The Coming Energy Infrastructure Overcapacity Glut
October 1, 2015
By: Bill Powers
When free money is thrown at any part of the energy industry for a long enough length of time, the natural boom bust cycle can be taken to extremes and massive distortions can develop.
Due to unprecedented access to all forms of debt capital, especially the high-yield variety, the exploration and production (E&P) industry of North America drilled tens of thousands of uneconomic wells over the past six years. Concurrently, an epic building boom for energy infrastructure to process all of this new oil and gas production was easily financed as investors reached for yield during a period of zero-percent interest rates.
The billions upon billions of dollars cheap capital that has been raised for infrastructure MLP (which includes pipeline gathering, compressor and processing MLPs) have resulted in a worsening overcapacity situation in many basins. There is now too much capacity chasing declining production in nearly every once booming shale basin. For example, midstream processors in the Haynesville shale are now scrambling for business due falling production and a glut of capacity. More on the situation in the Haynesville below.
But more generally, this new reality for midstream MLPs is showing up in the marketplace in the form of big drops in the stock prices and corresponding rising yields.
While many MLPs now offer very high yields, most have payouts that are unsustainable over the medium-term (six to 24 months) and should be avoided. One company that is likely to see downward pressure on its prices is Azure Midstream Partners (NYSE:AZUR) that operates primarily in the Haynesville.
The company recently reduced its 2015 adjusted EBITDA guidance 10% given that “producer drilling activity will remain below expected levels for the balance of 2015.” (Source: http://finance.yahoo.com/news/azure-midstream-partners-lp-reports-111500533.html ) Azure units are currently yielding 22%. With falling production levels in both the Texas and Haynesville portions of the Haynesville and little hope of a rebound in activity at current commodity prices, I expect to see further downward guidance from Azure and many of its competitors.
In other words, we are at the beginning of what I expect to be a brutal bear market in infrastructure MLPs.
The biggest surprise to most investors in the midstream MLP space is the amount of commodity price risk embedded in these companies. How can this be? My broker told me that I should reach for that juicy yield since mid-streamers have fixed contracts with well-heeled producers in all the hottest basins…. Hmm… Unfortunately, markets, in at least this case, still work.
While it is certainly true that midstream companies have contracts in place that will provide for a steady stream of revenues in the short and intermediate term, we are now seeing financially distressed E&P companies, who are desperate to cut costs, renegotiate existing contracts at far lower rates.
Why would a midstream MLP that has invested potentially hundreds of millions in a gathering system—and is taking the standard 30% of a producer’s gas as a fee for processing and selling the gas into the interstate system—agree to reduction in fees? The answer is two-fold.
First, in older shale gas basins such as the Haynesville in northern Louisiana, mid stream companies are scrambling for business. This play already had a huge gathering infrastructure in place to service conventional production that was expanded to accommodate more than 8 bcf/d of new shale gas from the Haynesville formation.
After peaking at approximately 7 bcf/d in late 2011, Haynesville production is roughly 3.5 bcf/d and is falling fast. (Source: LA DNR and TX RRC) Declining production from E&P’s in the Haynesville means a smaller pie for the midstream MLPs to divide up.
Second, financially distressed shale-focused companies will increasingly play the bankruptcy card. Filing for restructuring would allow existing contracts to be renegotiated at potentially much lower rates. For example, it is very likely that distressed companies such as Goodrich Petroleum (NYSE:GDP), Halcon Resources (NYSE:HK) and Sandridge Energy (NYSE:SD) and others are seeking major concessions from their midstream providers.
To get a better understanding of just how much negotiating leverage midstreamers have lost with E&P companies who were once desperate to get their products sold no matter the terms, let’s examine the first large renegotiation between an E&P and a midstreamer.
On September 8th Chesapeake Energy (NYSE:CHK) announced that it had renegotiated its gathering contracts for its Haynesville and Utica project areas with the Williams Companies (NYSE:WMB). Below are a few of the highlights of the Haynesville deal:
–In exchange for extending the length of the agreement between the two companies and CHK providing higher volumes in future years, the companies converted a variable rate agreement to a fixed rate agreement.
–CHK’s expected gathering fee for 2016 drops from ~$.88 per mcf to ~$.65 per mcf, a 26% reduction under the new agreement. This reduced fee includes a minimum volume commitment penalty. (Source: http://www.chk.com/Documents/investors/20150908_Latest_IR_Presentation.pdf )
–CHK fee for gas gathering in 2018 drops to only ~$.53 per mcf in 2018 and escalates with CPI thereafter.
It is quite clear that WMB would not have converted its very lucrative existing gathering contracts with CHK to fixed rate agreements at greatly reduced rates if it believed it could have replaced CHK volumes with volumes from other operators. Given that there were only 26 rigs running in the play as of the end of September and not enough wells are being drilled to keep production at current levels, it seems Williams had little choice but to lock in fixed fees for guaranteed future volumes at a time of very low natural gas prices.
What other companies will be impacted by gathering system renegotiations?
Another midstream MLP that is likely to face a distribution cut due to the fierce competition and dropping activity levels is Southcross Energy Partners, LP (NYSE:SXE) that operates in the Eagle Ford shale area of Texas. Similar to other shale plays, the Eagle Ford has seen a large drop in activity, a plateau in production and a massive build out in processing capacity. Not a good combination for a smallish processor of hydrocarbons.
As a believer in the cyclical nature of markets and in mean reversion—even in markets that have been grossly distorted by the free money bonanza of the past six years—there will come a time when the midstream sector will offer an outstanding risk/reward ratio and juicy, sustainable yields. However, that time is still a long way off. I believe a fantastic buying opportunity for midstreamers lies on the horizon but there will be many, many distribution cuts and millions of frustrated investors before this time arrives.
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