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In the current price environment, highly leveraged exploration and production (E&P) companies facing liquidity-induced stress find themselves facing a dilemma. As borrowing-base cuts loom, capital markets remain tight and hedges roll off, many players, especially those with good-quality assets, are potentially able to weather the storm by divesting upstream assets in an effort to raise cash to bolster their balance sheets and bridge a capex and opex outspend that is likely to continue as prices remain depressed. However, these same companies often hesitate to sell their upstream assets at historic lows and miss out on value associated with an eventual price rebound. A stubborn bid-ask spread with respect to upstream transactions persists, and deal-making has plunged to a five-year low.1
With this backdrop, cash-strapped E&P companies that had built out or acquired significant infrastructure and midstream assets are actively considering options to monetize the same. For an E&P company, selling such assets makes sense. For one, even though valuations have fallen across the industry, the midstream sector potentially offers E&P companies an arbitrage opportunity.2 Midstream assets, especially those associated with long-term gathering and processing agreements backed by quality upstream properties, may be overlooked or undervalued within an E&P company structure. Independently, however, they are potentially valued at metrics that are higher than those afforded to the E&P company as a whole. Additionally, a successful midstream divestiture not only enables the E&P to retain its more valuable upstream assets, but it also provides much-needed capital to continue operating the same.
Potential acquirers, who have limited access to the capital markets in the current environment, will often be backed by an unprecedented amount of private capital that is actively looking to invest in the energy industry. As with any investment, buyers will need to consider a variety of factors relating to risk as they endeavor to structure a transaction that achieves specified returns. In addition to the big question on everyone’s mind these days (i.e., What happens when the E&P company goes bankrupt?), one must also be cognizant that, since such assets are often not midstream assets in the traditional sense and have been carved out from a company’s upstream assets, there is heightened risk that other potential problems may rise in the future. For example, if the seller is party to joint operation agreements (JOAs), it is possible that the seller does not own the assets outright, but, rather, jointly with other JOA parties. In addition, the oil and gas leases underlying midstream assets may contain provisions that limit future operational and exit flexibility. Further, the nature of the acquired assets and nuances with respect to their operation may result in income that is not qualifying income, an undesirable result for master limited partnership buyers. While there will certainly be tremendous value to be extracted in the midstream arena, thorough due diligence and careful deal structuring will be paramount as parties look at creative midstream monetization and investment structures over the course of this coming year.
1 http://www.cnbc.com/2016/01/27/us-energy-ma-hits-5-year-low-as-oil-patch-enters-survival-mode-report.html
2 http://www.oilandgasinvestor.com/monetizing-midstream-824581#p=full