Midstream: Charting a new course amid market dynamism Midstream: Charting a new course amid market dynamism Vivek Bansal and Anshu Mittal HE MIDSTREAM SEGMENT is not only a key Investors proceed with caution element in the O&G industry’s biggest supply A supply boom and strong demand for both story but also appealing to many energy- T crude oil and natural gas have enabled a highly focused investors for its consistent free cash flow advantaged business environment for midstream generation in the past. However, the segment, companies worldwide. Global O&G supply grew by despite its critical role and stable fee-based business 11 percent, while demand expanded by 8.5 percent model, has struggled to create additional wealth for over the past five years.1 Robust volume expansion its shareholders during the downturn as well as the (especially emergence of LNG and the coming of recent upturn in 2017–18. The short-cycled produc- new supply centers) and a stable fee-based busi- tion profile of shale resources and altered trade ness, as expected, explain the strong growth in flows and routes have brought new challenges to both top and bottom lines of midstream companies this segment, keeping it under pressure. How have worldwide (figure 1). In fact, the companies paid various sub-segments in the midstream segment dividends to the tune of US$19 billion while keeping responded to this complex business environment? their leverage ratio flat at 51.5 percent.2 1 Decoding the O&G downturn Although many industry pundits have provided piecemeal perspectives across the phases of the downturn and recovery, a consolidated analysis of the past five years and a complete perspective covering the entire O&G value chain could help stakeholders—from executive to investor—make informed decisions for the uncertain future. With this in mind, Deloitte analyzed 843 listed O&G companies worldwide with a revenue of more than US$50 million across the four O&G segments (upstream, oilfield services, midstream, and refining & marketing) in an effort to gain both a deeper and broader understanding of the industry. The ensuing research yielded a six-part series, Decoding the O&G downturn, which sets out to provide a big-picture reflection of the downturn and share our perspectives for consideration on the future. In part four of the series, we explore the state of the midstream segment—assessing its overall health, identifying possible reasons behind its flat performance, analyzing its investment profile, and comprehending the importance of revamping commercial and capital arrangements in this volatile market environment. However, the picture is quite different on the in- pace of infrastructure growth to absorb growing vestment and value creation front. The midstream supplies and meet latent demand—the market capi- sector has remained cautious even as upstream talization of global midstream companies in 2018 players expect future growth. This seems clear from was 4 percent lower than in 2014.4 falling midstream investments—midstream capex Unlike in other O&G segments and industries, CAGR across all regions has remained in the range investors in midstream typically use the common of -7 to -11 percent during the past four years.3 And lens of a yield-focused mindset to evaluate the while investors have acknowledged the discipline segment across the globe. However, changed exhibited by companies, they expect a much faster supply conditions on the upstream side and varying IGRE 1 Investments remained low despite strong fundamentals Capex S, right axis Revenue left axis Operating margin left axis O&G 14 154 154 157 161 production MMoe Investments remained low despite 150 rising production and revenues and 100 140 roust industry margins 5 130 0 10 85 110 80 100 75 0 70 Indexed 014100 80 65 70 60 60 55 50 50 2014 2015 2016 2017 2018 Sources S&P Capital IQ Deloitte analysis. eloitte Insights deloittecominsights 2 Midstream: Charting a new course amid market dynamism infrastructure needs and regulations of countries tribution commitments. But then, shale companies could require a deeper assessment by regions and surprised them by delivering phenomenal volume a more differentiated view by investors. While the growth even in a low-price environment. However, US midstream sector seems to find it challenging because of the time taken to build pipeline infra- to manage capital cycles in a more dynamic shale structure, midstream companies could not catch up. world, non-US companies are facing issues that are The result: Many midstream companies lost notable unique to the part of the value chain they operate volume growth potential as capacity bottlenecks in. And given the criticality of midstream infrastruc- pushed E&Ps to either delay completions or explore ture, even short-term uncertainty in resolving these other transportation options. challenges could pose risks to future O&G volume Realizing that being reactive was not working, growth. most midstream players then followed a proactive approach and increased their spend on infrastruc- ture development by 25 percent in 2017 despite US midstream: Both reactive their high cost of capital: ROC (return on capital)– and proactive strategies fail to WACC (weighted average cost of capital) spread averaged around -1 percent when midstream in- deliver vestments went up in 2017.5 Further, visible shale After the oil downturn started in mid-2014, mid- volume growth appeared to entice them to maintain stream companies, skeptical of the sustainability their high capex in 2018 as well (figure 2). But this of then high-cost US shale production, broke the growth came with a high cost of capital, and thus linear relationship with upstream investments and lower margins. slashed their capital programs. Despite realizing With oil prices falling and volatility returning that they were risking their future growth, most mid- in late 2018, now, there is a risk of supply growing stream companies reduced their investments seeing less than anticipated or planned for. Although shale rising cost of capital, falling returns, and high dis- production has consistently surprised to the upside, IGRE Managing high-cost investments in a dynamic shale world remains a challenge ROCWACC spread right axis Midstream capex change left axis pstream volume growth left axis Increased investments, 50 that too at a high cost, may not fetch desired 3 40 returns as notale pipeline overcapacity is 30 expected in many 2% asins 0 1 10 0 0 -10 Significant underinvestment for 3 years -1 led to capacity ottlenecks during supply -0 surge in 018, restricting growth for many players -30 - 2010 2011 2012 2013 2014 2015 2016 2017 2018 Sources S&P Capital IQ Deloitte analysis. eloitte Insights deloittecominsights 3 Decoding the O&G downturn some estimates caution against possible pipeline competition likely require a much closer alignment overcapacity of 15–40 percent over the next five of upstream growth and infrastructure planning in years in some shale plays.6 This could explain the the United States. underperformance of US midstream companies, where both reactive and proactive investment strat- egies have failed to deliver in a highly dynamic shale Non-US midstream: Bound environment. by regional differences One may rightly argue that midstream invest- ments self-balance over a period of time, and the lag Global growth in natural gas as a fuel for the or lead in infrastructure growth is intrinsic to this future and altered trade flows due to the shale business. But shale’s dynamism and intensifying boom have had a profound impact on international IGRE 3 Investment and performance issues in midstream sub-sectors pose a threat to future O&G trade growth Aove 014 elow 014 levels levels Revenue Margin Market cap. Capex Region (US$ billion) (%) (US$ billion) (US$ billion) Asia Pacific 6 11 14 6 Outside North America, midstream investments, urope 3 1 31 2 especially on the natural gas distriution front, are very low, posing Distriution atin merica 9 22 1 7 a threat to the anticipated natural gas and NG growth M 2 3 1 - urope 16 6 13 2 Drastic margin contraction and loss of investors' wealth Asia Pacific 16 6 13 1 in the shipping usiness, due to trade disruption and energy transitions, Shipping atin merica 6 13 7 3 pose a significant threat to capacity planned for exports M 2 2 6 4 Notes 1 alues mentioned against each parameter represent either 018 or last twelve months data ased on reporting cycles of various companies. Margin refers to weighted average operating margin of each company group in the respective region. 3 MEA stands for Middle East and Africa region. Sources S&P Capital IQ Deloitte analysis. eloitte Insights deloittecominsights 4 Midstream: Charting a new course amid market dynamism midstream companies. While Asian gas distribu- cut in nonresidential city gate price followed by the tors seemed highly cautious about the projected establishment of local trade hubs and exchanges.10 “high” gas demand growth in the region, the ship- Even after many thoughtful efforts, the country ping industry seems to have struggled to align with could only keep its gas distribution investments flat, changing trade patterns and geopolitical uncertain- which may not be enough considering its ambitious ties (figure 3). road map to expand LNG imports. It seems to imply that gas distribution investors remain cautious and may only buy the story of LNG growth once state Gas distribution: Growing policies and regional pricing become consistent and strong, yet failing on last-mile predictable. connectivity Gas distribution companies, especially in Shipping: Sailing in Asia-Pacific (APAC), witnessed one of the best per- troubled waters? formance periods as low commodity prices, and growing supply of LNG from Australia and the US Shipping and transportation companies, par- helped them capitalize on old infrastructure in- ticularly in Europe and Latin America, saw a vestments.