The business dynamics of Midstream Energy Companies

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Here is an excellent treatise on what are the key concepts in Midstream Energy companies, their revenue base, moats they enjoy and the risks they face... Main points are from Morning Star Research Analyst Joe Gemino, CPA

The midstream industry processes, stores, markets and transports commodities such as crude oil, natural gas, natural gas liquids (NGLs, mainly ethane, propane and butane) and sulphur. The midstream links remote petroleum producing areas and the consumers are located. Transmission pipeline companies such as Enbridge, Transcanada Corp, Pembina Pipeline Corp are some of the main players in the midstream petroleum industry. Not surprisingly, most midstream companies are based in Calgary with operations extending to east coast and into the United States. They also lead to exporting terminals.

Revenue Stream

Companies in the midstream energy sector normally generate predictable revenue streams (toll like charges), cash flows and distributions from the gathering, processing and transportation of crude oil,natural gas and other energy commodities.

Pipeline projects are linked to new production growth projects, and contracts extend over the life of the associated production project.

Regulators in Canada and the U.S. permit pipeline companies to recover costs to operate pipeline networks by collecting tolls for services. Regulated tolls include the recovery of the pipeline’s investment, a rate of return on the investment, and pipeline operating costs. The regulatory oversight provides stability in returns that typically exceed the company’s cost of capital. As a result, pipelines generate new project returns on equity that typically range from low double digits to mid-teens

Moat

Canada’s oil sands supply is landlocked and separated from the majority of its refining markets by large distances, relying on pipeline transportation

Pipelines are characterized by relatively high barriers to entry, high capital costs, and significant regulatory oversight.

 There are multiple ways for midstream companies to build moats, but efficient scale is the dominant source. Single pipelines can be attractive; however, a network of pipelines that serve multiple end markets and are supplied by multiple producing regions is much more valuable. Because oil and gas are fungible, midstream firms can optimize the flow of hydrocarbons across their systems to meet producer or end-user demand while locking in geographic price differentials, or use storage facilities tied to the network to lock in price differentials across time periods.

Regulatory approvals are granted only when an economic need for pipelines exist and does not permit oversupply. As such, regulation keeps out competitors and acts as an intangible asset to existing pipeline operations. Once approval is received, midstream firms typically seek to lock in project economics through long-term contracts with shippers before ever breaking ground on a new project, ensuring that at a minimum project and capital costs are recouped, with potential for excess returns over time.

While the competition among midstream firms for new projects is fierce due to the finite demand for additional infrastructure, once a pipeline is in service it tends to enjoy excess returns.

Risks

The profitability of midstream companies is not directly tied to commodity prices, as pipeline transportation costs are not tied to the price of natural gas and crude oil. However, the cyclical supply and demand nature of commodities and related pricing can have an indirect impact on the business as shippers may choose to accelerate or delay certain projects. This can affect the timing for the demand of transportation services and/or new gas pipeline infrastructure