Bloomberg News

Private Equity Sees Pipes as Second Shale Wave: Energy

March 27, 2012

Water and sand are mixed and then pumped through the tubes at pressures over 6,600 psi into the well during fracture stimulation, at the Marcellus Shale formation in Camptown, Pennsylvania, U.S. Photographer: Julia Schmalz/Bloomberg

Water and sand are mixed and then pumped through the tubes at pressures over 6,600 psi into the well during fracture stimulation, at the Marcellus Shale formation in Camptown, Pennsylvania, U.S. Photographer: Julia Schmalz/Bloomberg

Private-equity firms are ramping up investment in the next phase of North America’s oil and natural gas drilling boom: the estimated $40 billion in annual spending on pipelines and processing to bring the fuels to market.

Arclight Capital Partners LLC, EnCap Flatrock Midstream LP (0120473D:US) and Highstar Capital are among firms behind projects that would connect and help transform fuel from thousands of shale wells expected to be drilled this decade. Some owners, keen to quickly sell their pipeline stakes within a few years, may see 16 to 25 percent returns, said Andrea Kramer, a managing director with fund manager Hamilton Lane.

The interest in processing plants and so-called gathering pipelines that connect wells is “a new phenomenon” for private equity, said George Ball, chairman and co-chief executive officer of Edelman Financial Group Inc., the Houston-based company that manages $17 billion. “So far, it’s been a highly profitable form of investment for some of the firms.”

The new investment coincides with pipeline companies merging systems to handle more shipments, including Kinder Morgan Inc.’s $24.4 billion pending acquisition of El Paso Corp. and the bidding war that led to Energy Transfer Equity LP’s $5.4 billion Southern Union Co. purchase.

Private-equity firms are building pipeline systems even before full-scale drilling begins and the recoverable oil and gas is known, said William Lemmons, a managing partner at San Antonio, Texas-based EnCap Flatrock. Financiers with pipeline expertise and more appetite for risk have stepped in where larger investors choose to keep their money in production.

More Drilling Rigs

Estimated spending for gathering and processing may be as much as $40 billion annually as hydraulic fracturing opens up North American shale formations to more drilling, Lemmons said. The number of rigs drilling for oil in the U.S. reached 1,317 on March 16, according to Baker Hughes Inc., the most since 1987, when the company began tracking oil and gas rigs separately.

Pipelines that connect to wells offer owners a steady return, almost like toll roads, as long as producers need access to the delivery systems.

Williams Partners LP agreed on March 19 to pay about $2.5 billion for Caiman Energy Midstream LLC, a gathering and processing business in the Marcellus Shale, as well as form a joint venture to bring infrastructure to Ohio’s Utica Shale.

Caiman’s parent company is backed by EnCap Flatrock and Highstar Capital. It’s the second deal this month for EnCap Flatrock, which agreed to sell its interest in two-year-old Meritage Midstream, the builder of a gathering system in Texas’s Eagle Ford shale, for an undisclosed sum on March 15.

Arclight’s $100 Million

Arclight, based in Boston, paid $100 million for a 28 percent share in a gathering system in West Virginia and Ohio on March 21. Two days later, a company Arclight co-owns invested an undisclosed amount in a gathering system in the Eagle Ford.

M3 Midstream LLC, backed by private-equity firm Yorktown Partners LLC, said March 13 it will take part in a $900 million venture to build gathering lines and processing plants in the Utica. A week prior, Energy & Minerals Group, a $3.3 billion fund, announced a similar venture with MarkWest Energy Partners LP in the area.

EnCap Flatrock and closely held M3 declined to say how much profit they earn on their transactions. The Utica transaction is M3’s third gathering and processing venture.

“We strive to achieve private equity-style returns,” M3 Executive Vice President George Francisco said in an interview.

M&A Activity

Private equity investors have boosted spending on pipeline mergers and acquisitions. Private-equity firms were involved in $4.4 billion worth of deals for oil- and gas-gathering lines and processing plants in North America last year, a 63 percent increase from $2.7 billion in 2010, according to data compiled by Bloomberg.

As spending on exploring and drilling increases, the amount of investment needed to transport and process the hydrocarbons does too. Barclays Plc has estimated an 8 percent rise in North American exploration costs to $159.7 billion this year.

That level of exploration may require $20 billion to $40 billion in pipelines and processing, said EnCap Flatrock’s Lemmons.

“We’re certainly not going to get all of it, we’re probably not going to get half of it,” Lemmons said. “It’s still a very, very big number.”

Price Risk

Many pipeline operators are set up as master-limited partnerships, a structure that focuses on paying regular dividends, making it difficult for them to invest in new pipelines unless they can see an immediate return. Private- equity firms can forgo an immediate return in the search for a bigger payoff, Lemmons said.

“The private equity guys are the storm troopers willing to get in and put their money to work as first movers,” Bradley Olsen, an analyst at Tudor Pickering Holt & Co. in Houston, said in an interview March 19.

Larger private-equity firms may look at pipelines as a way to invest in energy without assuming the risk associated with oil and gas prices, said Kramer of Bala Cynwyd, Pennsylvania- based Hamilton Lane, which manages $21 billion in assets and advises investors on $125 billion.

“If the deal drivers remain consistent then it could increase and probably would,” Kramer said. “How much of an increase is anyone’s guess, but the funds that are investing in these areas are multibillion-dollar funds.”

The key for private-equity firms is to get into a field early and sign contracts with producers while there are still few pipelines, said Lemmons, whose firm has invested $1.2 billion in eight companies since 2008. Gathering pipelines are attractive because they take less time to plan and build than larger interstate systems.

‘Starter Kit’

Often, the private-equity firms are building with the intent of selling a “starter kit” of pipes, plants and contracts with producers that a larger pipeline operator can then expand, said Lemmons.

Drilling in shale fields -- formations that have to be broken apart with high-pressure injections of water, sand and chemicals -- increases the need for gathering lines, said Jim Dillavou, a Houston-based partner at Deloitte & Touche LLP who leads the firm’s energy merger & acquisitions unit.

While some companies are curtailing gas drilling as prices reach 10-year lows, they’ll still need pipeline gathering systems as they drill in more profitable fields that produce oil and gas liquids, Dillavou said.

“These shale plays typically involve drilling hundreds or thousands of wells; they all need to be connected to a pipeline,” Dillavou said in an interview.

Sticking With Exploration

Firms unfamiliar with the pipeline business may choose to stick to traditional investing in exploration firms, said Greg Beard, a senior partner with Apollo Global Management LLC, a private-equity firm that led the $7.15 billion buyout of El Paso Corp.’s oil-and-gas exploration unit.

A report released in June by the Interstate Natural Gas Association of America Foundation Inc. sees lower levels of spending on infrastructure. It estimated companies will need to invest about $63 billion during the next 25 years to build processing plants and 16,500 miles (26,500 kilometers) of pipelines to new wells.

“There will be a time when someone commits to building a gathering system and either the gas isn’t there or oil and gas prices don’t support the drilling,” Beard said.

To contact the reporter on this story: Mike Lee in Dallas at

To contact the editor responsible for this story: Susan Warren at

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