Could large parts of midstream become stranded?

The latest oil crisis is showing long-term investors how closely these assets are tied to commodity price volatility. But they also need to think of the implications of some of these commodities' being on their way out.

An investment in oil begins when a driller pushes their rig’s bit around 6,000 feet into the earth and hydraulically pulls back to the surface a thick stream of heavy tar or sweet crude.

Out of the ground, oil becomes a commodity that is serviced by a network of infrastructure that turns the fossil fuel resource into products sold on the global market. The transportation and storage of oil (as well as natural gas) makes up part of the energy sector investment chain known as the midstream space.

For more than a decade, midstream has drawn large amounts of institutional capital that was allocated to low-risk, long-term infrastructure strategies. Asset managers sold the notion that midstream assets were, to a degree, secure from economic volatility that might impact commodity prices. Investments where returns correlated to the price per barrel of oil was a private equity play, they said.

But in the coronavirus era, the concept that midstream infrastructure plays are mostly insulated from the price swings of the commodities they transport is coming under renewed scrutiny. In fact, GPs are quietly admitting that an investment in at least one part of the midstream space – gathering and processing (G&P) assets – should come with the acceptance of risk as high as the driller puncturing the ground.

G&P assets – tangles of small pipes that transfer oil from the wellhead where it’s drilled to the long-haul pipelines that cross entire countries – should be considered carefully as part of an infrastructure portfolio.

As the global oil market has collapsed over the last two months, driven by pandemic-related low energy demand and a supply glut, the suggestion that investments in these assets are not closely linked to the price of the commodity they depend on defies the reality of how close they are to the point of drilling.

The financial storm hitting the energy sector is thus hovering over the midstream space. And with fingers pointing at G&P assets, people who have invested in the sector are saying weakened contract structures are to blame for commodity price vulnerabilities.

After the last oil price downturn around five years ago, producers began renegotiating terms with midstream operators. For many G&P assets, the all-important minimum volume guarantee, which locks-in a baseline revenue for midstream companies working with producers, is being phased out, especially fixed-rate agreements.

Now, acreage dedication is the new normal, which pays a fee based on the amount of oil produced in a certain location. Instead of vital infrastructure generating steady returns, investors in these companies received exposure to a fossil-fuel land rush.

While infrastructure GPs are quick to point out how little exposure they have to G&P assets, it stands to reason that if producers could get midstream operators to alter their terms once, they can do it again. Also, if a producer’s business model doesn’t work, it’s right to ask whether the business model for midstream operators will – especially as projected oil prices months from now do not look good for anyone.

As one Korean pension source invested in North American midstream told us: “If oil prices keep falling, and upstream companies close their businesses, midstream companies will definitely be impacted.”

Even when this latest storm subsides, we should not forget that the rationale for this asset class is to invest capital in the parts of communities that form the backbone of economies.

While the argument for natural gas, which many investors view as a lower-carbon bridge fuel, remains intact for now, the fate of the suffering oil industry is becoming less certain. There are more energy sources available today than ever before, and environmental considerations are receiving heightened priority.

For example, renewables are now “the lowest cost [of energy] in two-thirds of the world,” as Actis’ Lucy Heintz told us in a recent webcast, and unlikely to be destabilised by low oil prices.

In that sense, people may very well look back on 2020 as the official start of the world weaning itself off oil. If that were to happen, it’s worth dwelling on what that could mean for the longevity of assets dedicated to storing and transporting commodities that are on their way out.

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