Potential in the pipeline

The shale boom in the US has changed the dynamic of where oil and gas are sourced from and where they need to go. As a result, new infrastructure is in acute demand to take products from supply to demand areas and address the needs of end-users.

In the US, a clear delineation of midstream energy has evolved – an industry that involves the gathering, processing and moving of oil and gas products from areas of supply to demand.

A recent study by the Interstate Natural Gas Association of America (INGAA) Foundation showed that the US and Canada will need to invest about $30 billion a year in midstream infrastructure for natural gas, crude oil and natural gas liquids up to 2035.

“We are still at the early stage of midstream infrastructure investment in the U.S. What we have been seeing is a lot of investment focused on addressing infrastructure needs for the first quarter of the game. We are now starting to get into the second quarter… I think you will see significant investment focused on logistical and processing infrastructure,” said Alex Darden, partner at EQT, a Swedish private equity firm with a focus on energy infrastructure.

So far, more capital has been spent on drilling wells in hydro-carbon basins (an upstream activity) than on logistics and transportation infrastructure. But the midstream sector is playing catch-up now.

DEALS ON THE UP

According to PwC, there was an increase in financial investor involvement in the US midstream space in the second quarter of this year. The quarter saw four transactions by financial investors in the oil and gas industry with a total value of $7.7 billion, representing more than a 400 percent jump in deal value compared with the same period last year.

“In the second half of 2014, we expect private equity to continue to monetise assets, but also pursue divested assets in the midstream and upstream space as they continue to look for opportunities to deploy capital,” says Rob McCeney, a PwC US energy & infrastructure deal partner.

These comments came on the back of a stellar second quarter for oil and gas transactions in the US. According to PwC, there were 21 shale play-related deals with values greater than $50 million in the second quarter, or $20 billion in total. Among them, four were midstream shale-related deals, representing $9 billion.

And the potential is more exciting than anything that has been achieved so far. The majority of the dry gas and liquids-rich regions – the Marcellus, the Utica, Eagle Ford and Bakken – are still under-supplied when it comes to midstream infrastructure, fund managers say.

“We are very into gathering and processing – things that connect LNG (liquefied natural gas), as well as LPG (liquefied petroleum gas) exports, exploring long-term contracts with Asian buyers for LPG,” says a fund manager.

HERE COME THE INFRA FUNDS

Traditionally, the midstream sector has been dominated by master limited partnerships (MLPs) and energy-focused private equity firms.

Only in recent years have infrastructure funds started entering the space as they note the availability of low-risk profile assets offering long-term steady returns.

Nonetheless, infrastructure fund managers say they are not in a rush to deploy capital. “Midstream isn’t as safe as people think,” claims a second fund manager.
One risk is the embedded exposure to global commodity prices given that midstream serves as the ‘middleman’ between oil and gas supply and demand.

For instance, LNG export terminals, or liquefaction trains, are built on the back of long-term contracts – typically with sovereigns or large regional users that have to import a large amount of energy. But those contracts tend to come with commodity exposure, given the volatility of natural gas prices globally.

The contractual framework and counter-party risk were frequently mentioned by fund managers we spoke with. Infrastructure projects are usually 20 – to 30-year projects but the contracts governing them are not necessarily long term. Often, the terms “can protect you somewhat but the contracts are not long term like you can find with power generation,” says a source.

‘PROJECT-ON-PROJECT’ RISKS

At the same time, counter-parties – usually the upstream players that drill wells – are often not investment-grade entities. Furthermore, sometimes there will be ‘project-on-project’ risks in that the projects based on upstream drilling in the basins have their own exposure to global oil and gas prices.

“Certain lenders and other capital providers may not be comfortable with that,” says the source.

Also, by having skin in the game, infrastructure funds are taking “a little bit more risk on construction and contracting the projects,” the source admits.

One concern goes back to the basic economics of hydrocarbon basins in the US. If the economics change for the worse in one hydrocarbon basin, rigs are likely to be moved to the next basin where the economics are more favorable, and the infrastructure there may be stranded given the pay-back for building it is usually six to nine years.

Working out the best way to access midstream at the moment, according to the fund manager, is “core to commercially-drawn contracts and getting support from a financing perspective on the back of those contracts”.

PATIENCE NEEDED

A further issue on infrastructure fund managers’ radars is regulatory risk because it may take a fair amount of time to get approvals from relevant regulators for an infrastructure project to actually get started.

For example, the US government has started allowing exports of liquefied natural gas since last year, but it can take a long time to get approvals from the Department of Energy (DOE) and the Federal Energy Regulatory Commission (FERC) before the construction of LNG export terminals can actually commence.

“That’s a very long process, and we wouldn’t seek to invest in greenfield development companies” given there are only a few liquefaction trains that have got approvals and will start construction soon, and many are still going through the process, says EQT’s Darden.

However, infrastructure funds are generally excited about the opportunities presented in this still-fledgling industry.

“It’s an evolving industry with a lot of money and a lot of attention, and that has opportunities and risks. From my perspective, it’s a case of sitting and watching some of the activity and making sure you really understand the fundamental risks before you deploy capital,” says a source.