Despite Obstacles, North American
Midstream Energy Companies'
Outlook Is Stable For 2017
Primary Credit Analyst:
Michael V Grande, New York (1) 212-438-2242; [email protected]
Secondary Contacts:
Mike Llanos, New York (1) 212-438-4849; [email protected]
Stephen Scovotti, New York (1) 212-438-5882; [email protected]
Gerald F Hannochko, Toronto 416-507-2589; [email protected]
Table Of Contents
Commodity Price Recovery Has Helped Support Credit Quality
Counterparty Risk Will Be Less Significant In 2017
Capital Spending Has Slowed, But MLPs Still Have Significant Plans
Regulatory Risk Should Improve, But Environmental Hurdles Will Remain A
Key Risk To Development
Asset Sales And Joint Ventures Are Other Ways To Improve Balance
Sheets
Distribution Cuts And Simplification Transactions Are The Next Phase In
The MLP Lifecycle
What Are The Credit Implications Of Collapsing The MLP Structure? It
Depends
An Improved Commodity Price Outlook Gives Us A Reason For Optimism
Related Criteria And Research
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Despite Obstacles, North American Midstream
Energy Companies' Outlook Is Stable For 2017
"How you respond to the challenge in the second half will determine what you become after the game, whether you
are a winner or a loser."--Lou Holtz
These inspirational words by the former Notre Dame football coach were heeded by many midstream companies in
2016's second half, but this game is not yet over. The dark clouds that appeared in the fourth quarter of 2015 seemed
to have given way to brighter skies across the midstream credit landscape in 2016's second half--commodity prices
improved, the capital markets were open, and counterparty credit quality never became a major risk. That said, 2017
presents a host of challenges for midstream companies: stretched balance sheets, weak coverage ratios, high cost of
equity capital, and significant financing requirements for a healthy backlog of projects somewhat temper our positive
view. How companies rise to the challenge of these risks will shape our view of credit quality in 2017.
S&P Global Ratings' outlook for the North American midstream industry in 2017 is one of cautious optimism, and we
are revising our industry outlook to stable from negative. We believe midstream companies will continue to build on
their 2016 strategic plans and financial strategies to reduce risk and enhance credit quality. The midstream industry's
ability to flawlessly execute its major growth initiatives and to raise equity and organizational restructurings that
position midstream partnerships to resume a path to manageable growth are among the top factors that we will
consider in our analysis for the coming year.
Overview
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•
•
•
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Distribution cuts and simplification transactions are the next phase in the MLP lifecycle.
Capital spending will continue, but it will be lower than in 2016.
The modest commodity price recovery will help midstream companies somewhat over the next 12 months.
Asset sales and joint ventures are likely to continue into 2017.
Counterparty risk will not be significant in 2017.
Commodity Price Recovery Has Helped Support Credit Quality
We believe the modest price recovery, at a minimum, will provide a floor of support for midstream cash flows during
the next 12 months, which supports improving credit quality. Relatively weak commodity prices, especially in the first
half of 2016, rippled through the entire industry, affecting investment-grade and speculative grade companies alike, but
had a disproportionate effect on those midstream businesses with commodity exposure. However, many
companies--most notably ONEOK Partners L.P.--were successful in changing contracts with commodity exposure for
fee-based ones, or reducing price exposure through increased hedging programs, which will somewhat offset the
volatility in commodity prices going forward.
The outlook for commodity prices has improved significantly since early 2016. In February 2016, West Texas
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Despite Obstacles, North American Midstream Energy Companies' Outlook Is Stable For 2017
Intermediate (WTI) crude traded at about $26/barrel (bbl) and Henry Hub Natural gas traded about $1.60/thousand
cubic feet equivalent (mcfe). As of Jan. 25, 2017, the spot price for WTI crude was about $53/bbl and the spot price for
Henry Hub natural gas was about $3.25/mcfe, an increase of 104% and 103%, respectively. In addition, natural gas
liquids (NGL) prices have improved about 70% to about 60 cents per gallon from an average price of 35 cents per
gallon in February 2016. Still, the downturn in commodity prices has been a prolonged one.
Despite the rally in WTI crude in 2016, prices are still off about 50% from high level prices in 2014 (see chart 1). The
recent rally in WTI crude is partly due to an agreement of the Organization of Petroleum Exporting Countries (OPEC),
effective Jan. 1, 2017, to cut production by about 1.2 million bbls/day and a reduction of non-OPEC production of
about 600,000 bbls/day.
Chart 1
Henry Hub natural gas prices have also increased since early 2016 due to lower injection rates (see chart 2). The lower
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Despite Obstacles, North American Midstream Energy Companies' Outlook Is Stable For 2017
injection rates are a result of a lower natural gas rig count during the past 18 months that is only now affecting
production. In addition, there has been less associated natural gas production from oil and NGL drilling, and warmer
than normal weather in the summer has also supported natural gas prices.
This modest rally in crude oil and natural gas prices helps inform our view for our commodity price deck. On Dec. 14,
2016, S&P Global Ratings updated its price assumptions for Brent and WTI crude oil and its U.S. natural gas (Henry
Hub) price assumptions. We increased our oil price assumptions to $50 per barrel from $45 per barrel for 2017 and
raised our Henry Hub natural gas assumptions for 2017 to $3.00 per million British thermal units (mmBtu) from $2.75
per mmBtu. All of our other price assumptions are unchanged. Higher prices will support credit quality for midstream
companies and their upstream customers.
Chart 2
Despite some exposure to NGL prices, the level of commodity exposure is relatively small across the Canadian
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Despite Obstacles, North American Midstream Energy Companies' Outlook Is Stable For 2017
midstream sector, with NGL fractionation exposure accounting for less than 10% of EBITDA on average. This is
partially due to the shrinking contribution of EBITDA as NGL prices fell, but, more importantly, due to the expansion
of fee-based volume-protected cash flows from capital programs put into service over the past 18 months. Our view is
that any incremental cash flow from these organic projects would likely be used toward deleveraging balance sheets or
funding the capital programs, both of which we view as credit positive.
We also include uncontracted merchant power generation as a commodity-exposed business in our analysis of
Canadian midstream companies. Companies such as TransCanada Corp. and AltaGas Ltd. reduce their merchant
exposure by turning their Alberta power purchase agreements (PPAs) back to the Alberta Balancing Pool, which then
administers the subsequent purchase and sale of electricity, removing the price risk from the midstream company. This
not only reduces the commodity exposure for the companies, but also improves metrics by reducing debt, because
S&P Global Ratings imputes debt based on the present value of the purchase obligation. Finally, TransCanada's
decision to finance a portion of the Columbia Pipeline Group Inc. acquisition with the proceeds from U.S. power asset
sales also reduces its merchant power exposure somewhat.
Counterparty Risk Will Be Less Significant In 2017
In early 2016, we believed that counterparty risk was the proverbial wolf in sheep's clothing--a significant credit risk
that would damage credit quality across the midstream flock. This concern was heightened when a judge presiding
over the bankruptcy of Sabine Oil & Gas Corp. ruled that the company could reject certain midstream contracts.
Ultimately, the court's decision was more the exception than the rule because most midstream companies and their
customers worked together to find mutually agreeable solutions to above market, or otherwise unfavorable contracts.
While we don't view counterparty risk as a significant factor driving midstream credit quality in 2017, it has
meaningfully weakened credit quality in the upstream industry and will require continued monitoring by midstream
companies.
U.S. oil and gas companies' average credit quality continues to be weak. About 40% (50 companies) of rated oil and
gas companies are rated 'B-' or lower. In fact, 2016 saw many oil and gas companies file for bankruptcy, miss interest
payments, or restructure their debt. For the most part, exploration and production (E&P) companies have honored
their contractual arrangements, even in bankruptcy. For midstream gathering and processing companies, being
connected at the wellhead certainly has its advantages, since it would be extremely difficult for a producer or
competitor to replicate the gathering system at the same costs in order to move the hydrocarbon to an end market.
Since producers need to keep production flowing in order to meet contractual obligations, the midstream companies
do have leverage. However, this isn't to say that midstream EBITDA hasn't been negatively affected by lower volumes,
mainly due to a decline in production from producer customers.
One example is Williams Partners L.P.'s renegotiation of its contract with Chesapeake Energy Corp. and Total S.A. The
renegotiation provided Williams Partners an upfront payment of about $750 million in return for eliminating
Chesapeake Energy's out-of-the money minimum volume commitment (MVC) payments and establishing a new
gathering agreement with no MVCs. We evaluate the impact of contract renegotiations on midstream companies on a
case by case basis. In many cases of renegotiations, the midstream company receives lower revenue in the near term
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Despite Obstacles, North American Midstream Energy Companies' Outlook Is Stable For 2017
in exchange for a longer contract commitment. In its renegotiation with Chesapeake and Total S.A., Williams received
a larger upfront payment in exchange for receiving somewhat less cash flow than would be received under the
previous MVC contract. We believe that we could see further contract renegotiations in 2017, especially if commodity
prices weaken from current levels.
We took a slightly different view of Rockies Express Pipeline LLC's contract renegotiation with a subsidiary of Encana
Corp. We affirmed the 'BB+' rating on the pipeline and revised the outlook to negative to reflect the impact that lower
revenues will have on credit measures during the next two years, despite extending the contract beyond the initial
maturity of 2019. The lower transportation rates result in a total revenue decline of roughly $250 million in 2016 and
2017 and higher leverage of about 4.75x.
The Canadian oil and gas sector proved to be more resilient than its U.S. counterpart, which mitigated any credit
deterioration for Canadian midstream companies. We've seen fewer contract renegotiations between Canadian
producers and their midstream counterparts, but companies have intensified their counterparty surveillance and
implemented ways to reduce their exposure through such means as increased collateral support from letters of credit,
for example. We also believe that the minimal counterparty credit issues observed thus far are a reflection of the better
credit quality of the larger Canadian producers, most of which are rated investment grade. Because production in the
Western Canadian Sedimentary Basin is skewed to the larger producers, counterparty exposure for the midstream
credits is also generally more heavily weighted to those companies, which are a lower credit risk than the typically
smaller U.S. shale producer.
Capital Spending Has Slowed, But MLPs Still Have Significant Plans
Lower commodity prices encouraged management teams to instill a level of spending discipline as they've tried to
reduce costs and improve efficiency across their asset bases. While the level of volatility in commodity prices has
subsided, management teams remain cautious for 2017. We expect the amount of capital spending to be 25% to 30%
less than during the 2013-2015 period but remain significant, particularly for most diversified investment grade
companies (see chart 3). For the investment grade peer group, spending peaked at $23.2 billion in 2015 and came
down to $17.3 billion in 2016. We expect spending in 2017 to be about 30% lower than the peak at roughly $16 billion.
In our view, certain basins will see more spending than others as E&P companies focus on basins that have better
economics. We believe the Permian and Anadarko (SCOOP and STACK) Basins and the Northeast region will see the
greatest amount of capital allocation in 2017. We expect gathering and processing companies to cautiously spend
5%-10% more capital in 2017 than in 2016. However, if commodity prices trend to levels experienced during the first
half of 2016, the pace at which these companies undertake such projects would likely decline. Given the volumetric
declines experienced during 2016, we expect organic projects to be backed by minimum volume commitments or
take-or-pay agreements to protect cash flow and minimize volatility.
Production growth for Canadian oil and gas producers has also slowed. The Canadian Association of Petroleum
Producers' June 2016 crude oil forecasts estimate that production from 2017-2019 will be about 200,000 barrels per
day lower compared with the 2015 forecast. As a result, planned midstream capital expenditures to support gathering
and transmission pipelines have likely peaked, and companies are now working through their approved capital projects
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Despite Obstacles, North American Midstream Energy Companies' Outlook Is Stable For 2017
(see chart 4).
Lower capital spending programs and more moderate growth prospects have led to a marked increase in merger and
acquisition (M&A) activity--not only blockbuster deals like Enbridge Inc.'s merger with Spectra Energy Corp or
TransCanada's acquisition of Columbia Pipeline Group Inc. , but smaller asset transactions by the midstream
companies like Pembina Pipeline Corp. and InterPipeline Ltd., both of which acquired assets from other oil and gas or
midstream entities.
In 2017, we would expect companies that have made large acquisitions to digest them and continue to execute
approved capital plans. We could see smaller midstream companies continuing to look for asset acquisitions or turning
to the M&A market to provide growth after 2018, when organic capital programs begin to taper off. Although that
could raise issues with financing or potential shifts in our assessment of the business risk if more commodity exposure
is added, we believe that the companies will continue to seek out stable contracted cash flows and finance them in
such a way as to not impair credit metrics.
For TransCanada and Enbridge, the relatively stable level of expenditures is supported by the capital programs of their
acquisitions in 2016--Columbia (closed) and Spectra (first quarter of 2017 close). The other midstream entities, on
average, will see a drop in expenditures as we get through 2017 and 2018. While there will undoubtedly be some
movement from risked or potential capital expenditures to a firm number, the peak spending is definitely behind them.
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Despite Obstacles, North American Midstream Energy Companies' Outlook Is Stable For 2017
Chart 3
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Despite Obstacles, North American Midstream Energy Companies' Outlook Is Stable For 2017
Chart 4
Regulatory Risk Should Improve, But Environmental Hurdles Will Remain A
Key Risk To Development
There is a palpable sense of optimism in the midstream energy industry that a Trump Administration will reduce
regulations and create a more accommodating operating environment in 2017. While we tend to share this view to a
certain extent, we also believe environmentalists will be emboldened to delay or prevent development. Though
activism isn't new, multiple projects have seen their in-service dates slip due to regulatory and environmental hurdles.
For example, Williams Partners' Atlantic Sunrise pipeline project has had over 400 route adjustments that have pushed
back the in-service date between six and 12 months. Permitting issues put the brakes on construction of the
Constitution Pipeline in the Northeast. Most notably, the Dakota Access Pipeline continues to make headlines
following public protests over concerns that construction will threaten local water supplies and the Standing Rock
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Sioux tribe's sacred burial sites. Notably, President Trump signed two executive orders to restart the Keystone XL and
break the stalemate with Dakota Access. However, we see this as only a first step of a long process, particularly in the
case of Keystone XL, to the pipeline in-service dates.
We believe it is crucial that midstream companies keep their long-lead-time projects to the scheduled time and within
budget, because significant delays or cost increases will postpone EBITDA and harm credit measures.
Asset Sales And Joint Ventures Are Other Ways To Improve Balance Sheets
As issuers tighten their belts to determine how to apportion their growth capital over the next 12 months, we expect
asset sales and joint ventures to continue into 2017. We typically evaluate the impact an asset sale or joint venture
(JV) has on a company's business risk profile by assessing several factors, including the impact on the company's scale
and the EBITDA lost; the level of cash flow stability derived from its remaining operations; and the company's pro
forma competitive position. Though more attractive assets would likely command a higher multiple, the remaining
asset base might consist of weaker assets or those with highly volatile cash flows, in our opinion, which could call into
question a company's long-term sustainability. For example, when Azure Midstream Energy LLC dropped certain
assets into its master limited partnership, Azure Midstream Partners L.P., it weakened the company's scale even
though proceeds were used the reduce debt.
If a company establishes a JV and decides to issue debt at the JV level, we will also determine the level of strategic
importance a JV has relative to its owners and consider management's intent as to whether we expect them to provide
support during periods of stress, and thus could end up proportionately consolidated the debt levels to that relative
sponsor or JV owner.
In certain cases, management teams would prefer to retain control of certain key assets, but may choose to partner
with a strategic investor to help expand the business. In some instances, establishing a joint venture helps spread the
capital requirement and preserve liquidity for the owner. In 2016, Crestwood Equity Partners L.P. formed a JV with
Consolidated Edison Inc. in which Crestwood contributed its Northeast natural gas pipeline and storage business for
approximately $1 billion. While the proceeds from the JV helped reduce Crestwood's debt levels, it also increased the
partnership's exposure to its less-stable gathering and processing cash flows, and we assigned a negative outlook to the
partnership.
In a similar vein, Kinder Morgan Inc. formed a strategic JV with electric and gas utility Southern Co., selling a 50%
equity interest in natural gas pipeline Southern Natural Gas Co. for $1.47 billion. Southern Co. is the pipeline's largest
customer, consisting of about 50% of pipeline capacity. Kinder Morgan used the proceeds to reduce balance sheet
debt, which in our view offset the EBITDA it gave up in the transaction.
Distribution Cuts And Simplification Transactions Are The Next Phase In The
MLP Lifecycle
While capital market access remains a key credit driver for the sector, midstream companies are adjusting their
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financial strategies and structures to better position themselves for sustainable long-term growth. Before Kinder
Morgan's decision to cut its dividend 75% in December 2015, management teams would only consider a cut as a last
resort to improve credit quality, knowing that it would mean the company would be shut out of the equity markets for
some time.
However, with the Alerian Index (a stock index that tracks energy master limited partnerships) following crude prices
lower in the first quarter of 2016 and little relief in sight, equity yields skyrocketed and the cost of equity capital
became--and to a certain extent continues to be--a credit issue (see table 1). Since most midstream MLPs pay out all
cash flow to unitholders after maintenance capital and interest expense each quarter, they rely on a balanced mix of
debt and equity financing to fund growth capital spending each year, as well as to refinance existing maturities and
term out their revolver borrowings (repay borrowings under their revolving credit facilities with permanent capital).
However, MLPs' high cost of equity already reflected investors' expectations of a distribution cut, which many
midstream companies used as an opportunity to reset their growth outlooks, fix their cost of equity capital, improve
liquidity, and reduce leverage. For these reasons, the consequences of a cut weren't viewed to be as punitive to a
company's equity price as were the distribution cuts in 2008-2009.
Table 1
Distribution Cut Summary
Company
Pre-Cut
Distribution
Post cut
Equity yield
(%)
Distribution
Equity yield
(%)
Distribution %
change
Equity yield as of
12/30/16
CSI Compressco
$0.5025
14.2
$0.3775
24
(25)
17
Archrock Partners L.P.
$0.5725
28.5
$0.2850
10
(50)
7
Crestwood Equity Partners
$1.3750
44.8
$0.6000
14
(56)
9
Calumet Speciality Products
Partners L.P*
$0.6850
16.3
Suspended
N/A
--
--
Ferrellgas Partners, L.P
$0.5130
10.6
$0.1000
7
(81)
6
Global Partners, L.P
$0.6970
8.8
$0.4630
12
(34)
10
Kinder Morgan, Inc.
$0.5100
7.5
$0.1250
3
(75)
2
Martin Midstream Partners
L.P
$0.8125
15.4
$0.5000
12
(38)
11
NGL Energy Partners LP
$0.6400
24.4
$0.3900
12
(39)
7
Plains All American Pipeline
$0.7000
10.3
$0.5500
7
(21)
7
Southcross Energy Partners,
L.P.§
$0.4000
29.3
Suspended
N/A
-
-
The Williams Company
$0.6400
11.6
$0.2000
3
(69)
3
*Dividends suspended effective April 15, 2016. §Dividends suspended effective Jan. 18, 2016.
What Are The Credit Implications Of Collapsing The MLP Structure? It
Depends
In our view, structural simplification for MLPs is the more transformative fix to their high cost of capital, rather than
simply a distribution cut or an IDR subsidy by its general partner, and the next step in the evolution of the sector.
However, while we generally view a transaction's ability to eliminate a partnership's incentive distribution rights as a
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credit positive, other factors may come into play that can offset this long-term benefit. Companies that have significant
general partner debt could weaken credit measures through the consolidation, which could result in lower ratings
despite being in a better position to grow. These companies will typically have less of a cushion in their credit
measures and ratings during periods of underperformance or if they poorly execute their growth strategy. Also, with
only one notable exception, the companies are still structured as MLPs, and all of the credit attributes we associate
with the structure will continue to apply. Most partnerships will continue their aggressive growth policies both
organically and through acquisitions and require external capital to fund large, discretionary cash flow deficits.
However, we will generally view partnerships that manage to a more robust distribution coverage ratio, and use the
excess cash flow to partly fund equity needs or repay debt, more favorably than those that don't, which may support
the current credit profile.
An Improved Commodity Price Outlook Gives Us A Reason For Optimism
Our optimism for the North American midstream sector stems from a somewhat better outlook for commodity prices,
which will also provide a boost to E&P companies; better capital market access; more efficient operations as a result of
cost reduction plans and lower cost of capital; and a more conservative approach by management teams toward
funding future growth. We believe companies will remember the lessons of a tumultuous 2016 and stick to a more
measured path, which should lead to improved credit profiles during the next 12 to 24 months.
Related Criteria And Research
Related Criteria
• Key Credit Factors For The Midstream Energy Industry, Dec. 19, 2013
• Methodology: Master Limited Partnerships And General Partnerships, Sept. 22, 2014
Only a rating committee may determine a rating action and this report does not constitute a rating action.
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