Midstream deals fuel an oil and gas M&A revival in Q1 2017

As oil prices stabilize around the US$50 mark, dealmakers are coming back to the table

Buoyed by the arrival of a pro-oil administration in the White House and relative price stability, M&A activity in the beleaguered oil and gas sector is beginning to regain some momentum.

The value of deal-making in the sector hit US$120.6 billion during the first quarter of 2017, more than three times the US$38.2 billion worth of transactions recorded over the same period a year prior. And the highest Q1 value since 2006.

Dealmakers regain their appetite

With oil trading above US$50 a barrel for the majority of 2017—compared with lows of around US$27 in 2016—many in the oil and gas sector are finally beginning to feel more confident.

But despite cautious optimism returning to the market, larger transactions were still underpinned by industry consolidation and a drive for restructuring. There were 49 deals of more than US$1 billion over the six months to the end of March 2017, more than in any other six-month period over the past decade.

North America and midstream out in front

The North American marketplace leads the way, with deals in the US and Canada accounting for 55% and 21% respectively of all oil and gas M&A during the first quarter. And the midstream sector in particular—predominantly processing, transportation and storage companies—has been undergoing a wave of consolidation.

Elevated transaction levels in the midstream sector reflect moves to achieve greater scale, capture geographical trends to maximize positions in the right basins and increase dividends.

Some of the larger deals were also driven by the need to restructure and improve credit profiles. While midstream companies typically charge fees to use their pipelines and equipment, and therefore only have secondary exposure to oil and gas price volatility, many midstream companies suffered from lower throughput volume, and share prices fell during the downturn’s sell-off frenzy.

One good example is November 2016’s Energy Transfer Partners transaction, effectively a merger with the company’s affiliate, Sunoco Logistics Partners. The recently completed deal, which creates one of the largest master limited partnerships (MLPs) in the US, was intended to reduce capital costs and enable Energy Transfer to continue making distributions to investors.

More recently, the Trump administration provided some support. The new President’s decision to greenlight the controversial Dakota Access and Keystone XL pipeline constructions was an abrupt about-turn on his predecessor Barack Obama’s position. Oil and gas operators and investors have been emboldened accordingly, with midstream M&A activity continuing into the second quarter.

In April alone, two deals worth a combined US$3.5 billion were struck, both targeting companies focused on the prolific Permian Basin, which as a relatively new production area has become a hub for midstream deals. Blackstone Energy Partners announced a US$2 billion agreement to acquire EagleClaw Midstream Ventures, while NuStar Energy agreed to purchase Navigator Energy Services for US$1.5 billion.

NuStar CEO Bradley Barron says the deal is effectively a vote of confidence in the US oil and gas market. “We expect that the purchase price, when coupled with modest future growth capex to build out the system, will result in a high single digit multiple as volumes ramp up over time."

PE firms have emerged as a strong buying force within the market, seen in Noble Energy’s US$454 million divestment of a 33.46% stake in CONE Midstream Partners, operating in the Marcellus Shale, to PE firm Quantum Energy Partners. The aim of the deal is to capitalize on Noble’s position in the Permian following the recent acquisition of Clayton Williams Energy.

Apart from the Permian, which has equally swelled headlines and valuations, southern Texas also saw deal activity when Kohlberg Kravis Roberts’ portfolio company Venado Oil & Gas acquired SM Energy, which holds producing acreage and midstream assets in the Eagle Ford, for US$800 million.

Master limited partnerships

One important driver of deal-making activity is that a significant number of US midstream companies are operating as MLPs. The MLP is a tax-advantaged, publicly traded structure for energy infrastructure companies. Many MLPs have promised investors growing yield, dependent on their own business growth, and now consider M&A their best chance of delivering on that promise.

MLP deals in the past 12 months include US-based ONEOK’s agreed acquisition of its stake in ONEOK Partners; transactions such as these are likely to continue throughout 2017. As MLPs are required to pay out nearly all their earnings to investors, lower borrowing costs can help them to keep growing distributions through acquisitions.

John Devir, one of the managers of the MLP & Energy Infrastructure Strategy fund run by Pimco, argues: “MLPs continue to offer attractive long-term total return potential, backed by a favorable blend of fundamental and technical factors. From a top-down perspective, we think that oil prices are likely to be more stable going forward, underpinned by strong global demand growth and better production discipline by OPEC… from the bottom up, MLP balance-sheet quality has improved as a result of deleveraging.”

Public plays

Energy analysts expect this consolidation to continue, with organic growth tougher to come by for midstream companies that are left lacking large amounts of capital to invest into new infrastructure.

The US is expected to complete only 4,175 miles of oil pipeline this year, according to research group IHS Markit—as recently as 2014, new pipelines spanning 9,679 miles were completed.

Besides the Permian Basin in West Texas, the best-performing shale region in the US, both conventional and unconventional oil-producing basins in North America are in need of further transport capacity. For example, Canadian operators are keen to see new pipelines built to connect the oil sands of Western Canada to US markets and the Pacific coast for further shipment to Asia.

A growing need for capital will flare up if oil prices remain stable, and companies will be sure to tap into equity capital markets. In April, Hess Corporation and its joint venture partner Global Infrastructure Partners successfully completed a US$339 million IPO of Hess Midstream Partners LP (HESM), an MLP that provides gathering and midstream services in the Bakken Shale play to Hess and third parties. Global Infrastructure Partners acquired a 50% ownership interest in HESM from Hess Corporation for approximately US$2.7 billion in 2015. Denver-based Antero Resources Midstream Management, with assets in the Appalachian basins Marcellus and Utica, is also looking to raise up to US$931 million from an IPO.

However, without a sustained increase in the oil price, producers in North America have little incentive to ramp up output, reducing the need for greater capacity. And despite President Trump’s change of approach, the regulatory question looms large; midstream operators know that plans for new infrastructure will be closely scrutinized and potentially delayed by expensive and time-consuming legal action from environmental campaigners.

In other words, both the threats and the opportunities now facing midstream oil and gas companies can be positive drivers for M&A activity, both among the MLPs and beyond. The consolidation seen over the past six months could be just the beginning.

Receive M&A Explorer quarterly email updates when new data is available.