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Let’s Make a Deal: Marcellus Shale Edition

By Peter Staas on April 11, 2012

We’re all attracted to winners. Despite mandated warnings that past results don’t guarantee future performance, all too many investors fall prey to what critical theorist Sanford Kwinter referred to as the “gravity-less rainbow”–the seductive fallacy that an asset class will appreciate in perpetuity.

Fortunately, many of the tailwinds that enabled the Alerian MLP Index to return 70.3 percent over the past five years remain in place. By comparison, the S&P 500 has eked out a 6.7 percent gain over the same period.

Source: Bloomberg

MLPs that own and operate midstream infrastructure for processing and transporting oil, natural gas and natural gas liquids (NGL) stand to benefit over the next several years from rising demand for takeaway capacity in prolific US shale oil and gas plays.

The Interstate Natural Gas Association of America (INGAA) estimates that the US and Canada will need to spend USD83.8 billion to build and expand enough midstream infrastructure to support the surge in onshore production. Although a trade organization that represents pipeline owners produced this report, many of the pricing and production assumptions underlying the INGAA’s estimates appear reasonable.

Demand for these midstream assets will be met by MLPs, setting the stage for the best-positioned names to grow their cash flow and quarterly distributions to unitholders. Rising cash flow and quarterly payouts inevitably add up to rising stock prices.

MLPs also continue to reap the rewards of an extraordinarily low cost of capital, the product of the Federal Reserve’s accommodative monetary policy. Because MLPs are pass-through entities that disburse the majority of their cash flow to their investors, publicly traded partnerships rely on the debt and equity markets to fund acquisitions and organic growth projects.

Able to raise inexpensive debt and equity capital with ease, members of the Alerian MLP Index have stepped up mergers and acquisitions (M&A) activity dramatically, announcing almost $89 billion worth of deals since 2010. Pipeline assets have been involved in $27.2 billion worth of transactions, with natural gas distribution infrastructure accounting for $16 billion in deal flow and oil and gas fields accounting for $15.5 billion.

Source: Bloomberg

The happy confluence of ready access to cheap capital, higher oil prices and robust demand for midstream infrastructure to support frenzied drilling in the nation’s shale plays should ensure that the Alerian MLP Index continues its recent track record of distribution growth.

Source: Bloomberg

Although these macro-level developments are encouraging for investors with exposure to MLPs, a close analysis of recent deal flow highlights a trend that continues to gather steam: The rush to expand takeaway capacity by acquiring privately held midstream assets servicing the Marcellus Shale, a prolific shale gas play in Pennsylvania and West Virginia.

Natural gas output from the Pennsylvania portion of the Marcellus Shale has surged since 2009, as drilling activity has remained elevated despite depressed natural gas prices. (See Marcellus Shale Map, for a background on the shale formation)

Source: Bloomberg

As producer Range Resources Corp (NYSE: RRC) takes pains to point out in its investor presentations, the southwest portion of the Marcellus Shale, which also contains return-boosting volumes of natural gas liquids, boosts the lowest break-even costs of many unconventional plays that primarily produce natural gas. Operators can even eke out decent returns in the northeast part of the Marcellus Shale because horizontal wells in the region yield substantial volumes of natural gas.

Some producers have announced plans to scale back drilling in the dry-gas portions of the Marcellus Shale until natural gas prices recover and access to takeaway capacity improves. Analysts estimate that the Marcellus Shale contains more than 1,300 shut-in wells, a number that will only decline if producers curtail drilling and midstream operators bring new capacity onstream.

Although one of the first successful domestic oil wells was in Pennsylvania, the commonwealth was hardly a hotbed of drilling activity before the emergence of the Marcellus Shale. MLPs have moved quickly to address the region’s insufficient midstream capacity and have announced a number of investments aimed toward creating a regional gas hub that supplies the population centers of the Northeast. These endeavors will also support accelerating drilling activity in the Ohio portion of the Utica Shale. (See Utica Club: Growth Opportunities for MLPs in the Utica Shale.)

Recent M&A activity reflects the growth opportunities in the Marcellus Shale. A number of MLPs have scooped up privately held midstream assets since the beginning of the new year because it’s easier to expand capacity on existing pipelines than to site and permit new ones.

Penn Virginia Resource Partners LP (NYSE: PVR), which owns and manages roughly 804 million tons of coal reserves primarily in Appalachia, has focused on diversifying its business by expanding its water handling and gathering and processing assets in the Marcellus Shale.

Although the partnership stood to benefit from expansions to its existing infrastructure in the Marcellus Shale, the stock had pulled back because of negative sentiment toward the US thermal coal industry. Not only have depressed natural gas prices prompted some power plants to switch to natural gas, but the unseasonably warm winter also elevated electric utilities’ coal inventories. Both factors have weighed on coal prices.

Nevertheless, we argued that the selloff afflicting units of Penn Virginia Resource Partners as overdone, citing the MLP’s limited exposure to declining coal prices and ongoing investments in expanding its gathering and processing capacity.

Our faith in Penn Virginia Resource Partners’ growth story was rewarded when management on April 10 announced the acquisition of Chief Gathering LLC from the privately held Chief E&D Holdings LP for $1 billion.

The transformational deal, which is expected to close in the second quarter, nets Penn Virginia Resource Partners six gathering systems in northeast Pennsylvania and a county in West Virginia.

Chief Gathering LLC is also in the process of constructing a pipeline that will connect the gathering system in Wyoming County to Williams Partners LP’s (NYSE: WPZ) Transco interstate pipe in Luzerne County, providing access to end markets in the Northeast and Mid-Atlantic. This pipeline has a peak capacity of 750 million cubic feet of natural gas per day and is backed by 15-year commitments that represent average annual throughput of 275 million cubic feet of natural gas per day.

After the deal closes, management estimates that midstream operations will account for roughly 75 percent of Penn Virginia Resource Partners’ distributable cash flow in 2013, up from 37 percent in 2011. Based on producers’ current drilling plans and the number of wells shut in because of insufficient midstream capacity, management expects throughput on these systems to exceed 1,500 million cubic feet per day.

Even if development and throughput falls short of these expectations (some analysts are calling for a roughly 15 percent decline), the newly acquired gathering systems will still generate a huge increase in distributable cash flow. We also like the long-term growth prospects for these assets as the Marcellus gradually becomes the primary source of natural gas for urban centers in the Northeast.

This transaction followed on the heels of another blockbuster deal in the Marcellus Shale: Williams Partners’ $2.5 million acquisition of Caiman Eastern Midstream from the privately held Caiman Energy.

Since entering the Marcellus Shale in 2009 through a joint venture, Williams Partners has assembled one of the largest midstream portfolios in the region. To date, much of this infrastructure has focused on the dry-gas portion of the play, where the firm expects to have more than 3 billion cubic feet of gathering capacity by 2015.

However, the purchase of Caiman Eastern Midstream gives Williams Partners a beachhead in the liquids-rich southwestern portion of the Marcellus Shale, an area that offers solid economics to producers and should enjoy accelerating drilling activity. The deal will add 150-mile gathering system, two processing facilities with about 320 million cubic feet of capacity and NGL fractionation plants capable of separating 12,500 barrels per day. Expansion projects will increase fractionation capacity to 42,500 barrels of NGLs per day by the end of 2012 and processing capacity to 920 million cubic feet per day by October 2013.

Management estimates that the addition of these assets will enable Williams Partners to grow its distribution by 8 percent in 2012 and 8 percent to 10 percent in 2013 and 2014. Williams Partners and Caiman Energy will also work to develop joint-venture projects in Ohio’s Utica Shale, another attractive growth opportunity.

At the same time, recent news flow related to Kinder Morgan Inc’s (NYSE: KMI) pending $24.4 billion acquisition of El Paso Corp (NYSE: EP) reveals the challenges that the emergence of the Marcellus Shale and Utica Shale pose to owners of the long-haul pipelines that transported natural gas to the Northeast corridor.

To gain regulatory approval for the deal, Kinder Morgan Inc and Kinder Morgan Energy Partners LP (NYSE: KMP) must divest a handful of assets, including two pipelines, gas processing and treating facilities and its 50 percent stake in the Rockies Express Pipeline.

Investors with a position in Kinder Morgan Energy Partners LP shouldn’t panic about this news; management has confirmed that these divestments will be immediately offset by drop-down transactions from Kinder Morgan Inc.

Much of the scuttlebutt around these asset sales has focused on what price the firm’s interest in the Rockies Express Pipeline will fetch. Completed in 2009, this long-haul pipeline has suffered throughput declines in recent years because of surging production in the Marcellus Shale, much of which has supplanted long-haul natural gas in the Northeast. In January 2011, Standard & Poor’s lowered its rating of Rockies Express Pipelines’ senior unsecured debt by one notch to reflect the risk that new contracts would feature less-favorable terms.

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  1. avatar
    rich larson Reply May 21, 2012 at 11:59 AM EDT

    what mlp’s are you recommending

  2. avatar
    L. Keith Reply April 12, 2012 at 9:51 PM EDT

    What MLP’s are you recommending buying at this time?
    L. Keith