Investing in the energy midstream sector has required a split personality of late.

Dr. Jekyll the MLP investor might fancy another quarter of strong results, with rapid distribution growth and assurances that lower oil prices will not undermine the demand for midstream solutions.

Mr. Hyde, on the other hand, might look forward to lots of pain for Dr. Jekyll and company as drillers retrench in response to lower share and commodity prices.

The market has so far split the difference, allowing MLPs a sharp rebound from the bottom that stopped a bit short of the old highs and has turned into a wait-and-see stalemate over the last month. The Alerian MLP Index is up nearly 12% since Oct. 14 but still down more than 5% from its Aug. 29 record high.

That sounds about right given the comments made by leading midstream executives following their partnerships’ third-quarter results.

There’s probably no better placed observer of domestic crude fundamentals than Greg Armstrong, the CEO of leading crude shipper Plains All American Pipeline (NYSE: PAA) who’s widely respected as one of the industry’s sharpest minds and straightest shooters.

Here’s what Armstrong had to say about low oil prices:

“Looking at the industry sector from a macro perspective over the short term, we believe the key question with respect to whether or not producers will maintain capital expenditure activity at recent levels is not whether the resource plays are economically attractive at plus or minus $80 oil, because many are, but whether or not the producers will elect to fill the funding gap created by the declining crude oil prices with incremental debt or issue an equity at depressed price levels. Alternatively, they can elect to decrease the pace of drilling and completion activity or they can bring in third-party financial capital, but the latter of that generally takes time to negotiate and to put into place.

“…Our current belief is that the near-term capital expenditure activity levels and expectations for linear volume growth will be curtailed. …We believe the combination of increased demand and slower supply growth will balance the market within a reasonable period of time, which, with a little help from Saudi Arabia, can be accomplished in as little as six months and as long as 18 to 24 months. Longer term, we remain optimistic about the outlook for continued U.S. and Canadian volume growth and the positive ramifications for such growth for midstream companies in general and PAA specifically.”

A little later, in response to an analyst’s question, Armstrong elaborated on his rationale for a drilling slowdown:

“I mean, if you just do the math, a $10 decrease [in the price of oil per barrel] reduces cash flow available to all E&P participants in the U.S. [by] about $32 billion a year. And if you allow 25% for royalties and taxes, that means there’s about a $22 billion hole in the pocketbook for those that were spending 100% of their cash flow. If you exclude the majors [because] some of them will continue to spend through it, you still have a pretty big number…let’s say, that’s $18 billion to $20 billion reduction in cash flow that’s available to fund capital. When we estimated that the total amount of capital being spent on just the crude oil drilling activities in all of the big basins, Bakken, Permian, Eagle Ford, was about $100 billion. So something has to give.”

In a more recent investor presentation, Plains All American provided a slide documenting the extent to which global liquid fuels supply could outpace demand growth over the next few years:

If this degree of oversupply were to persist it would require even lower crude prices with serious consequences for a variety of midstream processors reliant on sales tied to the price of crude, including the marketers of natural gas liquids and liquefied natural gas projects.

Fortunately, as Armstrong notes above, recent discounting of crude is already likely reining in drilling plans. And given the rapid decline rates of most shale wells, a relatively modest pullback in new drilling can have a big effect on production, as another PAA slide shows:


In PAA’s case, even under its assumptions of a drilling slowdown, the partnership still expects to increase its cash earnings and distribution per unit by approximately 10% next year.

Mike Hennigan, the CEO at rival crude shipper Sunoco Logistics Partners (NYSE: SXL) seemed even less preoccupied with the low price of crude. Has that soured any customer conversations on potential new pipelines out of any of the basins, he was asked.

“Overall, we are bullish crude price over the long-term, but we obviously recognize there is some uncertainty now with crude price dropping. If there was a sustained low crude price environment, it could impact future project development, but I really think that’s very hard to predict. We don’t know for sure at what price point future crude production could be curtailed. … Our intel tells us that production would be maintained in most areas down to $60 or so. … Producers…obviously…are disappointed that the commodity has come off, but we don’t think it has impacted anybody’s plans from what we can tell.”

A recent SXL investor presentation slide notes that shale costs have declined over the last five years, lowering the breakeven production price, even as the costs of tapping the oil sands and deepwater reservoirs offshore have risen.


This would imply that over the longer run those costlier resources would bear the brunt of any adjustment in supply. But oil sands and deepwater projects tend to have long lead times, and once their costs are expended, they’re sunk, leaving little incentive to curb output. In contrast, shale output is much easier to curb because of those fast initial decline rates and the flexibility of subtracting land drilling rigs on relatively short notice, so shale should still be expected to bear the brunt of any supply reduction in the near term.

SemGroup (NYSE: SEMG) is another portfolio recommendation closely involved with crude, benefiting in particular from production growth in the Bakken, Niobrara and Mississippi Lime plays, and with another finger on the market’s pulse thanks to extensive storage assets at the oil hub in Cushing, Oklahoma. CEO Carlin Conner told analysts that, so far, lower prices have translated into little more than talk among industry participants:

“As most of you are aware, commodity prices have been a major discussion point throughout the industry lately. We’re following the market dynamics, listening to experts and producers, but most importantly, talking with our customers. We do not see an impact on production from any of the basins we serve, and therefore, see no impact to our forecast. It is also important to note that our business is primarily fee-based. So for today, it’s business as usual. And based on everything we’ve heard, we do not expect anything different.”

 Targa Resources (NYSE: TRGP) talks to its customers in the Bakken and the Permian too about their drilling plans in light of recent crude prices, according to the CEO:

“Producers are, of course, being cautious and thoughtful. … Some have said that they couldn’t slow down immediately due to rig, sand supply and other commitments. Others have said that they expect to maintain current levels of activity, but may not increase those activity levels as much as recently planned. Some have said that they are moving rigs from one basin to another due to better economics.”

“…So far, we haven’t really seen any slowing down. We anticipate that with lower than anticipated prices, producer cash flow relative to their leverage may impact activity for some producers in some areas. And of course we’ve all read articles about and seen previous evidence of how producers will use any slowdown to extract mitigating cost reductions from their service providers. While we will obviously continue to monitor the situation, we are not currently expecting dramatic impacts to our 2015 volume outlook, either on the Field G&P side or on the downstream side.”

If price weakness is limited to the next 24 months as Armstrong expects, the combination of fixed-fee predictability and hedging by the midstream processors would likely protect much of their cash flow. A longer downturn would almost certainly sabotage many of the current growth plans and bring about a much deeper slump in MLP prices. That’s a risk to be monitored, but hardly the likeliest outcome at this point.