When I attended the Enercom Conference for a little cross-training, I did not expect to hear all that much about midstream companies. I was so pleased on the first day when I heard an upstream company brag about its midstream contracts. But then it happened again. And again. So I knew I had to do more research here. How was it that just a few months ago midstream investors were panicked that upstream companies were going to just stop paying their midstream providers, and here upstream was bragging about how lucky they were to work with such great midstream companies?
Upstream Companies Need Midstream Assets
An upstream company may have the cheapest cost of production and produce the highest quality oil, but if that oil’s just sitting in a Texas oil field, there’s very little profit to be made. Whether the upstream company owns and operates the pipelines and processing facilities or outsources that to another company, midstream assets are necessary.
Upstream companies do not generally disclose their midstream providers or details of the contracts. Fair enough, given the potentially competitive nature of such agreements. It may also be a matter of scale; Exxon (XOM) is a $362 billion company, and MLPs as a whole are $380 billion. Sometimes, XOM and other majors like Chevron (CVX) are the only shippers on a particular pipeline, which they will also own. Despite not continually using 100% of the capacity, they typically prefer to preserve the optionality of using the additional space, rather than leasing it out to a different production company. Since their main concern is uninterrupted takeaway capacity, there’s really no reason they would compromise their access to necessary midstream. Occidental Petroleum (OXY) even has its own midstream segment, composed of their pipeline and marketing businesses, and touts the benefit of this vertical integration.
When a company is operated on such a large scale, its success does not depend on gaining a foothold (and takeaway capacity) in a particular basin or acreage location. However, for a smaller company, knowing they have dedicated midstream access can make expansion into a new area possible.
Cabot Oil & Gas (COG), an $11.5 billion company, when working with Williams Partners (WPZ), communicates continually to be sure that a gathering line is in place as a well is completed. Not only does this provide immediate takeaway options, it prevents any flaring of gas. So, all of the production can be captured (and profited from!) and the environment also benefits. More to the point, in their own words, “Cabot has the ability to double its Marcellus production over time based on its previously announced firm transport and firm sales additions.”
As COG illustrates, sometimes the limiting factor to upstream growth, even today, is takeaway capacity, not pricing.
One takeaway option is necessary but more can be oh so much better. At the very least, it provides other options in case of a pipeline leak or necessary maintenance. At best, the upstream company has access to multiple pricing points and can choose the most profitable option. As shown below, Pioneer Natural Resources (PXD), touts the benefits of a variety of takeaway options from their acreage in the Permian.
Not Just Friends, But Partners
Sometimes, an upstream company and a midstream MLP will jointly own a pipeline. The upstream company appreciates secure access to capacity, and the MLP appreciates having an anchor shipper or shipper whose interests are aligned. The MLP then also will find other, third party customers for the remaining capacity, to diversify their exposure.
For a few quick examples: PXD owns an interest in a Permian gas processing facility owned by Targa Resources (TRGP). Likewise, COG and WPZ jointly own the Constitution Pipeline with Piedmont Natural Gas Company (PNY) and WGL Holdings (WGL).
Controlling the Capacity While Only Indirectly Owning It
Several upstream companies have gone even farther than partial ownership of pipelines. Since midstream is generally seen as a cost center for a production company, many have formed their own MLPs for just this reason. MLPs often receive premium valuations due to their tax-advantaged status. An upstream company may form an MLP with an initial series of assets (originally built out of necessity to run the upstream business), and more assets may be dropped down over time. By retaining the GP interest and control, the upstream company assures themselves of priority access. In return, the MLP has cash flow stability via (typically) minimum volume commitments.
The other side of the coin is that having most of the business with one entity can be very risky if that entity doesn’t (or can’t) pay its bills. Years ago, Chesapeake Energy (CHK) spun off its midstream assets into an MLP known as Access Midstream Partners (former ticker: ACMP). When ACMP merged with WPZ, the contracts came with them. So, until recently, CHK was one of WPZ’s major customers. While CHK has not declared bankruptcy as had been previously feared, the announcement of the renegotiation of its contracts with WPZ removed some uncertainty around the future of WPZ. Now that investors know only 15% of WPZ’s total revenues will be dependent on CHK, they have allowed its unit price to move higher.
Obviously, this would only be one factor in an investment decision, but when considering the upstream/midstream GP/LP relationship, also keep in mind:
• how much of the LP the GP owns
• where the LP is in the IDR tiers
• the MLP’s customer and basin diversity
• how many assets are still at the GP to be dropped down to the LP
As a gentle reminder, the GP does not owe fiduciary duty to either the LP or to the LP’s unitholders.
If you are looking to invest in an upstream company with a midstream MLP, perhaps it’s because you like the idea of a streamlined, exploration-and-production-only upstream company. Several of them formed the MLP by monetizing their midstream assets and a few also use the MLP as a funding vehicle. On the flip side, if you’re looking to invest in a midstream MLP with an upstream company, perhaps it’s because you like the idea of minimum volume commitments and aligned interests.
MLP investors are so familiar with midstream management teams bragging about their customers. Regardless of whether the customers are primarily upstream companies or utilities, we hear not only about how many customers they have, but also about diversity and their credit quality. It’s nice to hear the upstream companies brag about us.