Meritage Midstream: Stable infrastructure development in an unstable energy environment
How aligning business and operating models in the midstream industry drives performance through downturns
Meritage Midstream Services, headquartered in Denver, provides natural gas producers (upstream) across North America with a full complement of midstream services. The Company illustrates how the strong alignment between a company’s business and operating model can enable it to withstand, or even thrive, during an industry downturn.
The midstream industry: Not for the faint of heart
Meritage operates in the midstream industry, meaning it gathers, processes, treats and transports natural gas, liquids and byproducts from the wellhead to the point of sale or disposal. Upstream companies rely on midstream availability in order to sell their produced natural gas volumes. Similarly, since midstream providers are paid based on volumes flowing through the system, midstream companies rely heavily on sustained producer activity to ensure a return on capital – it is a symbiotic relationship. While the oil prices investors see in the market are determined by producer activity and demand, prices that the producers actually receive are primarily determined by infrastructure availability. As a result, upstream companies’ health is dependent on both their ability to produce volumes and midstream’s availability to take volumes to market. This dynamic has most recently impacted the Marcellus Shale (which lies under Ohio, West Virginia, Pennsylvania and New York), as the lack of midstream infrastructure has led to historically low gas prices at the wellhead, while manufacturing facilities in nearby Maine have been shutting down due to historically high gas prices[1].
Figure 1: Marcellus to NYMEX basis differentials
Figure 1: TGP Zone 4 and Transco-Leidy, the two main sources of transportation to market for Marcellus gas, have an expected price differential of -$2.50 to -$0.75 / MMBtu on a commodity with a market price of $2.00 – $3.00 / MMBtu, illustrating the importance of infrastructure. Producers realize the price in the market less the differential, meaning they net $2.25 to $0.00 / MMBtu.
However, the risks associated with this relationship are not shared evenly between both parties. Due to the vast networks of pipelines, processing plants and treating systems inherent in delivering natural gas to the end user, midstream projects can often be extremely time consuming and capital-intensive. Further, the projects require an economic basin and an active producer to provide stable cash flow.
During a commodity price downturn, producers frequently decrease drilling activity, which in turn reduces natural gas volumes flowing through the pipeline system. These risks are often exacerbated in exploration-stage or recently-developed gas formations, as the full potential of the formation has yet to be determined. However, natural gas volumes from these fields must be transported to market all the same.
Figure 2: Capital requirement / return as a function of asset maturity
Figure 2: Mature assets provide midstream companies with greater upside and lower capital requirements, which leads to intense competition among midstream companies for mature assets. As a result, early stage assets are under served, presenting an opportunity for midstream companies who can structure creative deals with their upstream partners to share risk.
Managing risk midstream style
Historically, midstream companies have handled this volumes risk by passing it along to the producer in the form of volume guarantees, whereby the producer must deliver a certain amount of natural gas or pay for the unused pipeline / plant capacity. However, this structure merely passes credit risk from the midstream to the upstream company. During a commodity price downturn, upstream companies lament taking on additional credit, and midstream creditors are wary of taking counterparty risk.
Meritage has developed a unique operating approach to entering new or under-developed basins. The Company classifies its projects across two different types of clients: the anchor tenant and the bolt-on.
Anchor tenant: The dependable friend
Meritage’s anchor tenant strategy combines joint venture partnership, volume commitments and flexibility to mitigate the risk of developing infrastructure in an unstable commodity price environment. Before entering a basin, Meritage will identify an anchor tenant (upstream company), usually the company that stands to benefit the most from infrastructure development. The Company will then establish a partnership with the upstream company whereby Meritage agrees to invest the upfront capital required to develop the infrastructure and the upstream company agrees to commit volumes to the project such that Meritage breaks even on its capital investment. This frees upstream capital to do what upstream companies do best – drill wells.
Meritage also provides the upstream company with the ability to earn into equity ownership of the project by signing up for additional volume commitments or by paying cash. This deal structure directly involves the upstream company in the success of the midstream company. Further, This deal structure provides highly-valued flexibility to the upstream companies who are cash-strapped due to low commodity prices – the anchor shipper can entice the midstream company to provide a much-needed infrastructure solution (as well as participate in the project), while the midstream company can ensure that risk is mitigated (or at least appropriately shared). Midstream companies can then establish a backbone in a new basin in order to go after the real prize in midstream: the bolt-on.
Bolt-on: The prize
Once Meritage has identified an anchor tenant, it begins the aggressive pursuit of bolt-on projects. Bolt on projects provide midstream companies with the real incentive to be in the midstream business. These include producers who have acreage in the basin, but aren’t willing to establish joint ventures or sign volume commitments in order to get their product to market. These companies are willing to higher fees (commensurate with their higher risk) in order to access infrastructure. Further, since the midstream company already has established a base of operations in the area, the cost to connect additional wells (and thus reap additional benefits) is much lower, which further increases economics. While the typical anchor project may provide return of capital or a small return, bolt on projects often offer 50% – 100% returns in a good environment.
Alignment of business and operating models: Driving performance
Through its unique and flexible deal structures, Meritage has managed not only to align its own business and operating models, it has also aligned its operating model to the business model of its major customers. By providing flexibility to producers and reducing the capital they have to spend, Meritage has grown the volumes shipped on its gathering system at a 100%+ CAGR and has built two processing plants since inception in late 2013. And through bolt-on projects, the Company has grown acreage dedicated to the system from 250,000 net acres to nearly 1,000,000[2].
[1] Source: Morningstar.
[2] Source: Company documents.
This is a pretty nice concept. I would be interested to hear how they fared in the current market situation with the low oil prices, especially since more and more companies are starting to survive by offering the ability to earn into equity ownership of the project.
Killer memo. I especially like the discussion of risk-sharing through joint venture arrangements. A few random questions (for discussion over a beer):
(1) Is midstream capacity increasing or decreasing?
(2) Are anchor tenents typically a bottom quartile producer on the cost curve, or is scale (hence volume) a more prized attribute?
(3) Why don’t downstream producers backward integrate into transport? I would think their cost of capital is cheaper than hedging the additional volatility.
(4) How are midstream companies valued? On an EV/Volume basis, or more traditional approach?