The Energy Infrastructure Newsletter • Winter 2024
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U.S. Midstream M&A Macro Trends:
Back to the Future
Advisor Access spoke with David Oelman, a partner with Vinson & Elkins LLP’s corporate group and member of its Management Committee. David has worked with some of the largest midstream companies in the U.S. over his 35-year career and was elected to the Alerian Hall of Fame in 2019 together with Kelsey Warren and Raymond Plank. The interview below represents David’s personal observations, not those of his firm.
Advisor Access: You began practicing in 1990 and have been significantly involved in the evolution of the U.S. midstream industry for more than three decades. How would you describe the biggest changes in midstream M&A activity over that time?
David Oelman: When I started working in the 1990s, there were very few publicly traded midstream names: Buckeye, El Paso, Lakehead, Transco and Tenneco. Buckeye was the first pipeline MLP [master limited partnership] and was formed in 1986. Many, if not most, U.S. midstream assets owned by public midstream companies today were owned then by the major integrated oil and gas companies as well as independent refiners and E&P [exploration and production] companies.
AA: What kick started the growth of a separately capitalized midstream sector?
DO: I worked on the Enron Liquids IPO in 1992. We printed “red herrings” three times before the IPO was completed—not a smooth launch. For an investor, Enron Liquids was meant to be “trust like,” with an emphasis on stable yield rather than growth. Enron Liquids’ strategy changed dramatically in 1997 when Rich Kinder left Enron, bought the general partner of Enron Liquids and changed the name to Kinder Morgan. Kinder quickly proved that an MLP could grow through M&A, just like any corporation. Starting with IPO proceeds in 1992 of $130 million, Kinder’s current capitalization is almost $60 billion.
Dan Duncan launched a similar M&A strategy in 1998 with Enterprise. That year, we also worked with Greg Armstrong and Harry Pefanis to create Plains All American. In all three of these cases, entrepreneurs saw an opportunity to buy midstream assets from majors and independents. Why were they selling? Convinced that North American oil and gas production was in long-term decline, many E&P companies wanted to sell non-core logistics assets to invest in higher return projects—namely finding new reserves which were largely offshore, an expensive undertaking. As E&P companies shed onshore transmission and storage assets, the “growth MLP” was born.
AA: A tremendous boom in MLP IPOs followed. How did the M&A model change?
DO: The growth of MLP IPOs continued, essentially uninterrupted, from the late 1990s through the mid- to late-2010s. Their M&A strategies would diversify as the asset class expanded.
Some MLPs grew just as Enterprise, Kinder, Plains and others had done—buying midstream assets from E&P operators or refiners to build out systems connecting multiple producing basins to refining and, eventually, export hubs.
But something else was going on. Strong financial performance—the AMZ produced double the returns of the S&P 500 from 2005–2014—was pushing valuations so high that select pipeline companies, E&P operators and refiners realized that their midstream assets could be dropped into the MLP structure and taken public while retaining control through the general partner—“unlocking” additional value and providing capital for the parent company. The “drop down” MLP was born and operators including El Paso, Spectra, Anadarko, Williams and others formed MLPs that would grow through M&A transactions with their sponsors.
AA: How did the Shale Revolution impact the trajectory of these MLPs and their acquisition strategies?
DO: The most startling fact about the “Shale Revolution” is that NO ONE SAW IT COMING. Proof positive: Cheniere Energy Partners was taken public in 1997 to IMPORT LNG. We helped Harold Hamm take Continental Resources public the same year and it was marketed as a “Bakken oil company”—it was not considered a shale company and he was not considered a “fracker” (a word he hates) yet.
The sudden and dramatic growth of oil and gas production from the emerging U.S. shale basins meant that the midstream assets majors had been selling to MLPs for over a decade suddenly became more valuable than at any time since originally constructed. Capital poured into incumbent and newly formed E&P companies as well as MLPs. Valuations continued to climb from 2007 almost uninterrupted through 2014. General partners [GPs] of MLPs grew so substantially that they went public as separate companies, with Plain All American’s GP IPO in 2013 the largest in the U.S. that year. Drop down M&A activity continued.
In addition, larger MLPs began buying smaller MLPs and midstream companies, slowly consolidating the industry. In addition to growth through M&A, many MLPs began building new gathering, pipeline and processing projects to connect newly emergent shale basins in anticipation of ever-increasing production. It was almost too good to be true—and, in fact, it was too good to be true. While U.S. shale production surged, OPEC “opened the spigots” from 2014 to 2016, cratering global oil prices. The “Great Reckoning” had come for shale E&P operators as well as their midstream brethren.
AA: You call it the “Great Reckoning.” As the Shale Revolution matured what happened to midstream M&A?
DO: The Great Reckoning was painful. Midstream companies had borrowed significantly to build new pipelines to carry increasing volumes, growing as much by building pipelines as through M&A. As commodity prices fell, E&P companies scaled back development and lowered production expectations. MLPs, originally premised on stable if growing distributions, started to cut distributions in favor of debt service. MLP equity values plummeted. The “drop down” model was broken, the Incentive Distribution Rights (IDRs) held by general partners became less attractive, and public GPs premised on growth stalled mid-flight.
There were three resulting trends during this period. First, the midstream industry needed to reduce debt levels and simplify their structures. Growth capital was slashed, IDRs were eliminated and MLPs merged with publicly traded GPs. Second, a number of sponsors bought in their MLPs (BP, Dominion, Oneok, Shell). Third, third party M&A gained steam. These three factors resulted in the number of publicly held midstream names dropping from in excess of 80 in 2015 to just over 30 today. In addition, a number of MLPs converted to corporations.
AA: Recently, there has been significant consolidation among upstream players. What does this mean for midstream M&A?
DO: The Exxon/Pioneer, Chevron/Hess and Diamondback/Endeavor deals, among others, all reflect growth through scale in the U.S. We would expect midstream M&A to follow suit. Oneok/Magellan, Energy Transfer/Enable and Energy Transfer/Crestwood are all reflective of this trend. Because midstream debt levels have been significantly reduced, together with capital expenditures, midstream names are in a much better financial position to complete M&A transactions.
In addition to the headline grabbing public mergers, much of the midstream M&A our firm is seeing consists of rationalization of assets by large midstream companies (divestitures) as well as purchases of assets from private equity sponsors—with the latter being the bulk of the activity. How quickly consolidation might continue is dependent, however, on a number of factors. First, low oil and gas prices could crimp production, having a knock-on effect on midstream valuations. Second, while most believe the new administration will reduce Federal Trade Commission scrutiny of mergers, midstream companies, by their nature, serve as consolidation points for producers and consumers and, even in Republican administrations, have drawn attention from anti-trust regulators. Big picture, we essentially return to where we started in the 1990s—where the smaller in number, but much larger and better capitalized midstream names will derive their most substantial growth through M&A.
AA: Thanks for your insights, David.