Permian G&Ps' Outlook Now Positive After Tumultuous Year

After a challenging environment in the Permian Basin for gathering and processing (G&P) companies in 2020, the outlook has dramatically improved. West Texas Intermediate (WTI) crude oil was approximately $60 per barrel (bbl) at the beginning of 2020 and collapsed with the onset of the COVID-19 pandemic. WTI hovered at about $20/bbl for much of March and April 2020, and gradually climbed to $70/bbl as of June 17, 2021.

When oil prices collapsed in 2020, producers significantly cut back their rig counts and shut in many wells. Smaller Permian-focused G&Ps capitalized with large amounts of debt relative to cash flows needed strong volume and cash flow growth in 2020 to deleverage. They found themselves in a precarious situation for much of the year. Crude production in the Permian averaged 4.8 million bbl per day (mmbpd) in January 2020 but fell to 3.9 mmbpd in May 2020 due to well shut-ins and a much lower rig count. Permian natural gas production followed a similar trajectory of averaging 17.1 billion cubic feet (bcf)/day in January 2020, falling to 14.9 bcf/day in May 2020.

However, as of May 2021 crude production averaged 4.5 mmbpd, up about 15% from May 2020. Natural gas production is up 18% from May 2020. While production and volume are not at pre-pandemic levels yet, the rising rig count is a positive indicator for future production and volumes. The rig count in the Permian is considerably above that of May 2020, but well below early 2020. But productivity per well has dramatically improved. For example, according to the U.S. Energy Information Administration (EIA), crude production per rig averaged 1,253 bbl/day in May 2021 in comparison to 745 bbl/day in May 2020.

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In 2020, U.S. crude oil production averaged 11.3 mmbpd, down 8% from 2019. As of June 2021, the EIA expects U.S. crude production to average 11.1 mmbpd in 2021, which would be a slight decrease from 2020, and 11.8 mmbpd in 2022, a 6% increase over 2021. The EIA expects 2021 natural gas production of 92.2 bcf per day, relatively flat to 2020. In 2022, the EIA expects production to increase roughly 2% to 94 bcf per day.

We expect crude production and volumes in the Permian to outperform overall U.S. crude production, given the favorable economics. Permian crude production was relatively flat in 2020 relative to 2019, an outperformance relative to total U.S. crude production over the same period. However, we note crude volumes varied widely in 2020. In 2021, we expect a modest increase, which will support the Permian G&Ps we rate. Many also recently completed infrastructure builds that will be a tailwind for volume growth. We also believe many will have excess free cash flow to pay down debt. We expect credit metrics to improve in 2021 relative to 2020.

We Have Taken Many Positive Rating Actions On Permian-Focused G&Ps In 2021

We rate several small G&Ps that either solely or primarily operate in the Permian Basin. Some focus on the Delaware Basin and others in the Midland Basin. These companies primarily gather natural gas or oil, or both. Some gather water as well. In general, the volumes of natural gas are correlated to crude volumes given a large amount of associated gas related to producers' crude-focused drilling programs. We rated many of these companies in 2017-2018, when we expected significant production and volume growth in the Permian.

With the dramatic drop in drilling and shut-in of wells in 2020, we took many negative rating actions on Permian G&Ps in the first half. Most did not have minimum volume commitments (MVCs), which could help offset lower than expected volumes. An exception is Lucid Energy Group, which has some downside protection given that MVCs make up approximately 40%-50% of its total volumes. In addition, many of these companies have primarily speculative-grade counterparties, which had their own financial difficulties that forced them to significantly cut back on drilling and lowered volumes on G&P systems.

After the effects of the pandemic became clear, we anticipated volumes for Permian G&Ps could decline meaningfully in both 2020 and 2021, which would leave them in a precarious situation with high debt loads relative to their cash flows. This would make it extremely difficult to deleverage and their capital structures unsustainable. However, expected modest Permian volume growth in 2021 brightens the picture dramatically. In addition, volumes for Permian G&Ps we rate proved much more resilient than we expected during 2020. Also, their capital spending budgets are relatively low in 2021, as most have spent the past few years building out infrastructure and have few projects. This will enable them to pay down debt with excess free cash flow and have much lower adjusted debt to EBITDA than we anticipated about a year ago.

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Additional detail on rating actions we took on Permian G&Ps in the first half of 2021. Note that the date of rating action and published expected credit metrics are in parentheses:

• Navitas Midstream Midland Basin LLC (Jan. 25, 2021): We raised the issuer credit rating to 'B' from 'B-' with a stable outlook. We project EBITDA will be $140 million-$150 million, which will leave discretionary free cash flows and improve credit metrics, with weighted-average debt to EBITDA of about 5.5x-6x. Processed volumes have increased steadily on a quarterly basis, about 688 million cubic feet per day (mmcf/d) in the third quarter of 2020, compared with 441 mmcf/d in the third quarter of 2019. This improvement is largely spurred by a stronger gas oil ratio across the basin and continued customer drilling activity.
• Oryx Midstream Holdings LLC (Feb. 23, 2021): We affirmed the 'B-' rating and revised the outlook to positive from negative, which reflects our view that Oryx will continue to gain throughput volumes and generate strong free cash flows in 2021 and 2022. We anticipate adjusted debt to EBITDA of 5.5x-5.75x over the next 12 months. In the second quarter of 2020, Oryx's Delaware volumes declined 12% to approximately 470,000 barrels per day due to the production curtailment and well shut-ins on its dedicated acreage. However, in the second half average Delaware throughput improved and amounted to about 490,000 barrels per day, which we expect to continue to increase in 2021.
• Lucid Energy Group II Borrower LLC (April 13, 2021): We affirmed our 'B' rating and revised the outlook to positive from negative, which reflects our view that Lucid will increase volumes in the cost-competitive Northern Delaware Basin with the completion of its remaining expansion project, Red Hills V, in December 2020. We expect adjusted debt to EBITDA to decline to between 4x and 4.5x in 2021. Despite less drilling activity in the Permian, Lucid's average volumes increased over 30% in 2020 to over 800 mmcf/d. With the build-out of Red Hills V, which came online in December 2020, Lucid's capacity is above 1,100 mmcf/d. We expect average volumes will continue to rise.
• Brazos Permian II LLC (April 14, 2021); We raised the rating to 'B-' from 'CCC+' with a positive outlook, which reflects our view that the company will continue to increase its throughput volumes and EBITDA during the next 24 months while generating positive free cash flow that it may use to reduce its debt balance. We project adjusted debt to EBITDA in the 6x-6.5x range in 2021, improving to below 6x in 2022. As Brazos' asset base is built out, it does not contemplate any major growth projects this year.
• BCP Raptor II LLC (April 22, 2021): We affirmed our 'B-' rating on the company and revised the outlook to positive from negative, which reflects our expectation that BCP will generate $40 million-$55 million of free cash flow in 2021. It will use that to reduce its adjusted debt to EBITDA ratio to the 5.25x-5.75x range over the next 12 months. Like several midstream peers operating in the Permian Basin, BCP faced challenging market conditions throughout 2020. However, the company expanded its gathered natural gas volumes 7% year over year and produced $9 million free cash flow in the second half.
• EagleClaw Midstream Ventures LLC (ECMV; April 22, 2021): We raised the rating to 'B' from 'B-' with a stable outlook, which reflects our expectation that ECMV will generate $35 million-$50 million free cash flow in 2021. It will use that to reduce its adjusted debt to EBITDA ratio to the 5.5x-6.25x range over the next 12 months. Like several midstream peers operating in the Permian Basin, ECMV faced challenging market conditions throughout 2020 but expanded its gathered natural gas volumes 17% year over year and produced $11 million free cash flow in the second half.
• Medallion Gathering & Processing LLC (April 23, 2021): We affirmed the 'B-' rating and revised the outlook to positive from negative. The positive outlook reflects our expectation that Medallion will continue to increase its throughput volumes and EBITDA while reducing its leverage to the low-5x area in 2021 and below 5x in 2022. We expect expanded volumes to be supported by improving well productivity and a further decline in well completion costs. As Medallion's system is built out, we anticipate it will continue to generate positive free cash from operations of $90 million-$100 million, which it could use to repay debt.

Outlook Also Favorable For Larger Midstream Players With Permian G&P Exposure

We also rate many larger and more integrated midstream companies that have G&P assets in the Permian and other basins. These include Plains All American Pipeline L.P., NuStar Energy L.P., Targa Resources Corp., DCP Midstream L.P., and Enlink Midstream LLC. They have different degrees of gathering and processing exposure to the Permian. Despite being integrated and more diversified, their G&P and crude logistics segments also were affected by the downturn in commodity prices, which lowered volumes than our expectations going into 2020. This somewhat weakened their overall cash flow and leverage profile expectations. As a result, even the larger midstream companies with some Permian G&P exposure announced various measures such as significant dividend cuts, curtailing growth capital expenditures, and other cost-saving initiatives to offset lower than expected cash flows.

In addition, some companies deferred capital spending or sold assets. These actions helped conserve cash when cash flows declined by varying degrees. With the improved outlook, we generally view many larger midstream companies with G&P exposure as slightly better positioned over the long term. Capital spending budgets are also significantly lower, as much of the infrastructure build-out in the Permian has been completed. In addition, the significant dividend or distribution cuts last year enabled these companies to have much better discretionary cash flow. We anticipate many with better discretionary cash flow will pay down debt. We would view it as a credit-negative if shareholder-friendly activities such as share buybacks became too sizable.

As an example, Targa took actions to protect its balance sheet in March 2020, cutting its dividend 90% and capital spending. However, the volume outlook for Targa has considerably improved over the past year, and that along with the meaningful cut in dividend has put Targa in a better position with meaningful free cash flow in 2021. In October 2020, Targa announced a share repurchase plan, which we viewed as a credit-negative. Credit metrics were still appropriate for the rating, and we affirmed the 'BB' rating.

What Happens From Here

Smaller Permian G&P companies are in a much better position than they were a year ago, with a much better outlook on volumes and discretionary cash flow that will be used in many cases to pay down debt and improve liquidity. The large midstream players with exposure to Permian G&P are also in a much better position than they were a year ago. Not only is the expectation for volumes meaningfully better, but dividend and distribution cuts have enabled these companies to have sizable discretionary cash flow that could be used to pay down debt. We will monitor and evaluate shareholder-friendly activity, including share buybacks and how they may impair credit metrics.

Despite the much-improved volume outlook, we expect they will increase at a much slower pace than expected pre-pandemic. With larger midstream companies having ample positive discretionary cash flow, we believe this could ultimately lead to industry consolidation. While hard to predict, we believe smaller Permian G&Ps closest to the wellhead and largely dependent on production volumes could be low-hanging fruit for larger diversified midstream companies looking for a larger geographic footprint to ensure volume flow for current assets.