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Credit FAQ: How S&P Global Ratings Factored Counterparty Risk Into Recent Midstream Energy Rating Actions

Counterparty risk has been a significant theme for midstream companies this year given deteriorating upstream creditworthiness and the importance of upstream activity to cash flows. Midstream counterparties generally consist of shippers in the upstream sector (exploration and production [E&P] companies), and to a lesser extent, players in various downstream segments (refineries, utilities, industrials, power producers, liquefied natural gas producers, etc.).

In February, we took various rating actions on nine U.S oil and gas E&P companies after revising of our natural gas hydrocarbon price assumptions (see "Rating Actions Taken On 9 U.S. Oil And Gas Exploration And Production Companies On Revised Natural Gas Price Assumptions," published Feb. 3, 2020). Then in March, the market changed drastically. After the one-two punch of the COVID-19 pandemic (demand shock) and the overseas Russian-Saudi price war (supply shock), market equilibrium was thrown off balance, and this has changed the landscape for oil producers. Oil prices fell below $25 per barrel (bbl) for a sustained period between February and May and bottomed out deep in negative territory in April, prompting producers to cut growth spending to preserve liquidity and curtail production to reduce exposure to lower commodity prices and quickly filling storage capacity. Both the oil price and volumes have rebounded since, but lasting damage was done.In March, we lowered our expectations for oil prices (see "S&P Global Ratings Cuts WTI And Brent Crude Oil Price Assumptions Amid Continued Near-Term Pressure," published March 19, 2020), and we took a staggering 108 negative rating actions (downgrades, negative outlooks, or CreditWatch negative placements) on the 88 U.S. E&P companies we rate from March through July. As of July 27, 35% of these E&P companies were rated 'CCC+' or lower,--indicating significant risk of future defaults. As of the same date, about 85% of this universe had an issuer credit rating that was either on negative outlook or CreditWatch with negative implications.

Chart 1

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At the same time, refiners, utilities, and other off-takers that generally make up end markets have suffered along with upstream companies, given the loss of demand for end products and power. However, we've taken fewer rating actions on these issuers because the stress has been less severe to date. Ratings on about half of the U.S. refiners have negative outlooks, but we did not lower any issuer credit ratings outright. Even as commodity prices rebound (oil prices have risen recently to about $40/barrel [bbl]), companies are still reeling from general demand and price weakness.

This weakness has affected our ratings on midstream companies, given we've had to reassess counterparty exposures for many of these companies. We think most players--including large, diversified companies and small, single-basin gathering companies--have seen some deterioration in credit quality among their customers. In fact, of the 80 rating actions we took on midstream companies between February and July 2020, 61 were negative rating actions (the others were mostly affirmations), and counterparty risk was mentioned as a key driver for 17 of these negative actions.

Chart 2

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Table 1

Rating Changes From February 2020 To July 2020
Company Early February Rating Early July Rating Notches Counterparty exposure Analyst
Antero Midstream Partners L.P. BB/Negative B-/Negative (4) Main customer and parent, Antero Resources; downgraded Mike Pastrich
BCP Renaissance Parent LLC B+/Negative B/Stable (1) General counterparty stress at Rover Pipeline Alex Shvetsov
CNX Midstream Partners L.P. BB-/Negative B+/Negative (1) Main customer and parent, CNX Resources; downgraded Karthik Iyer
Enable Midstream Partners L.P. BBB-/Stable BBB-/Negative 0 General counterparty stress Mike Pastrich
EQM Midstream Partners L.P. BBB-/Negative BB-/Negative (3) Main customer and parent, EQT Corp.; downgraded Mike Pastrich
Glass Mountain Pipeline LLC B/Negative CCC/Negative (3) General counterparty stress and exposure to Chesapeake Energy Alex Shvetsov
Inter Pipeline (Corridor) Inc. BBB+/Stable BBB/Stable (1) Main customer, Canadian Natural Resources Ltd.; downgraded Luqman Ali
Medallion Gathering & Processing LLC B/Stable B-/Negative (1) General counterparty stress; 60% of volumes from speculative-grade counterparties Viviane Gosselin
MPLX L.P. BBB/Stable BBB/Negative 0 Main customer and parent, Marathon Petroleum; revised to negative outlook Mike Llanos
Navitas Midstream Midland Basin LLC B/Stable B-/Negative (1) General counterparty stress; most customers are now non-investment-grade Viviane Gosselin
Oryx Midstream Holdings LLC B/Positive B-/Negative (1) General counterparty stress; 60% of volumes from speculative-grade counterparties Alex Shvetsov
PBF Logistics BB-/Stable BB-/Negative 0 Main customer and parent, PBF Holding Co. LLC; revised to negative outlook Mike Llanos
Rockies Express Pipeline LLC BBB-/Stable BB+/Negative (1) Multiple important shipping counterparties in Appalachia downgraded Mike Pastrich
Ruby Pipeline LLC BBB-/Negative B+/Negative (4) General counterparty stress amid elevated recontracting risk. Viviane Gosselin
Traverse Midstream Partners LLC B+/Stable B/Stable (1) General counterparty stress at Rover Pipeline Alex Shvetsov
Western Midstream Operating L.P. BBB-/Negative BB+/CreditWatch Negative (1) Main customer and parent, Occidental Petroleum Corp.; downgraded Mike Pastrich
Woodford Express LLC B/Negative CCC+/Negative (2) Main customer, Gulfport Energy Corp.; downgraded Rebecca Hu
Source: S&P Global Ratings

Frequently Asked Questions

How do you evaluate counterparty risk when the customer base is well-diversified?

A diverse customer base minimizes customer concentration, thereby reducing the potential for operational disruptions and cash flow volatility. In other words, diversification is important in mitigating counterparty risk because it reduces exposures to isolated events and the idiosyncratic risks of any single customer. For well-diversified companies such as Plains All American Pipeline L.P. or Energy Transfer L.P., we have more flexibility to consider average counterparty ratings, the percentage of investment-grade counterparties, and customer-base characteristics. We think the competitive position is often stronger in terms of scale, scope, diversification, and competitive advantage when the contract profile consists of a diverse pool of higher rated customers. Historically, it's much less likely that a single counterparty downgrade prompts a downgrade for a well-diversified midstream company.

We recently used this rationale for Enable Midstream Partners L.P. (Enable). We downgraded its largest customer, Continental Resources Inc., but we did not downgrade Enable when we reviewed it in April 2020, though we did consider general counterparty weakness when we revised the outlook to negative. Counterparties on the gathering and processing segment are exposed to commodity prices, but given the customer diversification, a single-notch downgrade on any single customer is less likely to change our view of competitive advantage. Enable benefits from strong, investment-grade counterparties in its transportation and storage segment.

Compare this to Antero Midstream Partners L.P. (AM), which receives nearly all of its volumes from Antero Resources Corp. (AR). If a counterparty's contracts represent most of a midstream company's revenue streams, and we believe the company likely could not replace the contracts at current rates, the counterparty ratings would constrain the midstream company's stand-alone credit profile (SACP). As such, our credit rating on AR caps our rating on AM. When we downgraded AR to 'B-' based on challenging market conditions in April, we also lowered the rating on AM to 'B-'.

What if a well-diversified company has very low-rated counterparties?

When a company has cash flow exposure to several non-investment-grade counterparties, we typically assess the competitive advantage as weak or adequate/weak. However, it's possible for a company with a diverse pool of low-rated counterparties to have an issuer credit rating higher than the average counterparty rating.

Rockies Express Pipeline LLC (REX), for instance, has a diverse customer base and includes both associated gas producers operating in the Rockies region and gas-focused producers in the Appalachian region. The company has a very diverse set of counterparties, and though there are three to four key customers on the Appalachian side, it would be unlikely for us to downgrade REX based on any isolated counterparty downgrade. That's why several downgrades on EQT Corp.--from 'BBB-' to 'BB-' did not in and of themselves prompt us to change the rating even though it's a key customer. However, when we downgraded several companies in a short timeframe in March, including Ascent Resources Utica Holdings LLC (to 'CCC+'), Gulfport Energy Corp. (to 'CCC+'), AR (to 'B-'), and EQT (to 'BB-'), we lowered our rating on REX to 'BB+' from 'BBB-'. We are comfortable rating REX several notches higher than its average counterparty because we think REX's leverage is sufficiently conservative for the rating, and we don't think upstream credit issues will materially affect volumes. Given the negative outlooks on the ratings on many of its counterparties, our rating on REX has a negative outlook, and we could lower the rating if we further downgrade its counterparties or if we think leverage will surpass 4.5x. An increase in leverage would likely be the result if volumes decrease or contracted rates fall materially. REX's diverse customer base also mitigates the recently announced Ultra Resources Inc. bankruptcy. Even if that contract were canceled outright, it wouldn't materially affect REX's credit metrics.

How do we assess customer concentration risk?

When we think a midstream company relies on a single counterparty to meet most of its obligations and the company could not replace the contracts at current rates, the rating on the counterparty may cap the midstream company's SACP. This is somewhat common in the midstream space.

We think EQM Midstream Partners L.P. (EQM) relies on EQT for its volumes and cash flows, even though EQT no longer controls EQM. While we see EQM as a stand-alone company completely separate from EQT, we still lowered our rating on EQM to 'BB-' when we lowered our rating on EQT to 'BB-'. This was due to the latter's importance as a customer. EQT supplies EQM with about 70% of its revenues. Based on the approach we've described, we could continue to match the ratings if we further downgrade EQT.

This relationship also plays out for Woodford Express LLC (WEX), a gatherer and processor in the SCOOP basin, which historically derived about 70% of its volumes from Gulfport. We believe that WEX's creditworthiness is limited by Gulfport's, as well as the producer's strategy and activity levels that it forecasts in the SCOOP basin. When we saw signs of lower volumes in the midcontinent area, and Gulfport announced it would scale back its drilling plans in the SCOOP basin, our forecast pointed to lower ratings, and we revised the outlook to negative. Eventually, we downgraded WEX to 'CCC+' from 'B' when we downgraded Gulfport to that level.

We use the 'CCC' rating category to capture unsustainable capital structures. Once we lower a rating to the 'CCC' category, we focus more on how long the company can maintain operations and service its debt without extraordinary support. In WEX's case, we think the company depends on favorable business, financial, and economic conditions to meet its financial commitments, but we don't think a default is imminent in the short term--hence the 'CCC+' rating. Gulfport's unsustainable capital structure and pullback of operations in the SCOOP basin is a main contributor to our opinion of WEX.

How do you weigh counterparty risk if the company's main customer is its own strategic owner, such as a producer or refiner?

HollyFrontier Corp. (HFC) is the strategic owner of Holly Energy Partners L.P. (HEP); it owns and controls it. We've given HEP a one-notch uplift, given its moderately strategic status to HFC, so the issuer credit rating is 'BB+' even though we think of HEP as 'bb' on a stand-alone basis. HFC supplies about 75% of HEP's cash flows, and the two companies are operationally interconnected. If we lowered the rating on HFC, our group rating methodology would prompt us to lower our rating on HEP. This captures our view that if HFC became distressed, it could extract cash from HEP, or perhaps file HEP into bankruptcy. This rationale also applies to CNX Midstream Partners L.P., which we consider strategically important to CNX Resources Corp.

Western Midstream Operating L.P. (WES) derives significant volumes from its parent, Occidental Petroleum Corp. (OXY). We assess WES as nonstrategic to OXY because we think OXY would sell WES if it could fetch an adequate price in order to pay down debt and refocus on upstream operations. OXY has control over WES as its most important customer and given its significant board representation, so our rating on OXY caps our rating on WES. Even if WES were to be completely separated from OXY, our rating on OXY would still likely cap our rating on WES because OXY's volumes and business are vital to WES's creditworthiness, and a lower rating on OXY indicates that WES is deriving its volumes from a weaker entity.

Diversification Is The Best Way To Mitigate Counterparty Risk

Energy producers' struggles with challenging market conditions and macroeconomic uncertainty expose midstream companies to counterparty risk. After lowering ratings on upstream companies, we've downgraded several midstream companies based on their reliance on lower-rated shipping customers. There are some mitigation techniques, but in order to truly mitigate counterparty risk, companies generally must diversify. If we consider a particular counterparty material to a midstream company, it typically caps a midstream company's SACP.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Michael Pastrich, New York + 1 (212) 438 0604;
michael.pastrich@spglobal.com
Secondary Contact:Michael V Grande, New York (1) 212-438-2242;
michael.grande@spglobal.com
Research Contributor:Sheryl Fernandes, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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