncertainties around credit quality and volume growth, they really pale in comparison to the problems that the energy industry—certainly the pipeline industry—was facing in the late ’90s and early 2000s. When Enron was going bankrupt, Williams and El Paso were on the verge of going bankrupt, too—and you had oil at $10 in the late ’90s.

You know, valuations were similar to what they are today and today you have a much better fundamental out- look than you did back then. I think value is unquestionable. It’s just a matter of how many dividend cuts are going to be made between now and the recovery and how many unattractive fi- nancings are going to happen between now and then.

I don’t think anybody at our firm is expecting oil to go back to $100 in the next year or two. I think it’s going to be much more of a slow grind, higher through the $50s and $60s, so you’re not going to get a magical crude oil-driven bailout for the midstream indus- try. But I think for those willing to be patient over kind of a zig-zagging, multiyear path, there’s no doubt that the overall trend is going to be higher.