Executives at Appalachian shale driller Eclipse Resources Corp. had some decisions to make on how they would get to market the natural gas and liquids they produced using some of the longest laterals in the business. It is a particularly difficult decision because Eclipse's newest target area, called Flat Castle, is hundreds of miles east of its Ohio wells.
The seven-year-old Marcellus and Utica shale producer would have to decide whether to build and operate a midstream unit inside the company or pay for a big pipeline player for services. It would cost the company $10 million to build a gathering and processing system now, CEO Benjamin Hulburt told analysts on a March 1 conference call. "But that becomes much more impactful in , where it's probably on the order of $60 million in capital" as more wells are drilled.
That is a lot of investment for a company with less than a $400 million market capitalization. "We are having discussions that run the gamut of different structures," he said of the management team, built with former Rex Energy Corp. and Chesapeake Energy Corp. decision-makers.
It is a question with three possible answers, all of which have been used in during the shale gas boom in Appalachia and elsewhere: Pay a big midstream outfit such as Williams Partners LP or MPLX LP for gas gathering and processing, spend capital to build midstream operations under the corporate umbrella, or spend capital building midstream operations that are spun off into a tax-advantaged master limited partnership.
'Stick to our knitting'
S&P Global Market Intelligence examined three of the top Appalachian gas producers — Cabot Oil & Gas Corp., EQT Corp. and National Fuel Gas Co. — to show how different executives with different facts have played it out over the past five years.
Cabot started building gathering lines and completed two compressors in Susquehanna County, Pa., in the northeast corner of the state, then decided to "stick to our knitting," in the words of one Cabot executive, which was drilling for gas, not running a midstream operation. They sold the gathering system to Williams Partners in 2010 for $150 million and entered a 25-year gathering agreement with the partnership. Because Cabot's wells produce only dry gas that can go straight to a transportation pipeline without processing, Cabot does not pay for those services, while EQT in the far southwest portion of Pennsylvania in a wet gas area needs processing services.
"With the exceptional well success we have seen in our Marcellus operations, we needed to adjust the way we thought about infrastructure and take-away capacity going forward," Cabot CEO Dan Dinges said at the time of the sale. "Williams Partners … is one of the premier midstream providers that has the capabilities to help us make a significant step change in the way we develop this resource and execute our program."
Cabot carries $1.5 billion in longer-term debt but is one of the first producers in Appalachia to become cash flow positive. It is expected to generate $225 million in free cash in 2018, according to analysts surveyed by S&P Global Market Intelligence, increasing to more than $1 billion in 2021 — cash Cabot says it will use to pay increased dividends and buy back shares.
Cabot's shares have lost nearly 30% in the past five years, while EQT shares have lost about 28%, both adjusted for dividend payments. But EQT shareholders got units in EQT Midstream Partners LP, the value of which increased 79% over the past five years, adjusted for distribution payments. The difference has been so stark that EQT has come under fire from a couple of activist hedge funds to split itself into separate midstream and upstream units and abandon the $6.7 billion merger with Rice Energy executed in November 2017.
The MLP option
EQT's strategy of building midstream in house, then "dropping down" the asset by selling it to its MLP, rewarded unit holders with a dividend and value appreciation, and the MLP in turn provided a ready source of cash to EQT.
"To remind you, the advantages … to EQT shareholders of forming an MLP includes maintaining operational control of where, when and to what specs gathering is built; access to an ongoing source of low-cost capital; and participation in any MLP distribution growth," EQT CEO David Porges told analysts on an April 26, 2012, conference call. EQT Midstream was born later that year. "Of course, a publicly traded currency would also provide a market view of the value of the MLP's assets."
The values of MLPs themselves, however, have significantly diminished over the past few years. Many energy pipeline partnerships have chosen to restructure as C corporations in the wake of the 2014 commodity price crisis, while remaining MLPs as a group have experienced persistently high leverage and capital costs that continue to drag stock prices down, even as crude oil prices have rallied.
As of the market's close March 26, the bellwether Alerian MLP Index had already lost over 13% on a price-return basis so far in 2018. With investors pressuring management teams to eliminate the structure of incentive distribution payments to sponsor companies and self-fund equity requirements, the future of MLPs is murky.
The long view
The third solution to the problem takes a longer-term view that makes analysts and activists impatient but dates to Standard Oil and John D. Rockefeller: Keep all operations in house as much as possible, and create value at every point on the supply chain.
National Fuel follows this philosophy, with portions of the company running Seneca Resources, its upstream unit, as well as a midstream segment that operates gathering and transportation pipelines servicing Seneca's fields in northern Pennsylvania and a downstream gas utility serving western New York.
National Fuel comes under fire almost annually from activist investor Mario Gabelli and his GAMCO family of funds. Gabelli's most recent demand is that National Fuel spin off its utility. The year before, he wanted the midstream units spun off into an MLP. Gabelli, National Fuel's third-largest shareholder, with a 7.3% stake, claims that investors are not getting full value for the midstream and downstream units if they reside under National Fuel's stock.
But there are several advantages to keeping all the company's assets under one umbrella, company spokeswoman Karen Merkel said. Coordination of gathering and Seneca's drilling operations is more cost-effective, while the rate-regulated pipelines and utility provide a stable base of earnings. Finally, there is a tax advantage, Merkel said. "As a consolidated income tax filer/payer, National Fuel can offset taxable income generated at the midstream and downstream businesses with deductions generated through Seneca's Appalachian drilling program," she said.
In the past five years, National Fuel has lost 6% in share value, adjusted for dividend payments, besting Cabot and EQT.
As for Eclipse Resources, its midstream decisions and the fate of the Flat Castle project are probably going to be up to somebody else. Late on March 26, the company said it is evaluating "strategic alternatives," indicating a sale, merger or reorganization could be in the works. The announcement came after Eclipse made modest profits in 2017 on improved NGL prices.