Pipeline company Williams’ rejection of Energy Transfer Equity’s (ETE) $53.1 billion, all-stock takeover this week has brought a months-long buyout attempt into the public eye. With that highly visible rejection has come an increasingly clear picture of the industry’s shift toward pipeline consolidation—and a look behind the curtain at how these companies operate.
“This is by far the most interesting thing to happen in my space in years,” Ethan Bellamy, top analyst of master limited partnerships and Managing Director of Robert W. Baird & Co., told the Fuse. “[ETE] is a spurned suitor that’s not taking ‘no’ for an answer.”
A potential rival to Kinder Morgan
ETE Chairman Kelcy Warren has indeed been very clear that he intends to continue his pursuit of Williams in a deal that would create one of the nation’s largest energy companies, rivaling even Kinder Morgan—that is, unless Kinder Morgan itself decides to make a play for a Williams takeover. Already, there is speculation that ETE will soon raise its offer for Williams from $64 a share to as high as $74 a share, a number that Bellamy says is certainly within the realm of possibility.
Dallas-based ETE controls some 70,000 miles of oil and gas fuel lines across the south and Midwest while Tulsa-based Williams has a strong network in the northeast—including the 10,000 mile Transco pipeline that links Texas to the New York area.
Together, the merged company would have a powerful and widespread footprint. Dallas-based ETE controls some 70,000 miles of oil and gas fuel lines across the south and Midwest while Tulsa-based Williams has a strong network in the northeast—including the 10,000 mile Transco pipeline that links Texas to the New York area. With a strong foothold in the Marcellus and Utica shale plays, it’s clear to see why Williams might appear particularly attractive to ETE.
“I believe that a combination of Williams’ assets with ETE will create substantial value that would not be realized otherwise,” ETE Chairman Warren said in his statement about the failed takeover. He went on to say that the push to purchase Williams does not end here. “I am a strong proponent of this transformative combination and support the issuance of a significant amount of ETE securities to complete the transaction. I am truly excited at the prospect of bringing together these two businesses under a common platform and creating additional value for every stakeholder.”
According to the Wall Street Journal, the deal could also potentially alleviate some of the shipment bottlenecks in the Marcellus shale formation, creating access in the west and south to low-cost gas from the formation.
Weathering the price glut
Even as other sectors of the oil and gas industry struggle amid low crude oil prices, the pipeline industry has managed to stay relatively afloat. Consolidation appears to be a critical part of the survival strategy for pipeline companies—both internally and otherwise.
ETE Chairman Kelcy Warren voiced this sentiment in February of this year in a call with shareholders and analysts, as U.S. oil prices began to move back up toward $60 a barrel. At that time, his company’s efforts to purchase Williams were already well underway behind the scenes.
“This is going to sound odd to you, almost sadistic, but I was disappointed to see a rebound in crude prices,” Warren said in the call. “I was excited to see who might be more vulnerable if we saw this market continue a downward trend and stay there a bit longer.”
Industry expert Bellamy sees Warren’s attitude as a trademark of the way that ETE does business: “ETE is always looking to go bigger and expand. There is never a time they’re not thinking about growing the business by leaps and bounds. This environment makes it easy because companies like Williams are cheaper.”
But according to some analysts, ETE’s offer—even at the significant 32.4 percent premium floated to Williams—treats Williams as a much more vulnerable entity than it is when viewed in the long term. In its own statement about the takeover attempt, Williams touched on this point: “[We] determined that [the offer] significantly undervalues Williams and would not deliver value commensurate with what Williams expects to achieve on a standalone basis and through other growth initiatives…”
At least one analyst posited that if one takes a long-term view, it becomes evident that Williams would perhaps be the more appropriate buyer in a deal with ETE, as opposed to the other way around, as it currently stands. As Bellamy sees it, a role reversal would be uncharacteristic of the way Williams operates.
“Organizations all come down to people, and I would hold up the respective [merger and acquisition] track records and say who’s more likely to do a major deal like this?” Bellamy says. “It’s very unlikely that Williams would pursue an unsolicited deal and go after ETE.”
When the rig count declines, the pipelines that served them fall into some disuse.
No matter the buyer, pipeline corporate consolidation has proven to be a viable solution in the current energy economy. When the rig count declines, the pipelines that served them fall into some disuse. For the company to keep expanding, construction is a costly gamble—better to expand by taking on another pipeline group’s existing infrastructure. Political opposition—similar to the resistance met by the Keystone XL Pipeline—has also made new pipeline construction a less rewarding investment prone to stalling for months or years on end.
“We’ve built out what we need from a network perspective, and so the in-market demand for new projects is dwindling. But at the same time, you have all this capital and people chasing ideas,” Bellamy explains. “People will start to realize in the next year that they don’t have as much money to spend as they did in the past and so that’s going to lead to further industry consolidation.”
A prime environment for consolidations
Research provided to The Fuse by Bain & Company, the strategic consulting firm, cites four trends as signs that midstream companies will soon see a wave of consolidation. Those trends are: A slowing of previously rapid growth, a fragmented industry, a consolidation phase already underway in numerous basins, and an increase of pressure on existing financial models.
According to the Bain research, consolidation solves multiple exigent threats to pipeline company owners. Through growth, for example, companies can expand their reach into multiple basins and protect themselves against reliance on no single stream. A diverse portfolio of shale plays ensures that they can remain profitable when oil is in the $60 to $70 range. The research also recommends a transition away from the master limited partnership (MLP) model in which many of these companies grew and evolved.
MLPs are a type of limited partnership which combine a low tax burden with the liquidity of publicly traded securities. As an asset class, MLPs have been a mainstay of the pipeline industry over the past two decades, and favored for their high payouts to shareholders. However, the same high payouts make MLPs a less competitive structure for companies that have grown past a certain point.
Instead, Bain’s research recommends a return to a traditional corporate model—advice that is reflected in ETE’s attempted deal with Williams that would have turned the newly-combined company into a C-corporation. That same type of transformation helped Kinder Morgan survive the end of 2014 and the dip in oil prices.
“As midstream companies grew using MLP models, their investment distribution rights drove outsized profits for their general partners,” the Bain research explains, going into greater detail on why the MLP model presents a challenge for larger companies. “For some of the largest midstream companies, [the MLP] model is becoming a financial burden. As the portion of income distributed through investment distribution rights grows, the cost of equity increases and the company becomes less competitive… Given the importance of equity in M&A financing, several companies have taken steps to improve the cost of equity by either eliminating these rights, resetting their values or restructuring to traditional corporations.”
Bellamy states: “The MLP is an implicit poison pill.”
As an analyst who has been closely watching ETE, Williams and the pipeline industry for years, Bellamy states: “The MLP is an implicit poison pill.”
But consolidation can have downsides for pipeline giants. While it may be a useful tool for eliminating competition and cutting back on administrative redundancies, it can also raise red flags with the FTC. “Consolidation is not the solution for everyone,” Bellamy says, “It’s a good strategy… unless you overpay it tends to make sense.”
While Bellamy said it’s not entirely clear to the outside observer whether or not ETE is going to be overpaying even at $74 a share, he believes the attempted Williams takeover is less a sign of an industry consolidation wave and more an “anomaly” based on ETE’s track record of seeking out similarly major deals.
As Bellamy puts it: “[Williams would] have to come up with something very compelling to fend off the offer.”