Like conjoined twins, the fates of upstream and midstream oil and gas companies have historically been intertwined. But they are siblings with much different personalities.
Upstreamers want to describe themselves as wildcatters that take big risks and generate big rewards. Meanwhile, midstream operators extol the steady, toll booth-like virtues of their assets that provide yield over an extended time frame.
But changes are coming, and they have the potential to transform the midstream sector in ways that reshape traditional relationships between upstream and midstream players. Midstream private equity sponsors have begun maneuvering their portfolio companies to take advantage of these shifts. But potential roadblocks abound.
Consider the state of the midstream space.
The Alerian U.S. Midstream Energy Index, consisting of 31 constituent public midstream entities, has seen many highs and lows since its launch in 2013. The index climbed as high as 863 in September 2014 but dived as low as 155 in March 2020. Unsurprisingly the highs and lows correlate closely to crude oil’s zeniths and nadirs. Today the index stands close to 491.
Challenging market dynamics have combined with ESG mandates to create a tough fundraising environment for existing and prospective private equity players.
“Generally speaking, private equity interest in energy in recent years has been way down,” said Creighton Smith, partner at Vinson & Elkins. Some of the largest private equity providers to the sector have taken a step back from investing in the space, he said.
“The overall pool of private equity-sourced capital has diminished,” agreed Tim Fenn, partner at Latham & Watkins. “Some of that slack has been taken up by other investor types. For instance, infrastructure funds have stepped in and taken private equity’s place.”
Fenn flagged Buckeye Partners as a stand-out example. In November 2019, Australian infrastructure player IFM Investments paid $10.3 billion to acquire Buckeye Partners and take it private.
“The market is still strong, but there are headwinds looking farther out,” said Chad Smith, partner at Kirkland & Ellis. Global economic pressure is putting pressure on commodity prices, and inflation is a “growing concern.”
Private equity sponsors that have remained in the space are feeling downright enthusiastic about their future prospects, however.
“We firmly believe we are entering an energy awakening,” said Jason Downie, co-founder and managing partner of Tailwater Capital. Discussion no longer focuses just on supply and demand but also on reliability, accessibility and affordability. In such an environment, oil and gas offers clear benefits, he said.
“The overall pool of private equity-sourced capital has diminished.”—Tim Fenn, Latham & Watkins
“We certainly believe we’re at the front end of a new investment cycle,” said Billy Lemmons, co-founder and managing partner of EnCap Flatrock Midstream. “There have been a lot of favorable fundamentals and have been many world events that increase or renew the role of hydrocarbons.”
Acknowledging that some private equity investors have moved out of the space, Lemmons sees that as a positive. “From an investment standpoint, there’s less capital that we need to compete with,” he said.
The export effect
Although EnCap Flatrock Midstream did not put much capital to work in 2020 and 2021, the midstream private equity shop has not been shy of deploying capital in 2022. The firm has completed nearly $2 billion in acquisitions, and its portfolio companies are positioned to add more than 1 Bcf/d of new capacity, said Lemmons.
EnCap Flatrock lists 20 current midstream portfolio companies on its website. One of those investments is M6 Midstream, which also boasts the backing of Yorktown Energy Partners, Martin Sustainable Resources, Ridgemont Equity Partners, Bengas Midstream Partners and Blackstone Credit.
In September, M6 Midstream announced a pair of acquisitions in the Haynesville Shale: the East Texas business of Midcoast Energy and Align Midstream II. The combined assets give M6 Midstream 1.7 Bcf/d of capacity with the ability to expand to 2.2 Bcf/d to move natural gas from the Haynesville to the Gulf Coast and LNG markets.
“We’ve certainly spent more time looking at LNG in the last year than in the past 14 years,” said Lemmons.
M6 Midstream is not EnCap Flatrock’s only investment close to LNG export facilities. It also backs Clearfork Midstream, which acquired Azure Midstream Energy in early 2022, giving the company 500 miles of pipeline and 1.2 Bcf/d of treating capacity across systems in North Louisiana and East Texas.
Infrastructure for LNG export is a “huge opportunity,” said Downie. Tailwater invested in Align Midstream II in 2017, which had assets that connected natural gas supply to key downstream pipelines serving the growing Haynesville Shale basin. Tailwater is again looking at additional investments in the Haynesville, Downie said, but he also sees the Eagle Ford playing a role in LNG supply.
“The market is still strong, but there are headwinds looking farther out.”—Chad Smith, Kirkland & Ellis
RBN Energy has seen a steady uptick in LNG interest through its consulting business, said CEO David Braziel. “Nearly every deal we’ve done this year is impacted by trends in the LNG market,” he said.
LNG sits at a critical juncture between energy security and energy transition, Braziel noted. “Not only do we want to help our allies in Europe but also exporting U.S. natural gas is the best thing we can do for decarbonization goals.”
Growing gas volume from the Permian Basin is also fighting to make its way to LNG facilities, Braziel said. Thanks to strong international oil demand and constrained global supplies, crude and associated gas production is booming in the basin but pushing up against capacity. Prices at the Waha hub went negative in late October, he noted.
Not surprising then that private equity has seen some of its biggest midstream exits in the Permian.
In January, Warburg Pincus-backed Navitas Midstream was sold to Enterprise Products for $3.25bn. In February, EagleClaw Midstream, backed by Blackstone and I Squared Capital, combined in a $3.11 billion all-stock transaction with Apache-owned Altus Midstream to form Kinetik. In July, Riverstone and Goldman Sachs completed the sale of Lucid Energy Delaware to Targa Resources for $3.55 billion in cash.
Next big thing
It’s not just the ebb and flow of markets and caroming impacts of geopolitical events that have private equity investors chomping at the bit. They see midstream as uniquely positioned to not only participate but possibly even lead the way in a whole new area of investment thanks to the signing of the Inflation Reduction Act (IRA) in August.
At first glance, the new legislation might not seem cause for excitement for midstream private equity sponsors. Yet the new legislation promises to turn molecules that used to be considered waste into new sources of economic value.
The IRA includes significant tax credits and benefits for carbon capture utilization and storage (CCUS) through enhancements to Section 45Q of the Internal Revenue Code, according to a publication by BakerHostetler.
“Carbon capture and sequestration—that is literally midstream 101,” said Tailwater’s Downie. Midstream companies have long generated fees removing CO2 from natural gas to make it pipeline ready. “An amine treater is literally a CO2 stripper,” Downie said.
Midstream also has expertise in injection wells, which will be critical to sequestering carbon, he said.
The IRA provides a tax credit as high as $85 per metric ton if the captured carbon is stored in a geologic formation, or $60 per ton for CO2 used in oil and gas fields. Available 45Q tax credits more than double to $130 per metric ton for carbon used in oil and gas fields that have been removed from the atmosphere through direct air capture.
“We firmly believe we are entering an energy awakening.”—Jason Downie, Tailwater Capital
Latham & Watkins’ Fenn noted that another important new feature of the IRA is the transferability of the tax credits. With the new legislation, tax credits can be transferred to another party, like a bank or insurance company that would have a greater need for the credits. Transfers come with “lots of requirements” but makes CCUS far more attractive to midstreamers. Previously they had little use for credits because of the tax benefits of depreciation, which can significantly lower their tax bills, as well as the overall limitations on the use of credits by passthrough entities.
Tailwater is all in.
The private equity firm created Tailwater Innovation Partners to provide guidance to portfolio companies on ESG, energy innovation and operational improvement. And Tailwater already has one portfolio company, Frontier Carbon Solutions, focused on bringing CCUS to Wyoming. The company announced a partnership with direct air capture technology company CarbonCapture to create a system that could permanently remove up to 5 million tons of CO2 from the atmosphere by 2030.
EnCap Flatrock also sees great promise in adding CCUS to the traditional suite of services its midstream companies provide. When M6 Midstream announced its dual acquisitions in the Haynesville earlier this year, it disclosed plans to build what it calls a “new generation gas gathering” system that can capture and sequester up to 2 million tons of CO2 per year.
Stakeholder Midstream, another EnCap Flatrock portfolio company, seeks to provide CCUS of CO2 extracted from its Campo Viejo gas plant in the Permian. In September, Stakeholder announced that it received Environmental Protection Agency approval of its monitoring, reporting and verification plan for the permanent sequestration of CO2 at its Pozo Acido injection well near the Texas-New Mexico border.
Midstream management teams “have to figure out how to adapt and get really creative,” said Braziel. One wrinkle is that the 45Q credits have just a 12-year life, he said. That could impact valuations in an industry accustomed to projects delivering 20 to 30 years of cash flow.
Although midstreamers have always faced risks, they were well-understood hazards, he said. Entering the CCUS market will challenge them with unfamiliar regulatory and political risks. “Some will make the jump, and some will not,” he warned.
For this new strategy to work, it’s clear midstream players will need to find ways to share with upstream partners.
Tailwater’s Downie sees joint ventures between midstream and upstream companies as one way to split this newfound economic value.
“We certainly believe we’re at the front end of a new investment cycle.”—Billy Lemmons, EnCap Flatrock Midstream
EnCap Flatrock’s Lemmons expects the details to be ironed out through negotiations and thinks a percentage of liquids or percentage of proceeds model could address the situation.
But the rewards are worth the risks.
Lemmons said that the addition of CCUS offers a compelling investment thesis that could attract generalist private equity funds or infrastructure funds that might otherwise avoid the oil and gas back to the sector. They could become the future acquirers of midstream systems being funded today, he pointed out.
Carbon capture is “definitely” attracting private equity that has traditionally stayed away from energy, said Kirkland & Ellis’ Smith. Even those private equity sponsors that have gotten out of the E&P space for ESG reasons could look at midstream to retain exposure to upstream without being directly invested in it.
For Lemmons, who has had a front row seat to observe the industry over multiple decades, carbon capture is just the latest character in a story constantly being written.
“We really do believe there is perpetual opportunity in midstream, and in every new chapter there’s an opportunity to invest.”