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Trends Favor Midstream

By Peter Staas on Jun. 20, 2017

In this intensely competitive environment, shale basins within the US onshore market will also jockey for market share, with the lowest-cost areas offering the best potential for volumetric growth.

Although all the major shale plays feature their sweet spots and marginal acreage, much of the asset acquisitions and drilling activity during the recent up-cycle have centered on the Permian Basin and central Oklahoma’s emerging STACK play.

The reservoir rocks in both areas include exposure to multiple oil-bearing formations, enabling producers to extract hydrocarbons from the same infrastructure—potentially a major source of cost savings and a huge competitive advantage.

For example, during Occidental Petroleum Corp’s (NYSE: OXY) first-quarter earnings call, the company’s president of domestic oil and gas asserted that the company would realize a more than $10 per barrel reduction in its break-even costs on wells targeting secondary benches at its Greater Sand Dunes play in New Mexico.

These opportunities help to explain the frenzy for exploration and production companies to add exposure to the Delaware Basin, an area where blocky acreage packages conducive to drilling longer laterals are easier to come by than in the Midland Basin.

In our view, EOG Resources’ (NYSE: EOG) $2.5 billion acquisition of Yates Petroleum in fall 2016 stands out on the list of deals involving assets in the Delaware Basin. An early entrant to many of the leading shale plays, EOG Resources boasts some of the lowest-cost core acreage in the Bakken Shale and Eagle Ford Shale; the company’s big splash in the Delaware Basin says a lot about the quality of the resource base and the opportunity set.

This urgency also extended to the midstream segment, where Plains All-American Pipeline LP (NYSE: PAA) and NuStar Energy LP (NYSE: NS) earlier this year purchased expensive gathering systems in the Permian Basin.

Given the equity issued to fund these transactions and the elevated yields at which these stocks traded, these deals won’t alleviate the near-term risk to either master limited partnership’s (MLP) distribution or the challenges posed by impending debt maturities. These desperate moves underscore the potential for the Delaware and Midland Basins to take market share in an environment where oil prices remain lower for longer.

The elevated multiples associated with these transactions in part reflect the quality of the counterparties and expectations for output growth.

Concho Resources (NYSE: CXO) is the anchor shipper on the Alpha Connector system that Plains All-American Pipeline paid $1.2 billion to purchase, while Parsley Energy is one of the main customers for NuStar Energy’s newly acquired Navigator system in the Midland Basin. In addition to volumetric upside on the gathering systems themselves, this throughput should feed some of the MLPs’ other assets.

Midstream Focus

In this environment, we prefer midstream names that offer the best leverage to volumetric growth stories and have the balance sheet strength to pursue joint ventures with cash-strapped rivals.

Not only do these MLPs pay generous yields that can improve your total return during periods of volatility, but the most recent down-cycle also prompted many midstream operators to take the necessary steps to put themselves on a more sustainable path by cutting their distributions and paying down debt.

Investor sentiment toward MLPs remains weak, reflecting concerns about oil prices and the reputational damage inflicted when blue-chips like Energy Transfer Partners LP (NYSE: ETP), Kinder Morgan (NYSE: KMI), Plains All-American Pipeline LP (NYSE: PAA) and Williams Partners LP (NYSE: WPZ) slashed their payouts.

But MLPs’ recent underperformance, above-average yields, and leverage to US shale oil and gas producers taking market share make for a compelling risk-reward proposition for patient investors. These qualities make our favorite MLPs excellent buys during periods of volatility in the energy market.

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