There has never been a better time in the last 40 years than now to be investing in gas. That, at least, was the opinion of one US-based fund manager Infrastructure Investor recently spoke to. It is a bold outlook in the age of the energy transition, where LPs are searching for strategies beyond “vanilla” wind and solar funds and where renewables account for about 20 percent of the US’s electricity generation.

The logic goes that as the US continues to build its renewables capacity and the grid infrastructure to deal with this, there will be an increasing reliance on gas to provide baseload capacity. Further afield, players in the US natural gas industry see an export opportunity, with liquefied natural gas lending a helping hand in Europe’s ongoing gas crisis and its reliance on Russian imports.

That’s the here and now, but even the GP who so strongly declared it was the season of sunshine for gas expressed a reluctance to actually deploy money into natural gas or natural gas-related infrastructure. The main concern, the GP stated, was about who would buy this asset in five to seven years’ time and what its terminal value would be. A reliance on long-term contracts to cover the investment was not one they were willing to make.

A long-term transition fuel?

A more nuanced view was espoused by Adebayo Ogunlesi, chairman of Global Infrastructure Partners, at our Global Summit in Berlin in October 2021.

“When you start seeing more and more investors exiting fossil fuels, you have to worry about that,” he told attendees. “But if you assume there’s no terminal value, is this still an investable asset? If the answer is ‘yes’, because of long-term contracts or because you think gas will continue to be a transition fuel for the long term, then you can still invest in it.”

“The energy transition to full carbon neutrality will take many years, if not decades. However, we can make some big near-term impacts by focusing on efficiencies, emissions improvement and switching to lower-carbon liquid fuels”

Andrew Ward
Clearstream Capital

Ogunlesi added: “We are much more cautious about oil.” That approach is mirrored by Kinder Morgan, the New York-listed operator of more than 137,000km of oil and gas pipelines in North America.

“We look at a terminal value assumption assuming no multiple expansion, and then we look at variations on that last in terms of the terminal value, and we make a decision based on a risk-adjusted basis,” Kinder Morgan chief executive Steve Kean said on the company’s Q4 2021 earnings call.

Some will ask if, with these approaches, natural gas-related assets lose elements of their infrastructure tag. Certainly, their long-term nature is called into question, as is the stability of cashflows beyond the contracts currently in place.

“It’s been a challenged sector because, at the end of the day, the cashflow for a gathering or storage system comes from oil and gas producers, and they are now committing less capital to exploration and drilling projects, partially because the capital markets are pushing them to delever and not invest in more projects,” says Doug Kimmelman, founder and senior partner at New Jersey-based Energy Capital Partners.

Long-term value

And yet when it comes to electricity generation, the road to 100 percent renewable energy is long and difficult.

“The majority of the market agrees we need gas plants in the interim,” says Recep Kendircioglu, co-portfolio manager and head of infrastructure investments at Manulife Investment Management. “The question is: how long do you need these plants for and what’s the value of those plants 10 years from now?”

So, with received wisdom of terminal value being one of the aspects that determines investment returns, how are managers viewing this space?

 

“The question is: how long do you need these [gas] plants for and what’s the value of those plants 10 years from now?”

Recep Kendircioglu
Manulife Investment Management

 

“Clearly, there is long-term value as is seen in the equity and debt markets,” insists Matthew Runkle, senior managing director in Blackstone’s infrastructure team, which took a stake in midstream group Tallgrass Energy, its first 2019 deal from the open-end Blackstone Infrastructure Partners fund.

“While there may be a more limited buyer universe in five, 10 or 20 years, there are many reasons why these assets will have long-term value, notably including energy security and grid maintenance, as was recently recognised by the European Union,” Runkle adds.

Indeed, September 2021 saw the listed Canadian group Enbridge acquire US-based Moda Midstream for $3 billion, which, according to Enbridge chief executive Al Monaco at the time, fit its search for “low-risk cashflows, establishing a new platform for low capital intensity growth, and an attractive financial return”. The deal though, was priced at about a multiple of 8x EBITDA, a low even in the post-pandemic era of midstream valuations. EBITDA multiples in the space sit at about 9.7x, compared with the 10.5x average prior to covid-19.

“People assumed incorrectly that oil and gas production volumes would continue to increase. The growth has shut off and so the multiples have been depressed,” says Kimmelman.

New realities, new approaches?

So, if managers are to accept this as the new normal, how does the approach to gas infrastructure change if the assumption of little to no terminal value is correct?

“More and more of what we see is people signing five- to seven-year contracts and hoping the investors will be able to finance based on those and take the risk at years five through seven,” says Kendircioglu, regarding investments in gas-fired plants.

“That used to be quite helpful for us in the past, but we are a little more reserved on that approach now, as it’s harder for investors to feel confident about the value in year seven. We have existing assets in five- to seven-year contracts, we’re focusing more on what our leverage is at the end of the contract. You don’t want to be caught in a market where your contract expires but you still have meaningful leverage.”

This theme of ensuring assets and their terminal value are at least somewhat protected from what the future holds is also present for Andrew Ward, formerly partner and managing director of the energy-focused private equity outfit Riverstone Holdings and now founder of energy transition-focused Clearstream Capital.

“While there may be a more limited buyer universe in five, 10 or 20 years, there are many reasons why these assets will have long-term value”

Matthew Runkle
Blackstone

“The energy transition to full carbon neutrality will take many years, if not decades,” he says. “However, we can make some big near-term impacts by focusing on efficiencies, emissions improvement and switching to lower-carbon liquid fuels in hard-to-electrify transportation sectors.”

But it is this time horizon that might be the crucial factor in how important terminal value becomes when investing in this space. “We have an advantage in that we’re an open-ended fund without pressure for a forced sale,” says Runkle.

“That said, we will always consider public market trading levels and M&A transactions in our evaluation of whether to continue to hold or to exit.”

Avoiding terminal risk value

With infrastructure’s latest trend being the growth of perpetual capital funds in the market, and most of them of the size to afford such types of deals, this might be key in retaining investment and making terminal value less of a crucial factor. Although, of course, long-term investment can mean different things to different players.

“If you have patience and hold for 10 to 15 years without pressure to sell, you can rise to additional demand and keep generating really good cashflows and have less reliance on the terminal value,” says Kendircioglu.

Regardless of what one might see as defining long term, the focus on yield will be key to avoiding terminal value risk and, as public MLPs have shown with an average yield of 9.18 percent, there is plenty of value to be accrued in this respect.

“Valuations in the market across most industries are historically high. When this is the case, you want to be very careful when structuring your investments, so that your whole investment return is not coming from the terminal value,” Kimmelman adds.

“So, we are very focused on investments that throw off a cash yield. A great investment in this environment would be perhaps after five to seven years, you’ve returned all of your capital from cash distributions and the terminal value proportion is much smaller. A lot of investments out there are counting on 100 percent of the return coming from what you sell it for. That is a risky proposition.”

Present gains, murky futures

Many in the sector see those capital gains after five to seven years. As noted, today’s macro-factors are lending themselves to gas-related infrastructure still being valuable investments in the near term. There is a view that the value could only increase on the road to decarbonisation, perhaps negating the question of terminal value.

“Electrification can actually create more momentum for gas plants. If you use electricity for heating, you can have a largely renewable system but an increased demand and that could be a push for gas plants,” says Kendircioglu. “It’s not just about gas plants, but what type of gas plants and what role? Capacity gas plants are more sticky. It’s hard to eliminate that in the market.”

While some managers may feel this way, there could be bumps in the road when it comes to the LPs. In Infrastructure Investor’s LP Perspectives 2022 Survey, published last month, 31 per cent of respondents said they would deploy less to conventional energy, the sector that drew more such responses than any other in the survey.

The tide may be turning enough that while managers see good deals available, the question might rest on whether there are enough LPs willing to fund them.

Ward sums up the dichotomy. He firmly believes “natural gas has a very long future in the energy transition”, particularly to provide baseload power and complement carbon capture, and struggles to see an era of obsolescence for natural gas pipelines.

However, he acknowledges the exit price will likely be below that initially paid and that the LP universe is narrowing.

“LPs are pushing to decarbonise. The view on energy investing has started to fundamentally change,” says Ward. “Poor recent returns combined with a mounting wave of ESG focus has reduced capital earmarked for the traditional energy sector, decreasing liquidity for exits and depressing valuations. In the long run, you’re going to find fewer investors able to invest in the fossil fuel space.”

“People assumed incorrectly that oil and gas production volumes would continue to increase. The growth has shut off and so the multiples have been depressed”

Doug Kimmelman
Energy Capital Partners

Others, however, might seek a more contrarian approach. One source tells Infrastructure Investor about a number of North American LPs requesting tailored approaches from GPs towards this sector to try to capitalise on the valuations as others exit.

Sam Pollock, head of Brookfield Asset Management’s infrastructure group – which declined to comment for this piece – and chief executive of listed outfit Brookfield Infrastructure Partners, hinted at as much in BIP’s Q4 2021 earnings call in February.

“We have seen and we’re covering some of the valuations of midstream assets with the rising commodity prices,” said Pollock. “I think we’ll see a number of opportunities surface there, as this sector becomes underinvested due to ESG wins.”

Nuanced opinion

Meanwhile, Kendircioglu takes a nuanced view and believes midstream assets might be more at risk from ESG tailwinds than gas-fired plants.

“It’s really more focused on whether it’s a demand or supply asset,” he says. “Has it already been drilled or are you counting on further drilling? We are seeing some decent prices being paid so clearly there are some buyers who are more constructive on these values than others.”

There are though shoots of green coming out of the pipeline proposition, which could in theory give the future-proofing boost required from a terminal value perspective. Proponents of green hydrogen suggest that gas pipelines could be retrofitted to carry hydrogen in the future. It’s a belief held by several gas operators, particularly in Europe, although the US Department of Energy is more cautious, stating that “only modest modifications” would be needed to ensure pipelines have a 15 percent mix of hydrogen to the existing gasflows.

“It’s something we’re evaluating today,” says Runkle. “There are challenges with the type of pipe in terms of what it’s made out of, what vintage it is and whether you can alter how much hydrogen you can put into a pipe.”

Others are a little more circumspect about some of the challenges outlined by Runkle.

“Hydrogen will play a role in small incremental areas such as industrial application to replace diesel fuel in a bus fleet, for example,” he believes. “Right now, hydrogen is not ubiquitous enough on an industrial scale for people to use it in pipelines and make a difference.”

So, there is no green-coloured magic wand to wave away any issues of terminal value – although with the right time horizon and entry price, there might still be life left in the asset class.