The evolution of the US shale oil and gas sector over the last decade has required a large investment in midstream infrastructure.
The headline theme for private credit in midstream infrastructure is one of yield and value. With sub-investment grade corporate loans returning c. 5 percent p.a., midstream infrastructure credit with comparable cash yields across sub-investment grade to investment grade credits can deliver yield and risk-adjusted value.
Timing is also part of it. Oil prices are stabilising, gas prices remain steady and corporate distress is working its way through the energy sector. Prices on upstream oil and gas loans indicate a phase of improving credit quality. According to Thomson Reuters prices in oil and gas loans declined to a low of c. 55¢/$ in early 2016 as oil price declined. Loan prices have now stabilised to c. 70¢ as certainty slowly returns to the sector.
Midstream infrastructure is maturing with distinct characteristics to the high-yield or sub-investment grade credits associated with the upstream activities. There is a long-term investment grade opportunity that is often related to gas export projects, either as LNG or petrochemicals, via pipeline to Mexico. The medium-term sub-investment grade sector is based around project financings to domestic oil and gas gathering and processing.
There has been a fundamental shift over the past decade as US shale oil and gas have grown to contribute c. 45 percent of total US oil and gas production volumes according to the EIA. The US is becoming an influential swing producer for oil and a globally competitive source of low-cost gas. The implications extend beyond midstream to include supporting growth in renewable energy as low-cost gas displaces coal-fired electricity generation while balancing the variability of renewable generation.
The result is a build-out and repurposing of US midstream infrastructure to connect new supply and demand. During the early stages of this evolution, some new midstream assets had weak infrastructure qualities while some mature midstream infrastructure assets had their infrastructure qualities threatened by quickly shifting supply and demand patterns.
The emergence of meaningful shale gas production began around 2005 to 2008, and then accelerated around 2009. The rise of shale gas production was sustained in the face of declining gas prices as developments in technology and access to resources made a large new resource base economic. The stable price environment and recent leveling off in production indicates a maturity that supports large and long-term investments in gas infrastructure.
The pattern for tight oil, which includes shale oil, is different. Shale oil production growth commenced more recently and during an elevated price environment. The scale of production suggests shale oil as a whole has matured but recent production declines indicates that some weaker assets are less sustainable in lower price environments.
The abundance of low-cost gas in the US has rejuvenated the gas export sector. This includes gas exports as LNG, petrochemicals and gas pipeline exports to Mexico that offer long-term investment grade private credit opportunities.
The LNG sector is an example of this trend. The first of four new multi-billion dollar LNG export terminals commenced exporting US gas earlier this year. Other projects are coming online between now and the early 2020s. LNG credit is not just a US opportunity, but a global relative value situation as USD-denominated credit to LNG export projects span the Middle East, Americas, Asia, Australia and Africa. This sector is wider still when considering the LNG transport and re-gasification and distribution infrastructure in the destination markets globally.
Gas export projects are typically structured on a non-recourse basis with long-term offtake contracts from investment grade counterparties. This supports a long-term investment grade private credit opportunity. The recent $1 billion BBB-rated 20-year bond issuance offering a yield of c. 4 percent p.a. from “Train 2” at Freeport's LNG terminal is an example of the value above corporate and government credit.
There is a deep pipeline of similar projects needing large multi-billion dollar volumes of long-term debt. This pipeline is underpinned by consistent growth in global energy demand where increased Asian growth offsets flat to declining OECD demand for energy. BP's 2016 Energy Outlook details this trend and highlights that continued expansion in LNG export is necessary to connect demand with supply.
The growth of the US LNG sector and its role in Asian LNG re-contracting demand is an example. Asia is the largest LNG market globally where US projects are able to offer LNG at around c. $9/mmbtu relative to projects with oil-linked contracts at around c. $12/mmbtu according to the International Energy Agency.
The decline in oil prices, however, has reversed this competitive advantage for US projects in the short term. This has slowed the development of new US projects until the advantage returns. Exiting projects with long-term tolling contracts are expected to remain a key player due to the combination of sustained low gas prices in the US and growing demand.
GATHERING AND PROCESSING
Gathering and processing assets have been central to the build-out of the US domestic infrastructure connecting flows of oil, gas and water from well-heads to the regional transport infrastructure networks. Today this is primarily a medium-term sub-investment grade opportunity, often as senior secured credit with multifaceted project finance structures that can perform like investment grade credit over time.
The lack of gathering and processing infrastructure results in local commodity price variations. Producers with limited access to infrastructure bear discounts on benchmark prices to cover transport and storage costs. Investments in gathering and processing infrastructure provide a price advantage to alternatives such as trucking, and can achieve better safety, environmental and community outcomes. However infrastructure investments require long-term viability of oil and gas production which is now occurring with maturity of the sector.
Historically much of this infrastructure was substantially debt-funded, often with corporate debt issued by sub-investment grade exploration and production companies. As oil prices declined the investment stopped and some companies defaulted, while others had to contend with constrained access to capital. This resulted in businesses liquidating their higher quality and mature assets to provide capital to de-lever, invest in the most profitable parts of their business, or participate in M&A. As a result, there have been a number of sale and leaseback-styled transactions for integrated gathering and processing systems with medium- to long-term offtake agreements. The offtake contracts provide a floor to income while the maturity of the underlying oil and gas producing reserves provides confidence of medium-term demand for infrastructure.
There is also the distressed credit opportunity in the midst of default. We continue to prefer the value related to longer term and higher certainty from participating post-default. For example, one issue to emerge has been the treatment of offtake contracts during bankruptcy proceedings. Contracts with onerous price or underutilised capacity payments have seen both companies and other creditors challenge the ranking in bankruptcy of at least a portion of these contracted payments.
Where we see value in gathering and processing is situations where the midstream infrastructure is essential with high barriers to entry and is underpinned by a user of the system that has a quality reserve base, low operating costs and access to liquidity to invest in well development that supports production and in-turn infrastructure utilisation.
What this means for private credit investors is that, looking forward, the midstream infrastructure opportunity is changing. The period characterised by assets with significant upstream exploration and production risks, and more recently default and distress, is now passing.
Looking forward midstream infrastructure is increasingly longer term with a stable outlook of performing assets that offer a range of yield and value alternatives from long-term investment grade to medium-term sub-investment grade. LNG and the gathering infrastructure are just two parts of a very large, deep and diverse sector within the North American private infrastructure debt market.
This article is sponsored by Hastings Fund Management. It was published in the US Special supplement of PDI's September 2016 issue