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A Sputtering Growth Engine Could Ignite an M&A Boom in This Sector

By Matthew DiLallo – Sep 13, 2020 at 11:18AM

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After another deep downturn took away its growth prospects, leaving consolidation as the only path forward.

The U.S. oil industry had been growing by leaps and bounds until this year. Output in the country averaged 12.23 million barrels per day (BPD) last year, more than double the production rate of a decade ago and shattering the previous record of 9.64 million BPD set in 1970. Industry forecasters expected that upward trend to continue, with estimates that production would grow to 13.2 million BPD this year and hit 13.6 million BPD by 2021. 

However, COVID-19 obliterated that forecast by upending demand, which forced the industry to cut back on supplies. Visions of continued growth for the pipeline sector have evaporated, which will probably cause it to shift gears. The next logical phase is consolidation, which would enable pipeline companies to cut costs and increase their scale so that they can endure what will likely be several more lean ahead years. 

Business people shaking hands overlaying upward pointing arrows.

Image source: Getty Images.

From boom to bust

It wasn't all that long ago that the U.S. oil industry desperately needed more pipeline capacity, especially in the high-growth Permian Basin. Pipeline companies such as Plains All American Pipeline (PAA 2.32%) were racing to build new infrastructure as fast as they could. This building boom saw the sector construct several new pipeline systems to support the oil industry's projected growth.  

However, with COVID-19 knocking the wind out of its sails, "takeaway capacity is more than needed currently not just for crude but also NGLs as well as natural gas," according to comments by Plains All American CEO Willie Chiang at a recent industry conference. He further noted that "the constraints have been significantly removed with the reset of production, which positions it well for when production comes back."

Now companies have started canceling projects since they're no longer necessary. This week, Enterprise Products Partners (EPD 0.51%) nixed its Midland-to-ECHO 4 pipeline, which would have added 450,000 BPD of new capacity to the Permian Basin. While that cancellation will cost Enterprise $45 million, it will also save the company from spending $800 million to build what would likely be an underutilized pipeline. Those savings will give the company the financial flexibility to do other things, like buying back its beaten-down shares.

Switching fuel sources

With the industry's growth prospects drying up, pipeline companies will likely need to alter their strategies. Chiang noted that "as we go forward and times are continuing to be more challenging, I think you're going to see more" consolidation in the sector. That would enable pipeline companies to cut costs and better optimize their systems.

For example, last year Energy Transfer (ET 1.61%) bought smaller rival SemGroup for $5 billion. One of the draws of the combination was that Energy Transfer expected to benefit from more than $170 million in annual cost savings. That would come through commercial and operational synergies and financial savings as it used its higher credit rating to refinance SemGroup's debt at lower interest rates. The merger also enabled Energy Transfer to optimize its system by building a new pipeline to connect two oil terminals. 

Aside from saving money and optimizing, pipeline companies will also seek deals that bolster their financial profile. They don't want to buy a deeply indebted rival that would weigh on their leverage metrics since one of their main focuses has been improving their balance sheets. While that desire will make it harder to get deals done, many pipeline companies did reduce their dividends this year to use that cash to pay down debt, which should make them more attractive to buyers in the future.

Expect the urge to merge to get stronger in the coming quarters

The pipeline industry is heading into a period with low expansion opportunities because oil companies have all the capacity they need for quite a while. The sector is likely ro pivot its strategy toward consolidation to help reduce costs and improve earnings. As that happens, it could finally snap the space out of its current doldrums, given that the average energy infrastructure stock is down more than 35% this year.

Matthew DiLallo owns shares of Energy Transfer LP and Enterprise Products Partners. The Motley Fool recommends Enterprise Products Partners. The Motley Fool has a disclosure policy.

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