One development we are watching closely, that could bring about a change in our outlook, is the state of exploration and production (E&P) capital spending. A theme across Q3 2019 calls was the expectation that E&P growth spending would soften as management teams focus on free cash flow (FCF) and balance sheet preservation. This was mostly heard from Midstream companies with Gathering & Processing businesses and/or natural gas exposure. This will likely slow Earnings before interest, tax, depreciation and amortization (EBITDA) growth for the Midstream sector, but we still expect EBITDA to grow at a rate greater than Gross Domestic Product (GDP) which will continue to push leverage lower.

Our Industry Assessment is supported by:

Level of competition

The sector has above average barriers to entry given the cost and regulatory process necessary to build major pipelines, increasing the value of the already established infrastructure.

Regulatory environment

The sector faces increasing scrutiny in terms of the new-build regulatory process. For now, the pressure is focused on the Northeast and Eastern U.S. but could spread over time. Mitigating this negative pressure is the Federal Energy Regulatory Commission (FERC) regulated returns for certain assets which are supportive of credit quality, increasing cash flow stability.

Activism

While not widespread, we are seeing increasing activity from private equity and other financial buyers taking advantage of the dislocation between public and private market valuations. In the last 12 months we have seen EnLink Midstream (ENLK) and Buckeye Partners (BPL) purchased by financial buyers with the following capital allocation policies much riskier, causing ratings downgrades from low Investment Grade to High Yield. We don’t see this affecting the entire sector and larger core names, but it is worth monitoring given the continued disconnect between public and private market valuations across the Midstream sector.

Merger & Acquisition (M&A) Risk

While we expect to continue to see M&A on the fringes of portfolios (an example is Energy Transfer buying SemGroup), we continue to see large mega-deals as unlikely from strategic buyers. The vast majority of management teams remain focused on debt reduction as a main pillar of capital allocation.

Environmental, Social and Governance (ESG)/transformational risk

While we recognize the risks associated with Midstream companies’ place in the fossil fuel supply chain, we believe this risk is offset by the sector’s asset intensive characteristics as well as primarily contracted operations. All else equal, we would prefer a company engaged in the transportation of natural gas as we see fewer long-term threats to the use of natural gas vs. crude oil. Unique to the Midstream sector, companies historically were structured as Partnerships. This produced burdensome distributions, a negative for creditors, while also increasing complexity, lowering transparency, and decreasing minority shareholder rights. All else equal, we would prefer companies structured as a C-Corp, rather than a Partnership, or Partnerships that have cancelled incentive distribution rights (IDRs) as we feel this was the most equitable structure for all stakeholders. There continues to be increased social and environmental pushback to new pipeline builds in certain parts of the country. At the current time, these are small parts of larger asset portfolios but could increase risk over time.

Position in credit cycle

EBITDA continues to grow at rates greater than GDP and leverage reduction remains a focus of the majority of management teams.