An overabundance of investment capital has driven a wedge between US midstream asset valuations and actual shipping demand for infrastructure, and the imbalance looks to only be getting more severe as time goes on.
In the Permian, for instance, there are 2.16 million b/d of pipeline takeaway capacity, already above the 1.932 million b/d November production, according to Platts’ unit Bentek Energy.
But there is also 1.17 million b/d more capacity slated to come online in the form of new projects and expansions in 2016 and 2017, set against oil prices that may still be low enough to weigh on production.
The culprit behind both the overbuild and the severity of its impact is the commitment structure that supports the projects. Most projects have a dependable investment return in the form of take-or-pay contracts, under which shippers agree to move a certain volume of crude on the pipeline years in advance, and have to pay for the space regardless of whether or not they actually use the space.
That makes pipelines look like particularly attractive investments, and Plains All American CEO Greg Armstrong has pointed to the ready access to capital as the source of the overbuild in recent earnings calls. The available capital, fueled in large part by “irrational optimism,” Armstrong said.
That has driven up the value of the assets beyond their usefulness to the market.
“We definitely have an oil problem, but part of it has been driven by easy money,” Tony Starkey, energy analysis manager for Bentek, said. “There is still a ton of money around the world that wants to do something to earn a return.”
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Pipelines look like a good investment for that money because the take-or-pay contracts seem secure, and appear to be a safe haven against the dropping oil prices.
“There’s a lot more certainty in the midstream [than upstream], particularly if your contracts are structured well,” said Jay Squiers, the managing director at Petro Capital Funds at Platts’ Oil and Gas Acquisition and Divestiture Outlook conference. “I think there’s a lot of money chasing those deals.”
But the imbalance can’t last forever — contracts or no, the declining growth in shipping demand and growing supply of space will have to push down tariffs eventually.
“The problem is that there aren’t that many great places to invest because, while easy money has done wonders to boost asset prices, it hasn’t done much to improve aggregate demand,” Starkey said. “Without which, the long run prospects for investments today look pretty grim.”
The take-or-pay contracts have, to some extent, insulated pipeline companies against competition from their neighbors — they still have to compete for spot volumes, but lengthy term contracts appear to lock in customers regardless of whatever low-cost options appear.
That was borne out to some extent in the second half of last year, during which time the spread between West Texas Intermediate crude at Midland climbed past its counterpart in Cushing as shippers were forced to move crude at a loss in order to meet contracted volumes.
That spread peaked when Platts assessed WTI Midland at WTI Cushing plus $2.75/b on Aug. 13, 2015, and Midland was stronger than Cushing on a total of 98 trading days in 2015.
But if midstream companies want to see growth — or even if they just want to avoid decline — they might have to allow some leeway in their contracts.
“When oil is in the $30s, ‘sticking it’ to the upstream guys doesn’t bode well for midstream if supply stops growing or falls,” Starkey said. “Yes, they are contracted to receive payment, but they also want growth on their systems, and seeing your counterparty go bankrupt likely isn’t in your best interest.”
On top of that, newer projects likely don’t have the same term length on contracts that the older ones did, since they are dealing with a “smaller and smaller supply group” and increased competition, Starkey said. That means less time until shippers can renegotiate their terms.
“I imagine the upstream folks have been less interested in locking in long-term contracts,” Starkey said.
That hesitance bears a contrast against the rabid pace of pipeline expansion that preceded the price decline of 2014. After the turn-of-the-decade shale boom sent inland production skyrocketing, the question for pipeline companies was less “how much will this cost?” and more “how quickly can we get this in the ground?”
But now there’s plenty of capacity, and prices have to shift to acknowledge that fact. Starkey said he thinks the market will turn to some combination of cancellations, consolidations and tariff deflation in order to relieve the pressure from the imbalance.
“Outright cancellations are possible for projects not too far along the completion process, consolidation could happen anywhere there is overlap, a la what happened with Saddlehorn and Grand Mesa in Colorado,” Starkey said. “Tariff deflation could occur if there is overcapacity out of particular regions, and midstream companies lower their transport costs to retain market share.”