Executive Q&A viewpoint

By year-end 2014, oil and gas prices slumped as the Organization of the Petroleum Exporting Countries (OPEC), which controls more than one-third of the global output of oil, continued steady production. At the same time, US hydrocarbon production continued apace due to improved hydraulic fracturing technology and drilling programs based on held-by-production contracts, making cheap natural gas plentiful. How does this low-price environment affect gas processing operators, and what are the optimal management strategies heading into 2015?

For answers, Gas Processing talks with James “Jim” Benson, co-founder and managing partner of Energy Spectrum Capital. Energy Spectrum was founded in 1996 to manage private-equity funds that make direct investments in companies that acquire, develop and operate midstream energy assets. Since its inception, the company has raised more than $3.6 B of equity capital from corporate and public pension funds, insurance companies, endowments, banks and other institutional investors.

GP. Do you think the recent drop in oil prices has any effect on gas plant operators?

Benson. Yes, I think there are going to be some challenging times for gas processors. There is quite a bit of liquids-rich natural gas being produced today, including casing-head gas being produced by oil wells, and NGL are more correlated to oil prices. The significant oil development in West Texas, which produces casing-head gas, is a good example. As oil prices drop, liquids prices have been hit, as well. The greater the correlation to falling oil and natural gas prices, the more NGL margins are being squeezed.

GP. Are there any mitigation strategies to meet that challenge?

Benson. One of the strategies for processors is to hedge their commodities, and hopefully many have already done so. Those that have their natural gas and NGL hedged will mitigate some of the downward pressure associated with a falling market. However, those that were not hedged will see lower revenues and reduced processing margins.

Another strategy is to alter producer contracts. Many of the gas processors make their margin off of percent-of-proceeds contracts. These contracts are structured so that the operator of the processing facility contracts with the producer to process natural gas, strip out the liquids, and then sell the gas and NGL in the market. The processor makes the margin off of the retained percentage of what the residual NGL and natural gas are sold for in the market.

Another type of contract is a fixed-fee contract. If the gas processor has the ability to alter contracts to fixed fees, then there is potential to mitigate the price risk associated with natural gas and liquids swings.

GP. Which type of contract is more commonly used?

Benson. There are still many percent-of-proceeds contracts being used. Processors that are interested in locking in margins are structuring their contracts to mitigate that downward pressure with fixed-fee contracts—but the percent-of-proceeds contracts still represent a large percentage of contracts in the marketplace.

GP. In terms of mergers and acquisitions, do you foresee any contraction in the industry?

Benson. Going forward, I think there will be quite a bit of consolidation in the midstream space. We look at that over the entire industry, not just with private companies. We believe there will also be additional consolidation activity in the master limited partnerships (MLPs). We think we will see continued consolidation in the midstream overall. There could be opportunities in the mid-sized to larger independents, including the majors.

Down the road, there may be opportunities to capture assets from some of those groups. We believe there will be opportunities to acquire assets from the mid-sized to larger independents that could spin off some of their midstream assets to a midstream provider as another way to raise capital.

GP. Is that happening now?

Benson. Not in any material way, as the activity in the market is pretty quiet right now. There’s probably some of that occurring, but right now it’s a much more competitive market. What usually happens, when prices swing as they have recently, is that dramatic swings push the buyers and sellers further apart. That makes it a lot more challenging to get a deal done today. We see this in every cycle when prices move dramatically one way or the other. The M&A activity tends to dry up for a while until the market settles out.

GP. Geographically speaking, are any US plays better positioned than other plays during this price environment?

Benson. A midstream provider, including gas processors, should look at areas where there is a lower-cost opportunity for producers to drill. For example, if you are in a higher-cost environment to make an economic well, then an area with a cheaper environment to drill in will be the first place you want to be.

As prices deteriorate, we will see some challenges in certain basins. Processors want to make sure they maintain volumes and throughput, and hopefully develop a strategy to increase pipeline throughput to their pipelines and processing systems. So, the focus for the midstream provider is to look at areas where there is likely to be continued drilling. In this market, the low-cost areas are going to be better served and more drilled. The goal with any midstream solution is to maintain and, hopefully, increase throughput.

The Eagle Ford and West Texas [shale areas] are good examples. In my opinion, those are two of the most attractive areas [for drilling]. The Marcellus-Utica shale areas are good areas, too; however, in the Marcellus, there are high gas price differentials to move the gas to market. Producers still have processing needs for their rich gas, but there is a lot of dry gas up there, as well.

The Midcontinent and Rocky Mountain areas with legacy assets are still good areas, and I think there could be some consolidation opportunities in those areas as systems become less utilized.

GP. What kind of effect would LNG exports have in this market?

Benson. Every way we can enhance taking commodities to a market is good for our industry. If we could export not only LNG but also crude oil, and lift the ban on crude exports, then the energy complex in this country would benefit overall, and not just natural gas processing. That would enhance every aspect of the business, in my opinion.

GP. Do you see any other major challenges for gas processors between 2015 and 2017?

Benson. I think the biggest challenge is going to be the continued price environment. As we all know, the best cure for low energy prices is low energy prices [because they encourage consumption, which, in turn, causes prices to rise]. Over time, sooner or later, it will bounce back, but there will be challenges for the E&P companies, midstream providers and the service companies over the next 12 to 18 months. This affects the entire industry.

GP. Any idea when these prices might rebound?

Benson. You know, history has repeated itself several times in the past. But, in this environment, it makes sense to look at the social needs of the OPEC nations. They need higher energy prices to support their overall economies and social activities. Although they might not need higher prices to break even on oil and gas drilling and production, they need a higher price environment for social services, as do many countries that have different thresholds.

Overall, we are looking at an average price of around $90/bbl-plus oil to support those social needs. So, sooner or later, I believe that prices will gravitate back up to $80/bbl to $90/bbl. We don’t know if that will happen in six months or two years. It will just take time to flow through the system and work its way out.

GP. What are some aspects of a successful processing company?

Benson. In this environment, probably the No. 1 consideration is to look at leverage. Many companies that are heavily leveraged will have some challenges, because their cashflows may be impaired due to this low-price environment.

When prices drop this much, this fast, businesses that are leveraged three to four times EBITDA [earnings before interest, tax, depreciation and amortization] may find that they are six to eight times leveraged. There could be some challenges for companies that maintain a high debt burden. Going forward, modest leverage positions in this market give any processor or midstream provider the ability to ride out a difficult price environment.

GP. What’s in store for the MLPs?

Benson. This is going to be an interesting time over the next six to 12 months. I think we will see some consolidation in this business. When we look at gas processing, a large component of that is within MLPs. The MLPs’ ability to sustain their distributions and continue to weather this storm is going to be challenging. This environment will affect the MLP space overall—not just the gas processors—in the ability to raise capital and continue to grow their businesses. They depend upon continued access to the market, despite their equity being devalued so much. Some MLPs have been hit pretty hard when looking at their price per unit, but there could be continued downturn with many of these equities over time.

I think that just about everyone has seen their equity portfolio get hit quite a bit recently. Fortunately, some are better capitalized. I think the investment community will be looking at well-capitalized companies and/or MLPs during the next 12 to 18 months.

Interestingly, you would think that the general equity markets (non-energy-related), overall, would be enhanced because of the lower energy prices, but the overall market always seems to follow crude oil prices when the price drop is this fast. As a result, we’ve seen downward pressure on the stock market following this downward move in crude oil. As I previously mentioned, the cure for lower oil and gas prices is lower oil and gas prices. We will see better days ahead; we always do. GP

James “Jim” Benson is a managing partner and a founding partner of Energy Spectrum, with extensive relationships and networks within the energy industry. He focuses primarily on business development activities and the sourcing and financing of new transactions for Energy Spectrum’s midstream private equity business. Through his extensive industry relationships and active marketing efforts, Mr. Benson participates in the evaluation and negotiation of potential investments, and assists portfolio companies in arranging and structuring debt financing. He has approximately 30 years of private equity, investment banking, financial advisory and commercial banking experience in the energy industry. Prior to co-founding Energy Spectrum in 1996, Mr. Benson was managing director at R. Reid Investments Inc. for 10 years, where his experience included energy-related private placements of debt and equity, acquisitions and divestitures. He began his career at InterFirst Bank Dallas, where he served for four years and was responsible for various energy financings and financial recapitalizations. Mr. Benson received a BS degree from the University of Kansas and an MBA degree, with high honors, from Texas Christian University.