(Estimated reading time: 3 minutes)
The article in brief:
- Midstream energy companies’ exposure to energy prices is generally thought to be indirect.
- Their somewhat ambivalent view of the price of oil is predicated on some minimum level of flows, not a wholesale shutdown of demand.
- As midstream companies consider the impact of the pandemic, their concerns range from immediate questions of intangible asset impairment to longer-term questions about structural impacts on the market.
Although their exposure to oil prices is indirect, midstream energy companies certainly don’t have long-term immunity to the global economic slowdown associated with the novel coronavirus pandemic. VRC’s Energy Infrastructure Services practice has been engaged in active—and very much two-way—client conversations about what the collapse in oil prices to below $20/barrel means for their businesses and valuations.
The overwhelming consensus? Only time will tell.
It’s not the most satisfying answer, but for many midstream companies straddling a glut in supply and record low demand, operations—and acquisition activities that necessitate valuations—have effectively been paused while larger forces work themselves out.
Toll Roads & Tankers
The correlation between midstream enterprise values and energy prices is not straightforward. While it is a simplistic example and the reality is more complex, for illustrative purposes, we could compare midstream energy companies—those that own and operate the infrastructure for storing and transporting oil and natural gas—to the owners of toll roads. Just as the state transportation authority doesn’t much care whether a toll is paid for a Ferrari or a Ford Fiesta, a pipeline operator is somewhat ambivalent about intraday fluctuations in the unit price of the oil or gas coursing through the pipeline.
On the other hand, if the cars or fossil fuels significantly decline, or even stop coming altogether for a sustained period, it will eventually become a problem.
That’s where many midstream operators find themselves today. With demand near or at all-time lows and producers parking surplus oil in tankers and storage tanks. (Storage companies are the one segment of our client base that has seen a significant, positive, and immediate impact, given the demand for storage.)
VRC's Energy Infrastructure Services practice has been engaged in active client conversations about what the collapse in oil prices means for their businesses and valuations.
Where the Near-Term Impact Will Be Felt
For some midstream energy companies, the most proximate valuation challenge raised by the slowdown will be familiar to many other types of companies—whether to characterize the pandemic and resulting economic slowdown as a triggering event for the impairment of goodwill. The bulk of midstream energy company assets are tangible—physical equipment like pipelines and storage tanks. But many also carry intangible assets—customer relationships and long-term contracts–on their balance sheets, and many are questioning whether impairment tests are in order on those assets.
Our advice in the immediate aftermath of the crisis has been for companies that tested for impairment last year and found they had a substantial cushion to consider a simple refresh of those tests. In such a framework, rather than completely updating the full set of projections supporting goodwill value—projections that are highly uncertain as the pandemic runs its course—companies should consider running the numbers from the most recent impairment test again and updating any input figures they already have, such as the share price, market multiples, and discount rates. For market multiples, it may be more prudent to review them over a longer period, rather than to compare them to current multiples, given current market uncertainties.
However, as the economy begins to reopen, and we get greater clarity on the long-term impact, many companies indeed will need to conduct new impairment testing using new business forecasts.
Possible Longer-Term Affects
Over the longer term, here are a few of the other impacts we foresee in the midstream energy space:
- If oil prices remain at or near current depressed levels for an extended period, many midstream companies, particularly those with exposure to shale-based production, are going to suffer, as shale extraction requires a higher oil price point to be profitable. The flipside of this is that prices for natural gas, which have been languishing due to high production as a by-product of shale oil extraction, could begin to climb.
- The period for new contracts for transporting energy products are likely to be shorter—typically five years instead of 10—until greater demand certainty is forthcoming.
- When and if the M&A market picks back up, discount rates on future cash flows could remain higher to reflect the doubt still overhanging the energy market and economy.
Obviously, there is still a great deal of uncertainty in the oil patch these days. We in the Energy Infrastructure Services practice are here to help and look forward to working with clients to navigate this challenging time.
We welcome you to contact the article authors, Philip Mastil, CFA or Robert Schulte, for a more detailed conversation about the capabilities and credentials of VRC’s Energy Infrastructure Services Practice Group.
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