Three companies dominate Canada’s midstream energy business. In contrast, ownership of oil and gas pipelines, gathering and processing systems, storage and other related infrastructure is highly fragmented in the US. But consolidation is picking up steam.
The biggest deal so far: Last week’s offer from ONEOK Inc (OKE) for Magellan Midstream Partners (MMP). The merger would create the fourth largest US midstream company with combined enterprise value of $60 billion and initial yearly EBITDA of $6 billion.
It’s an entirely different animal from anything we’ve seen so far in the sector this cycle, such as last year’s buy-ins by Phillips 66
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ONEOK/Magellan will own about 50,000 miles of pipelines and related infrastructure. Assets will be roughly evenly divided between natural gas and liquids, which range from crude oil and natural gas liquids to refined products. And the company will be a national player, servicing basins from the Bakken in the upper Midwest to the Rockies and Gulf Coast.
ONEOK and Magellan currently don’t overlap much. That gives even the highly merger-skeptic Biden Administration’s Justice Department few if any hard reasons to reject their union on anti-trust grounds. And management expects to realize $200 to $400 million in annual post-merger cost savings by 2027, which will power free cash flow per share accretion of “more than 20 percent.”
That’s plenty of fuel to accelerate annual dividend growth from both companies’ current low single digit percentages. And management’s projections are based on cost savings including overhead and taxes. So they’re likely to prove conservative as the energy upcycle progresses.
The offer for Magellan is a substantial premium to its pre-deal price. That too is a contrast with previous midstream acquisitions this cycle, including Williams Companies’ (WMB) $1.5 billion buyout of the MountainWest pipeline system that closed in February. And unitholders will receive cash of $25 per share while maintaining upside from the energy upcycle with 0.6676 shares of ONEOK.
It’s fair to say the majority investor reaction to this deal so far has been skeptical. Some large ONEOK holders have complained the price is too high. The usual “shareholder advocacy” law firms allege the offer is too low, given the tax consequences for long-time owners of Magellan. And the general consensus among analysts—reflected in a pair of recent Barron’s articles—is this is a one-off and won’t be followed by more midstream M&A.
Whether the offer is too high or too low is a matter of debate. And there are always tax consequences when a partnership is acquired by a C-Corp.
Nonetheless, ONEOK/Magellan is likely to close on schedule in Q3. And it won’t be the last merger in US midstream, a sector not only ripe for consolidation with the means to do it.
Let’s start with the means. A decade ago the US midstream sector was overbuilt. The shale-drilling boom induced record IPO volume. And the combination of cheap capital and seemingly limitless demand for infrastructure encouraged management to throw caution to the winds—piling up debt to build enough pipelines to keep up with dividend growth promises.
Flash forward to today following multiple bankruptcies, literally hundreds of dividend cuts and years of investor neglect if not ambivalence toward the sector. The result is the surviving US midstream companies have become almost wholly financially self-reliant.
Rather than spend aggressively on CAPEX and unsustainable dividends, companies routinely generate surplus free cash flow after all their investments, debt service and dividends paid. Some of that surplus has gone to stock buybacks. But with credit ratings in a decided uptrend, it’s increasingly available for acquisitions.
As for motivation to merge, that’s coming from growing scarcity of assets coupled with unprecedented and increasing barriers to building. Even before the Biden Administration stepped up regulation of fossil fuels, extremely well-funded “keep it in the grounders” had perfected the art of delaying new pipeline construction to death in the courts.
As a result, only a handful of mostly incremental projects entered service the past few years. The capacity glut of the past decade is a thing of the past.
That’s already showing up in improving contracting activity, now picking up steam in contrast to doomsday forecasts for plunging rates and abandoned pipelines. And it’s crystal clear in the premium ONEOK is paying for Magellan.
Values of oil and gas pipelines will only rise in coming years. Midstream companies may get some relief with building rules—should energy permit reform become the means to a deal to extend the US federal debt limit, as some observers are speculating. But with the Federal Reserve pushing up interest rates and elevating recession risk to quell inflation, oil and gas producers staying conservative on output and ongoing court challenges to projects continuing, management will investment conservative.
That makes mergers and acquisitions of other pipeline companies the surest way by far to grow earnings and dividends, at least for the next few years.
Who are the best takeover candidates? The only North American midstream company probably out of the running is Enbridge
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