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Big Returns for Midstream Oil and Gas Companies

By Elliott H. Gue on July 22, 2011

The New York Times recently sparked a wave of controversy after the news organization published a series of stories that questioned the sustainability of the shale gas revolution. These pieces suggested that shale gas producers have overstated the productivity of their wells and that shale gas fields are unprofitable in the current pricing environment.

These articles undoubtedly had their intended effect, mobilizing both critics and supporters of shale gas development and stimulating a vociferous debate. Although arguments that the emperor has no clothes always attract plenty of eyeballs–the primary motivation of many media outfits–readers must evaluate the logic underpinning these claims and distinguish the rational from the sensational.

The New York Times is correct that some shale gas fields are uneconomic in the current pricing environment, which explains why drilling activity has declined in the natural gas-rich Barnett Shale and Haynesville Shale.

But the articles largely ignore the economics of the Eagle Ford Shale and other unconventional fields that produce large amounts of high-value oil, condensate and natural gas liquids (NGL) such as butane, ethane and propane. In general, exploration and production firms have shifted production from dry-gas fields to liquids-rich plays that offer superior profitability.

Moreover, the shale gas industry has undeniably changed the domestic energy mix in recent years: Natural gas production from US unconventional fields has soared to about one-quarter of total domestic gas output, up from only 4 percent a half-decade ago.

This production boom has enabled the US to overtake Russia as the world’s leading producer of natural gas, while the resulting supply overhang and closed domestic market has ensured that the country enjoys natural gas prices that are far lower than anywhere else in the world. That hardly sounds like a Ponzi scheme in the making.

A subsequent Op-Ed piece published in The New York TimesClashing Views on the Future of Natural Gas–highlighted some of the inaccuracies, distortions and exaggerations evident in the paper’s late June series on shale gas fields. The article also criticizes the stories for their reliance on anonymous sources and individuals who are known opponents of the shale gas industry.

But mergers and acquisition activity provides the best refutation of The New York Times’ articles on shale gas. From Chevron Corp (NYSE: CVX) and ExxonMobil Corp (NYSE: XOM) to Total (Paris: FP, NYSE: TOT) and Royal Dutch Shell (NYSE: RDS.A), some of the world’s largest and most-respected energy companies have invested billions of dollars to add exposure to US shale oil and gas fields.

These firms employ veritable armies of geologists, petroleum engineers and experienced oilfield workers to evaluate the productivity of these unconventional fields. I have more faith in the Super Oils’ take on the economics of shale oil and gas fields than I do in the slapdash reporting of a  journalist.

Investors who own unit of midstream master limited partnerships (MLP) should cheer the entry of major integrated oil companies into US unconventional plays; these deep-pocketed Super Oils have the capital needed to drill aggressively in shale gas fields and can afford to take a long-term view on commodity prices. However, it appears as though investors continue to underestimate the need for pipeline, storage and processing infrastructure to support the growth of North America’s unconventional fields.

In contrast to the experts at The New York Times, ExxonMobil has a bullish outlook for natural gas production and demand. A comprehensive report recently issued by the Interstate Natural Gas Association of America (INGAA), a trade group for the pipeline industry, echoes this sentiment.

Although one should question the independence of the INGAA’s analysis, the trade group’s assumptions for US natural gas consumption aren’t unreasonable; the INGAA assumes US power demand growth of just 1.3 percent annualized through 2035.

The INGAA report also doesn’t make aggressive assumptions about new sources of demand for natural gas. For example, the report assumes that gas doesn’t gain widespread acceptance as a transportation fuel. Although the authors acknowledges that some bus and taxi fleets will run on natural gas in 2035, the white paper doesn’t factor in the use of gas in passenger cars or commercial trucks. Moreover, while the INGAA report assumes that the Kitimat liquefied natural gas (LNG) plant in western Canada will begin operations, the analysis avoids projections about additional LNG export capacity. If either LNG exports or natural gas-powered vehicles gain greater acceptance, the INGAA demand assumptions would be overly conservative.

The INGAA forecasts that natural gas will win market share among electric utilities and that these gains will account for three-quarters of the projected increase in natural gas consumption. This prediction makes sense: Stringent regulations will gradually increase the cost of coal-fired power, prompting US utilities to shift to natural gas, the cleanest-burning fossil fuel. Natural gas-fired plants are also comparatively easy to site and build and tend to engender less public opposition.

At the same time, alternative energy sources such as solar and wind power can’t compete with coal and natural gas on price or practicality. These inherently intermittent sources of power–the sun doesn’t always shine and the wind doesn’t always blow–can’t offset the need for reliable, baseload electricity. In fact, the more solar and wind power farms the world builds, the more thermal or nuclear power plants are required to compensate for any power shortfalls.

According to the INGAA, building the infrastructure to meet production growth will require roughly $8.2 billion (2010 dollars) in investment per year through 2035–a total of more than $200 billion worth of new projects.
As I mentioned in the June 24, 2011, article, MLPs: Another Opportunity to Buy This Summer, processing and transporting NGLs is big business for  oil and gas MLPs, many of which have reported strong NGL demand from US-based petrochemicals producers and are building significant processing and pipeline infrastructure to meet that demand.

These MLPs are gaining attention from astute investors because their unique organizational structure offers a simple value proposition: tax-advantaged high yields, strong recession-resistant growth potential, and limited exposure to commodity prices. The shale oil and gas revolution remains one of the most compelling growth opportunities for MLPs.

Most MLPs are involved in processing, transporting and storing natural gas and NGLs, activities that limit exposure to commodity prices. Producers book capacity on these assets under long-term contracts that guarantee minimum cash flows to the MLP. These agreements are usually inked long before the MLP begins construction on a new infrastructure project.

MLPs are the dominant builders and owners of natural gas pipeline, processing and gathering infrastructure in the US; the group will take a leading role in enabling the shale gas and oil revolutions to continue.
Although $8.2 billion per year might not seem like a huge amount in the context of the massive $14 trillion US economy, consider that the entire combined market capitalization of all MLPs in the Alerian MLP Index currently stands at just over $150 billion. The need to build out natural gas infrastructure will be a huge tailwind for MLPs in coming years.

Furthermore, the INGAA estimates that if we include the need to build out oil pipelines and NGL transmission lines, the annual required capital outlay jumps to $10 billion. Because many MLPs also operate oil-related infrastructure, they stand to benefit handsomely from this spending as well.

The MLPs that are best-positioned to benefit from rising onshore oil and NGL production are those with existing infrastructure in the hottest plays–the barriers to entry are steep. For more on our top shale oil picks and our favorite MLPs, sign up for a free trial of The Energy Strategist.

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