Kinder Morgan's $76 billion acquisition of El Paso Pipeline Partners and other infrastructure properties last November may have been the largest deal in the midstream oil and gas sector, but it has not been the last. Since the Kinder Morgan transaction closed in November, we've seen M&A activity from Next Wave Energy Partners and Woodside Petroleum.
According to KPMG's Mergers & Acquisitions survey, which looks at overall activity, 82 percent of respondents plan to make at least one acquisition in 2015, and 36 percent believe oil & gas will be the busiest sector. This would make 2015 the busiest M&A season since 2007. In addition to that that strong general backdrop, there are a number of reasons to expect vigorous M&A activity in the midstream oil and gas sector throughout 2015.
Midstream companies aren't particularly sensitive to commodity price swings
Declining crude and natural gas prices
Even though they've recovered slightly, crude oil prices are down more than 40 percent in a year, and natural gas continues to endure price pressure, according to the US Energy Information Administration. These declines badly hurt the profitability of upstream companies and, to a lesser extent, downstream companies in 2014. Midstream companies, however, aren't particularly sensitive to commodity price swings. Their long-term contracts pay on the volume, not the price, of the underlying commodity moved. Indeed, while the broad S&P 500 Energy index lost nearly 10 percent in 2014, some midstream-focused companies saw their stocks rise 10 percent or more. That financial strength likely will spur those companies to look for solid midstream acquisitions to add stability to their balance sheets and diversity to their product line.
US Energy production continues to rise
US crude oil production increased 13.2 percent through March 2015, and the country is at its highest production level since February 1973. Liquefied natural gas production averaged just over 3.0 million barrels per day in March, 9.1 percent above last year's output. The US continues to invest in infrastructure to export liquefied natural gas, particularly to energy-hungry Asian countries. And Congress has talked about providing legislative relief that would liberalize crude exports and increase volume even more. All that extra production makes the midstream oil and gas companies – responsible for moving and storing all that oil and gas – look more attractive as businesses.
Capital spending on oil and gas midstream and downstream infrastructure increased 60 percent from 2010 to 2013
New Infrastructure is still sorely needed
Capital spending in oil and gas midstream and downstream infrastructure was $89.6 billion in 2013, an increase of 60 percent from 2010. Most observers expect this trend to continue, particularly for natural gas, where some basins have virtually no pipelines. A need for new oil transportation infrastructure is also acute. And because renewable forms of energy are intermittent, there should be a significant build-out of new, natural gas-fired plants and a corresponding increased gas supply to replace the energy produced by retiring coal generation plants. Expect midstream players to be both acquirers and sellers of all these assets, as energy companies seek diversification to strengthen their balance sheets and keep up with rising infrastructure costs.
Companies are looking for geographic diversity
Lower prices increase upstream companies' risk levels, prompting some to reduce risk by diversifying geographically. According to the KPMG M&A survey, 39 percent of all energy companies said the need to geographically diversify was a major reason they were considering a merger or acquisition.
In the wake of low energy prices, companies don't want to place all their bets on one basin or offshore area. We believe mid-sized and large midstream companies will continue to move into new geographic areas to reduce their risk.
Regulations are becoming more complex
Observers expect stricter rules and emission standards on coal plants, increasing the demand for natural gas. At the same time, there are already new rules in place on the storage and transportation of all forms of energy. Look at North Dakota, the home of the Bakken basin, for some recent examples of increased government oversight. The state has enacted new rules requiring companies to capture at least 85 percent of natural gas produced during oil production by 2016. It also has penalized five oil companies and forced them to reduce production for burning off more natural gas than allowed. Additionally, North Dakota has legislation on the table that would eliminate using older rail cars to ship flammable liquid, which includes most Bakken crude. Lawmakers could also require oil companies to stabilize crude to ensure lower flashpoints. This type of increased oversight, in North Dakota and elsewhere, likely will raise storage and transport costs. Larger midstream companies can more easily absorb these increased regulatory costs.
Increased M&A activity among midstream companies isn't a certainty, of course. M&A activity could slow if producers curtail their production, prices drop more than expected, or Congress and the states ease off on efforts to increase safety regulations for coal plants and transporting crude by rail. But midstream oil and gas companies are poised to be excellent businesses in 2015, and industry trends seem to be favoring larger, more geographically diverse companies. Those forces make midstream players both potential acquirers and targets for acquisition.
This article was originally published in Oil & Gas Monitor.