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Slower shale growth may reignite investor enthusiasm for midstream, analysts say

Slowing U.S. oil and gas production provides a favorable opportunity for pipeline companies to regain their stride in the stock market and with reluctant investors, analysts at investment banking firm Mizuho said.

With shale output already declining amid struggling commodity prices and an upstream sectorwide commitment to cut spending, midstream companies focused on gathering and processing are already facing declining revenues and credit profile risks as producer customers seek to renegotiate contracts. Meanwhile, pipeline transportation and more diversified companies that have less commodity exposure are under pressure from investors to demonstrate that they can enforce capital discipline as demand for new infrastructure decreases.

But the challenging environment could move midstream operators to make choices that would entice investors to return, Mizuho analysts wrote in a Jan. 17 note to clients.

"We are in the optimistic camp," Mizuho said. "A slowing in shale growth can mean good things: a sunsetting in outsized sector CapEx, reduced risk of asset overbuild, and opportunities for enhanced cash returns with greater visibility to higher free cash flow."

Many midstream companies have already pledged to spend less on growth projects in 2020, but they must also "pass on projects investors may see as nonessential," the note said, particularly when it comes to the glut of proposed crude oil pipelines in the Permian Basin. That dwindling slate of projects will enable pipeline companies to generate free cash flow while putting more cash toward share buybacks and "responsible" distribution increases or improving balance sheets, the analysts added.

"Either application could bring investors back into the fold enticed by midstream's sustainable new look," they said.

At the same time, companies can look ahead to 2021 and consider the additional chemical plants, crude oil export facilities and Permian gas pipelines that Mizuho calls "the areas left for sizable midstream energy spend."

Kinder Morgan Inc.'s Permian Highway and the joint venture Whistler pipelines have reached final investment decisions and are expected to move forward. The Permian will not need another new long-haul gas pipeline until 2023, East Daley Capital Advisors Inc. analyst Matthew Lewis said in a recent interview. On the crude exports front, Enterprise Products Partners LP gave the green light in 2019 to its Sea Port Oil Terminal project in the Gulf of Mexico after signing development agreements with a Chevron Corp. subsidiary.

Another potential benefit of slowing shale production and the project spending decline is that pipelines may not see as much competition when it comes to re-contracting firm transportation capacity since the market could "reach an equilibrium" that alleviates low tariffs, according to Mizuho.

Still, the analysts acknowledged that a complete sector turnaround is a hard sell for those who witnessed the midstream industry's financial struggles in the wake of the 2014 commodity price crisis.

"Concerns are understandable given the ghosts of midstream past, specifically the build-out of pre-crash infrastructure projects designed to accommodate producers whose drilling plans were predicated on high commodity prices," they wrote. "We doubt the subsequent fallout has been forgotten by investors who were burned the last time around."