Examining Midstream Contracts Amid Slowing Volumes

Summary

• In general, the companies that have reported average contract life provide some assurance that midstream companies can continue to benefit from the contracts in place.
• For new midstream projects, minimum volume commitments (MVCs) and significant contracted capacity provide a layer of defense in an environment of slowing production.
• Declining volumes and increased competition in some basins could exacerbate recontracting risk for companies that have contracts expiring over the next several months. However, the staggered nature of contracts, even for a single asset, helps keep recontracting risk manageable.

With crude and natural gas production volumes slowing and a notable bankruptcy filing from producer Chesapeake Energy (CHK) this week, questions have arisen about the durability of midstream contracts. What protections are in place that can support operational resilience? How are companies handling contracts that are expiring and mitigating the associated recontracting risks? Today’s note takes a closer look at midstream contracts amid a challenging macro energy backdrop.

Chesapeake Energy bankruptcy increases questions about midstream contracts.
The conversation around managing contract risks has become even more relevant given this week’s Chapter 11 bankruptcy filing by Chesapeake Energy. Media reports suggested CHK was seeking approval from the court to cancel $311 million in pipeline contracts, including $293 million for Energy Transfer’s (ET) Tiger Pipeline. Last week, the Federal Energy Regulatory Commission (FERC) issued a declaratory order affirming that it has concurrent jurisdiction with bankruptcy courts to review and approve potential rejections of natural gas transportation agreements with rates filed under the Natural Gas Act in bankruptcy. While it is uncertain exactly how FERC will treat CHK or other bankruptcy cases, the ruling provides some additional insulation for midstream companies by requiring input from FERC that a contract cancellation would benefit the public good.

In addition to ET, Chesapeake notably accounted for 6% of consolidated revenues for Williams (WMB) in 2019, primarily within its West segment. However, WMB noted on its conference call update in March that it would be very difficult for the contracts with CHK to be rejected given the lack of precedent for splitting up contracts with embedded minimum volume commitments. Crestwood Equity Partners (CEQP) also listed CHK as a major customer for its gathering and processing activities in the Powder River Basin in 2019. In response to the filing, CEQP said yesterday it is prepared to operate assets during the bankruptcy process and does not expect changes to its previous free cash flow and financial metric guidance from May. While bankruptcies create uncertainty for midstream, producer assets have historically continued operating through bankruptcy proceedings, requiring access to pipelines and other midstream assets. Contract renegotiations also tend to be more likely than complete revocation of contracts.

Contract protections provide some insulation amid potential oversupply of capacity.
As a result of depressed commodity prices in recent months, US crude and natural gas production are declining and expected to see annual declines through 2021. The decrease in volumes has made it more likely that energy infrastructure could become overbuilt in the short term as new pipeline capacity comes online. While growth capital spending was already declining, spending is expected to drop further in 2020 as lower production reduces growth opportunities and companies prudently pare back investments where possible (read more). That said, projects approaching completion in 2020 are likely to advance.

In general, midstream companies have emphasized that upcoming projects have a high percentage of contracted capacity or minimum volume commitments (MVCs) that provide some insulation in an environment of declining volumes. This should not come as much of a surprise as midstream companies will generally not undertake a project without significant underpinning by long-term commitments that assure a reasonable return on investment. For instance, MPLX (MPLX) noted on its 1Q20 earnings call that 100% of the contracted capacity on the large Wink to Webster crude pipeline project is covered by MVCs when it comes online in 1H21. Similarly, ONEOK (OKE) said its 80,000 barrel per day West Texas LPG pipeline expansion and MB-4 fractionator at Mont Belvieu were 100% contracted when they were placed in service in 1Q20. Both MPLX and OKE, among other companies such as Enterprise Products Partners (EPD), are making deep capex cuts while also advancing firmly contracted projects. Alongside a reduction of capital expenditures of more than $1 billion this year, EPD noted on its 1Q20 earnings call that it does not see its second propane dehydrogenation plant (PDH 2) and Midland-to-ECHO 4 crude pipeline projects as cancelable given that they have been underwritten by long-term contracts.

Examining the average life of existing contracts.
Similar to new projects, existing infrastructure assets often have contact protections like MVCs, but long-term contracts eventually expire, introducing recontracting risk. Depending on the asset, there may or may not be a readily accessible alternative competing for volumes. For example, a crude pipeline from the Permian to the Gulf Coast faces more competition than a dedicated product pipeline taking gasoline away from a refinery with no other pipeline alternative. Entering 2020, new energy infrastructure and capacity expansions were already beginning to heighten competition in some areas. In the Permian, for example, crude pipelines placed into service in the second half of 2019 and early 2020 have contributed to narrower crude price differentials between Midland and the Gulf Coast, placing downward pressure on pipeline rates (read more). Competition is most meaningful for legacy pipelines that have near-term contract expirations. As expirations approach, pipelines will likely try to renew contracts with existing customers or may hold an open season to solicit broad interest. Rates will likely depend on the competitive environment. In rarer cases, midstream providers may reconsider how they are utilizing the pipeline and opt to reverse the direction of the flow, convert the pipe to transport a different hydrocarbon, or make other changes to draw interest from shippers and meet a need.

To better gauge potential recontracting risk, investors can look at remaining contract life and other disclosures around contract expirations. While details are often sparse and vary by company, as demonstrated by the table below, contract expirations tend to be staggered across assets. With many contracts boasting remaining lives of several years, the macro environment could be significantly different at expiration than it is today. Contract lengths can vary for a single large pipeline given different customer preferences and commitments. For example, roughly half of the committed capacity on Magellan Midstream Partners’ (MMP) Longhorn crude pipeline from the Permian was set to expire this fall, and MMP said on its 4Q19 earnings call that it had reached a new ten-year take-or-pay commitment for Longhorn, significantly reducing recontracting risk.