What the Latest Pipeline Merger Means

And how patient investors will profit from it.

2023 is shaping up as a challenging year for oil and gas companies. Not only are commodity prices much lower than last year. But costs have risen sharply up and down the value chain, due to inflation and much higher interest rates.

Pipeline companies aren’t feeling the pinch quite as badly as oil and gas producers. That’s because their earnings are mostly locked in by long-term contracts with shippers and off-takers/consumers. And those contracts frequently include inflation adjusters as well.

But lower energy prices have made North American shale oil and gas producers even more conservative, adjusting output lower to maximize free cash flow. And that’s meant subdued volumes so far this year for most pipelines, as well as the gathering and processing systems that feed them.

There are a few notable exceptions. The Permian Basin of West Texas and New Mexico, for example, continues to grow output. The Haynesville shale of Louisiana is thriving, thanks to its ability to feed the growing US LNG export sector. And the Bakken of the upper Midwest has thus far defied predictions of a pullout by producers, with major independents like Hess Corp (NYSE: HES) doubling down in the region.

Best in class companies are also by and large still largely sticking to guidance. That’s a very good sign their management anticipated 2023’s challenges and can therefore stick to operating and financial plans—including cutting debt and raising dividends.

But higher financing costs, the near impossibility of building major new pipelines in the current regulatory environment and rising risk of a recession—meaning lower system volumes for longer—is a substantial headwind to even the strongest midstream companies’ growth going forward. And that’s leading more in the sector to turn to the obvious solution: Joining forces by merging.

In my May 21 Substack Post “Magellan Midstream is Merging,” I highlighted that company’s takeover by ONEOK Inc (NYSE: OKE) as the harbinger of a new more profitable chapter of North American midstream company consolidation.

Mainly, dating back to the middle of the previous decade, the vast majority of midstream company takeovers have been effectively “take unders.” That is, acquirers have been able to make purchases at hefty discounts to  historically normal earnings and book value multiples because targets had little choice other than to accept their offers.

In contrast, ONEOK’s offer for Magellan Midstream (NYSE: MMP) is not only at a hefty premium to the target’s pre-deal price. But it offers substantial upside to the acquired company’s shareholders long-term, including dividends.

At this point, ONEOK/Magellan has cleared all regulatory hurdles. There’s some opposition to the deal from long-term unitholders, who will likely face a meaningful tax liability. But at this point, odds favor approval at Magellan’s special meeting on September 21, with a close by early October.

Now another major midstream merger has been announced. This one is between two companies in our www.energyandincomeadvisor.com model portfolio. Energy Transfer LP (NYSE: ET) is acquiring Crestwood Equity Partners (NYSE: CEQP) in an all-stock deal, swapping 2.07 of its units per CEQP unit.

That ratio provides a modest premium to Crestwood’s pre-deal trading range. It will immediately boost CEQP dividends, which have been frozen since May 2022. And there’s upside leverage to undervalued Energy Transfer LP, in the early stages of what’s shaping up as one of the most explosive oil and gas price upcycles in history.

Crestwood’s annual revenue of $5.2 billion is a fraction of Energy Transfer’s $80 billion plus. But as part of a much bigger and stronger company, its assets will punch far above their current weight.

Energy Transfer has a long history of getting the most out of its acquisitions, closing five meaningful deals since the beginning of 2021. The latest, this spring’s purchase of Lotus Midstream, is already boosting the bottom line. And management expects the same for Crestwood, with $40 million in initial synergies already targeted.

Energy Transfer is also investment grade rated, winning a boost to BBB by S&P this month and on the verge of similar boosts from Fitch and Moody’s. Crestwood, in contrast, currently draws a junk BB rating. Both S&P and Moody’s currently have it on watch for upgrade because of the prospective merger. And that means a substantial opportunity to refinance its $3.9 billion of debt at lower rates when the deal closes, potentially resulting in meaningful interest cost reduction.

That’s just another benefit of joining forces. And my bet is we’ll see a growing number of midstream and pipeline companies come to that realization in what’s still a highly fragmented sector.

The main potential hurdle to closing deals is the Biden Administration, which has become increasingly skeptical of M&A across multiple industries. But given ONEOK/Magellan drew no real pushback on anti-trust grounds, there’s reason to believe the various agencies won’t oppose Energy Transfer/Crestwood, or dozens of other prospective midstream mergers.

Who’s next in midstream M&A? As I wrote in May, almost every sector company currently operating in North America is a prospective target. And the ranks of potential buyers include large midstreams (Energy Transfer isn’t done yet), super major oil companies and larger independent producers, private capital and Berkshire Hathaway (NYSE: BRK/B)—which is now in process of purchasing 100 percent ownership of the Cove Point LNG export facility in Maryland.

My cardinal rule betting on M&A is to never buy any stock of a company I wouldn’t want to own if there never were any deal. That rules out a lot of weaker fare among the 150 or so energy companies we track in Energy and Income Advisor.

One I have recommended to EIA readers is Plains All America Pipeline (NYSE: PAA), arguably already the premier Permian Basin pipeline and midstream. The stock is up better than 30 percent since the beginning of 2023. But you can still buy it at barely one-quarter of its previous energy up-cycle high in 2014, when it was arguably a far less valuable company.