- 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.
Recontracting risk remains in focus amid a tough environment.
Given today’s less favorable market environment, contract profiles and renewals become even more important. Factors largely out of the control of midstream companies, such as the health of producer customers, the balance between production and pipeline capacity in a basin, and macroeconomic factors impacting commodity prices, can all influence recontracting risk. For contracts expiring in the next 12-18 months, the recontracting process is likely to be more difficult given slowing volumes and increased competition as a result of added pipeline capacity in some areas. New contracts may have lower rates than legacy contracts given increased competition and other market pressures.
Outside of contract expirations, customers may proactively try to renegotiate rates in a lower commodity price environment if under stress. This can happen with third-party customers or when a midstream company is servicing a producer parent. In these cases, midstream rates are typically adjusted with terms extended, or the midstream provider is made whole with a lump-sum cash payment. In some examples from the 2014-2016 downturn, the renegotiated contracts maintained the same net present value of cash flows. More recently, recontracting agreements announced by TC Energy (TRP CN), EQM Midstream (EQM), and Antero Midstream (AM) serve as examples of midstream companies and their customers reaching mutually beneficial agreements, with EQM and AM offering fee reductions in exchange for extended contract durations and increased volume commitments over time.
A handful of companies discussed upcoming contract expirations in their 2019 annual reports. EnLink Midstream (ENLC) said its five-year MVC with Devon Energy (DVN) for the Chisholm gas processing facility in the STACK will expire in December 2020. The contract is expected to generate $60 million in shortfall revenue at the midpoint in 2020 as volumes have been below the MVC levels. TC PipeLines (TCP) said the Wyoming-to-North-Dakota Bison natural gas pipeline is expected to be about 40% contracted on a ship-or-pay basis in 2020, in line with 2019 levels. With the remaining long-term contracts on the pipeline expiring in January 2021, TCP is exploring alternatives, including reversing the pipeline to transport associated natural gas from the Bakken. Shell Midstream Partners (SHLX) was able to recontract volumes on its Zydeco crude pipeline system under throughput and deficiency agreements containing minimum volume requirements following an open season in 2Q19, but the rates of the new contracts are lower than before. SHLX noted that the market backdrop determined the rates, terms, and time period of the agreements. Two Zydeco contracts will expire in 4Q20 but have a shipper option to extend the term by six months. These examples described in annual reports demonstrate that midstream companies are focused on finding practical solutions to mitigate recontracting issues.
Midstream company disclosures on long-term contracts need improvement.
In compiling the data for this report, it’s clear that more can be done by midstream companies to continue to increase transparency for investors. While some companies provide detailed contract information, overall disclosure of contract data within midstream is lacking, including details around contract life. CEQP notably included a summary table of its gathering and processing operations with major customers, weighted average remaining contract term, and types of contracts (see below). MVC data was also inconsistent and vague where available, with most companies selectively providing percent exposure to MVCs broadly, for a specific business line, or for occasional projects. While recognizing that some data may be withheld for competitive purposes, additional detail around contract life and built-in protections would provide investors with improved means to evaluate individual companies effectively and better gauge risks. Greater transparency could also provide some assurance around the stable nature of cash flows related to long-term contracts for most midstream assets.
Source: CEQP 2019 Annual Report
With production declining, MVCs provide the first line of defense in ensuring some cash flow stability for midstream, but long-term contracts with protections eventually expire. Declining volumes and increased competition in some basins could exacerbate recontracting risk for companies that have contracts lapsing over the next several months. However, the staggered nature of contracts, even for a single asset, helps keep recontracting risk manageable.