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Midstream analysts predict quiet 2017 amid regulatory limbo, tightening M&A

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Essential Energy Insights - September 17, 2020

Essential Energy Insights September 2020

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Midstream analysts predict quiet 2017 amid regulatory limbo, tightening M&A

The outlook for the midstream sector in 2017 is one of tempered optimism as the oil and gas industry benefits from strengthening commodity prices but pipelines still face regulatory hurdles, restrained M&A activity, shifting investor preferences and scrambles for capital as interest rates rise.

Although the incoming Republican administration is expected to be more sympathetic toward midstream and energy infrastructure projects, gas pipeline developers may not get the best of the "Trump bump," according to Washington Analysis LLC analysts Robert Rains and Gianna Kinsman.

"We retain a mixed outlook for natural gas pipelines, particularly northeastern projects, due to the persistent tension between state and federal regulators, which we do not expect to be alleviated by the incoming Trump administration," Rains and Kinsman said in a December note, pointing to challenges involving the Atlantic Sunrise expansion project, Access Northeast and the Constitution Pipeline.

Although the new administration will consider legislation to speed up pipeline project approvals and put a break on pushback from states like New York, "it is doubtful that [Sens.] Elizabeth Warren [D-Mass.] and Bernie Sanders [I-Vt.] will allow this to happen," they wrote.

New York state, which withheld a water quality permit for Constitution in April, will likely uphold its denial again if the U.S. Court of Appeals for the 2nd Circuit remands the project back to the state Department of Environmental Conservation for another review, their note said.

Tortoise Capital Advisors LLC Managing Director Rob Thummel agreed that pipeline developers will likely continue to grapple with state regulators for approvals, but he was more optimistic overall. "The latest protests that have continued will likely result in state regulatory agencies taking their time to approve new pipelines [but] I still think the pipelines will get built. It's not a matter of 'if.' It's a matter of 'when,'" he said in an interview.

M&A

Deloitte's John England expects midstream M&A activity in the form of synergistic combinations but does not see significant growth opportunities for midstream players next year.

"There's going to be a continued focus on cost reductions, operations-wise. They're going to have limited growth opportunities in 2017 [because] the growth of midstream is largely driven by upstream companies, which will grow again in 2017. But it will be a slow path" he said in an interview.

Even as organic growth opportunities moderate, England contends that changing investor preferences for midstream assets could pose some challenges. In a 2017 industry outlook, he said growing demand for unconventional, short-cycle projects "may raise some broader questions regarding energy supply and security."

An estimated $620 billion of projects through 2020 have been postponed or scrapped in the throes of the downturn, and, as a result, "the appetite for long-term, complex, major capital projects has waned," England wrote.

Thummel said midstream players will look to rein in their capital costs to position themselves for opportunistic M&A moves. But he added that 2017 will be much calmer after an active year rife with much drama, including the proposed Spectra/Enbridge Inc. mega-merger and the collapse of the contentious Williams Cos. Inc./Energy Transfer Equity LP courtship.

Thummel said efforts to curtail general partner distribution payments or eliminate incentive distribution rights altogether could continue in 2017 through simplification deals akin to Plains All American Pipeline LP's ownership consolidation.

Rising rates

ALPS Advisors Inc. Research Director Jeremy Held believes that the Alerian MLP index, which tracks energy master limited partnerships, can match the pace of expected interest rate increases because its cash flows have historically grown at 5% to 6% annually.

The Alerian, yielding 7.3% as of late December, would be less sensitive to a gradual rate liftoff than real estate investment trusts and utilities, which offer yields of only between 3.5% and 4%, he pointed out.

On Dec. 14, the Federal Reserve raised the federal funds rate's target range by 25 basis points, to a range of 0.5% to 0.75%, and signaled more increases on the horizon after years of keeping its key interest rate close to zero. The low rates have tended to be beneficial to energy master limited partnerships, which rely on heavy borrowing to finance large projects and attract equity investors seeing more attractive yields than U.S. Treasurys can offer.

Investors chasing yields could continue to be drawn to MLP stocks on the Alerian MLP index, which is yielding more than 7% and grew by 19% on a total-return basis from the beginning of 2016 through Dec. 27. But Thummel of Tortoise, whose top midstream holdings include Plains and Energy Transfer Partners LP, had some advice for energy MLP investors: "Don't look just at the yield of the company," he said. "Focus on the underlying assets of the company and how it derives its cash flows. You're better off buying a company that has a 5% to 7% yield and which can grow its dividend stream by 3% to 4% annually, probably even by 4% to 6%."

Eric Donovan, who works with energy and commodity firms as managing director at an affiliate of financial services firm INTL FCStone Inc., expects an influx of debt deals in the first half of 2017 as midstream issuers scramble to nail down capital for growth projects and refinancing activities before the borrowing costs rose further.

Donovan expects the 10-year Treasury, whose yield was below 1.5% in mid-2016, to reach 3.05% around the end of 2017, catalyzing more bond deals in the earlier part of the year.

"When we hit 3.05%, debt will become a lot more expensive for issuers. So Q1'17 or the first half of 2017 is when you're going to want to do it," he said.