Oil and gas production in the Permian Basin has been growing so fast in recent years that it has overwhelmed the region's infrastructure. That has midstream companies racing to build new pipelines as quickly as they can.

However, with several projects on track to start up later this year, and more in development, the region could soon have more capacity than it needs. That's leading some project developers to rethink their plans to better match infrastructure with regional demand.

A gas pipeline under construction with a cloudy sky above.

Image source: Getty Images.

The green light quickly dimmed

Last fall, midstream giant Energy Transfer (NYSE:ET) and its partners Magellan Midstream (NYSE:MMP), MPLX, and Delek US Holdings sanctioned the Permian Gulf Coast pipeline. It was to transport oil from the fast-growing Permian Basin to the Texas coast, where crude would flow into Energy Transfer's terminal near Nederland, Texas, and Magellan Midstream's terminal near Houston. The partners believed that they could have the pipeline up and running by the middle of last year.

This week, however, Magellan Midstream disclosed that it was reducing its capital spending projections by $450 million for 2019 and 2020. Driving that cut is the company's view that the Permian Gulf Coast project won't proceed as planned. As a result, the company expects to invest only $1.25 billion into capital projects over the next two years, down from $1.7 billion. That will give the company much less fuel to grow its distribution to investors, which Magellan had hoped to increase by another 5% to 8% next year.

An upstart with big oil backing

Two factors have changed since Energy Transfer and its partners sanctioned Permian Gulf Coast. First, oil prices took a tumble last fall, which led several oil companies to reduce capital spending. Because of that, oil production likely won't grow quite as fast, especially since more producers are aiming to live well below their means so that they can return cash to investors. In addition, ExxonMobil (NYSE:XOM) and its partners Plains All American Pipeline (NASDAQ:PAA) and Lotus Midstream sanctioned the Wink to Webster Pipeline, which is very similar to Permian Gulf Coast in scope and size.

Because of that, Energy Transfer has been in discussions with Exxon and Plains All American to combine their two projects. Energy Transfer's CFO Tom Long stated on the company's fourth-quarter conference call that "we will continue to go down parallel paths in order to evaluate and achieve the most efficient and accretive [project] for our partnership." COO Mackie McCrea added:

We're trying to decide what's the best way to go. One would require more capital with not as good a rate of return. The other is less capital with a lot better rate of return.

Combining the two projects would result in all partners investing less money into one large-scale pipeline, which would yield higher returns on investment. This outcome seems increasingly likely given that Magellan has already assumed it won't proceed with the Permian Gulf Coast project. What isn't yet clear is if the company will join Energy Transfer, Exxon, Plains All American, and others on the combined pipeline.

Check out the latest earnings call transcripts for Magellan Midstream and other companies we cover.

Growing the right way

While Energy Transfer and Magellan Midstream secured enough long-term contracts with customers to justify moving forward with Permian Gulf Coast, they didn't fill up the pipeline's proposed capacity. Because of that, it appears as if they'll join forces with an Exxon-led project since they can combine their customer lists to fill up that pipeline, which would boost returns. The move makes lots of sense in an era when investors are increasingly demanding returns versus growth at all costs.

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