Chart 1

The Industry Is Resilient Despite Economic Uncertainty

S&P Global economists are forecasting slower growth for the U.S. economy, with real GDP growth at about 0.7% in 2023. We also believe that the Federal Reserve will keep rates higher for longer to combat stubbornly high inflation. We believe the higher risk of recession could affect current strong demand for refined products and further weaken commodity prices. We believe weak natural gas prices could prove to be a headwind for some midstream companies with gathering and processing business exposed to dry gas regions. Conversely, price escalators in certain Federal Energy Regulatory Commission (FERC)-based and cost-of-service tariffs have generally increased along with inflation, somewhat insulating companies' profitability from higher operating costs. We recently revised our commodity price assumptions to reflect weaker demand fundamentals (S&P Global Ratings Lowers Hydrocarbon Price Assumptions On Moderate Demand, published June 22, 2023).

Capital Markets Changes Could Pose Difficulties For Companies With Weaker Credit Quality

Midstream energy companies escaped the direct fallout from the recent regional banking crisis. However, uncertainty rippled through financial markets leading most midstream companies to sideline debt issuance. Higher interest rates and market volatility have separated investment-grade (rated 'BBB-' or better) midstream companies--the haves--from most speculative-grade companies--the have nots, in terms of capital markets access. While some speculative-grade debt is maturing in the next 12 to 18 months, more maturities occur starting in 2025 and later, which could be less of a pressure point if markets improve and industry fundamentals stay strong. However, debt maturities could be a key focus for speculative-grade companies if markets conditions are less favorable.

Debt Ceiling Stand-Off Resolution Moves A Mountain In Appalachia

Waiting out the congressional negotiations on the debt ceiling proved to be well worth it for the midstream industry and Equitrans Midstream's (ETRN) stalled Mountain Valley Pipeline (MVP) project. The legislation fast-tracks the remaining permits and divests courts of jurisdiction to review agency actions on approvals necessary for construction and initial operation. While this development is a credit positive for ETRN some execution risk surrounding completion of the project remains. For our latest views on ETRN's credit quality and rating, refer to our full analysis published June 7, 2023. This positive development notwithstanding, we believe reform of the permit process is a critical credit factor for midstream infrastructure development.

Ongoing regulatory risks will continue to make things difficult for the midstream industry, although we believe the near-term risk to credit quality is somewhat remote during the next five to 10 years. One example is that certain states and local jurisdictions seek to impose bans on natural gas usage in new buildings for cooking and heating. While only a few states have passed these types of restrictions into law, many other states and cities are proposing similar bans. At the same time, 24 states have prohibited state and local bans on natural gas usage and other electrification mandates. We believe these types of regulatory risks will likely increase and become more politicized in the coming years.

Will M&A Activity Start To Heat Up?

ONEOK Inc.'s (BBB/Stable/A-2) $18.8 billion acquisition of Magellan Midstream Partners L.P. (BBB+/Watch Neg/A-2) is the most significant merger in the midstream industry in recent years and could change the calculus in the c-suites of its peers. We believe scale and asset and regional diversity has never been more important, particularly as upstream companies continue to consolidate and expand their footprint of hydrocarbon reserves. Larger exploration and production companies will continue to strive to be more efficient. To do so, they require flexibility and optionality from their midstream partners, which in our view larger and more diverse midstream providers can more readily accommodate than smaller peers. We also note the distinct advantage investment-grade companies have over their speculative-grade peers given their financial ability, capital markets access, and balance sheet capacity to acquire selective assets or competitors. Our current view is that most companies will choose to build at a lower multiple if they have a strong backlog of organic opportunities rather than compete in a bidding process. However, we believe certain unique assets that provide a good strategic fit with the acquirer--for example, Gibson Energy Inc.'s (BBB-/Stable/--) acquisition of Buckeye Partners L.P.'s (BB-/Stable/--) South Texas Gateway Terminal--will continue to transact.

Financial Discipline Still Reigns As Companies Stay The Course

Midstream companies have maintained the financial discipline that was born out of necessity several years ago as the industry's self-funding model took hold. While significant leverage reduction has already occurred, companies remain conservative in their capital allocation strategies, balancing deploying capital for growth with modest increases in dividends or discretionary share repurchase programs.

Chart 2

To assess the shift in midstream credit quality, we've analyzed data from a selection of 15 investment-grade and 12 speculative-grade companies we believe are representative of the overall industry (see Appendix for a list of those considered, representing the data included in charts 2 through 8). Overall leverage improved at a steady rate over the last two years, though most of this was with investment-grade companies (see chart 2). This is consistent with our view that midstream companies have adopted more conservative financial policies and a balanced approach to shareholder returns. Notably, Enterprise Products Partners L.P. (A-/Stable/--) publicly announced the adoption of a more conservative financial policy and we subsequently upgraded it (Enterprise Products Partners L.P., March 17, 2023). Of our group of 15 investment-grade companies we've considered in the data set (see appendix), only TC Energy Corp. (BBB+/Negative/A-2) reported a material increase in S&P Global Ratings-adjusted leverage when comparing 2022 to 2020, reflecting significantly higher debt levels it used to fund its large capital spending program. Conversely, credit quality of speculative-grade companies was a mixed bag with half of the cohort's debt to EBITDA ratios weakening in 2022 versus 2020. For some, including Crestwood Equity Partners L.P.(BB/Negative/--) and Delek Logistics Partners L.P. (BB-/Stable/--), this resulted from acquisitions and increased capital investments.

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Chart 4

Overall capital spending rebounded significantly in 2022 after a cut of more than 20% in 2021. Those companies with lower ratings accelerated investment at a much higher rate with half of the highlighted companies in the group hiking spending by more than 50% year-over-year. Only NuStar Energy L.P. (BB-/Stable/--) decreased its spending over the same period. We anticipate 2023 growth capital will continue to increase across our rated universe. Several key projects we are watching closely this year include:

Equitrans' Mountain Valley Pipeline project.  Completion of the pipeline would represent more than $400 million (midpoint of company guidance) of incremental capital deployed if construction begins this summer and is wrapped up by the end of the year, which Equitrans is currently guiding to.

TC Energy's Coastal GasLink project.  The company recently announced increased costs for the project (with a total cost of C$14.5 billion) which it plans to fund in part with asset sales. TC Energy alone represents nearly 30% of the total spend for the investment-grade companies considered in 2023. If it were not included in our data, investment-grade growth capital would increase by roughly 7% versus about 20%.

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Chart 6

Free operating cash flow generation for speculative-grade companies peaked in 2021, reflecting more dramatic cuts in capital spending to bolster liquidity, conserve balance sheet flexibility, and use excess cash flow to reduce debt. Investment-grade companies had less dramatic cuts to spending but kept it at lower levels for longer, which combined with better operating performance led to higher free cash flows in 2022.

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Chart 8

The most striking difference between investment-grade and speculative-grade companies in the sector is the amount of discretionary cash flow available after capital spending and dividends. Speculative-grade companies' discretionary cash flow flipped from positive in 2021 to negative in 2022 as companies started to spend more on discrete projects and reinstate distribution growth as the economy and operations improved. Investment-grade companies continue to see value in having positive discretionary cash flow, even with growth spending posting modest increases. We believe this more conservative financial policy provides more financial flexibility and ultimately is more supportive of creditworthiness and ratings as the industry faces long-term challenges of peak demand and the gradual encroachment of renewable alternatives as the energy transition proceeds in the decades ahead.

Appendix

Related Research

• S&P Global Ratings Lowers Hydrocarbon Price Assumptions On Moderate Demand, June 22, 2023