Part 1: An Introduction to Midstream Energy Infrastructure
Part 2: Understanding the Pipeline Business
Part 3: Midstream Energy: An Investment Case
The
modern pipeline network in the United States has its roots in the outbreak of
World War II. Before the war, the East Coast was the largest consumer of energy
in the country. Refined products (such as gasoline, diesel, and jet fuel) were
delivered from Gulf Coast refineries via tankers. Tankers also carried raw
crude oil from the Middle East. However, once the US became involved in the
war, German submarines began sinking these tankers. Together, the government
and the petroleum industry-built pipelines that could cover long distances and
transport large amounts of oil.
This
network subsequently fuelled the economic boom that followed the war, and many
of those original pipelines are still in service today. There are both large
diameter trunklines that function like motorways (instead of being four lanes
wide, they are often 42” in diameter, or large enough for a child to stand
inside), as well as smaller delivery lines which connect the large pipelines to
each town.
Product
traveling through trunklines is fungible —the customer will receive product on
the other end that is the same quality as that which was sent, but they will
not be the exact same molecules. It is as if someone sent $100 to a college
student through a bank. That student will not get the exact same $100 bill as
his or her benefactor sent, but the student does not care because $100 is $100.
Money is fungible. However, smaller delivery lines operate on a batch system,
where the exact same molecules are delivered as were shipped. In this case, our
lucky college student gets a couple dozen cookies, and the ones delivered are
the exact same cookies his or her parents baked, not cookies that some other
people made.
Energy
Renaissance
Prior
to the 2000s, much of the energy industry was focused on peak oil and the ways
companies and our society would have to shift in response. While producers knew
that oil reserves existed, accessing the oil in a cost-effective way was still
difficult. Experts forecast that expensive and complex recovery methods would
be needed to continue to produce even a modest number of barrels.
In the early 2000s, the natural gas industry
in the US began widespread application of horizontal drilling and hydraulic
fracturing (aka Fracking). The technologies were not new, but the combination
of both technologies makes it possible to profitably produce the large reserves
of crude oil, natural gas, and NGLs trapped between layers of shale rock.
Horizontal
drilling was developed in the first half of the 20th century, and the first
commercial applications of hydraulic fracturing took place in 1949. After
seeing the success of natural gas companies in applying these technologies, oil
producers began implementing the same drilling technology, seeing strong
production growth from oil wells.
In
2009, the US became the world's largest producer of natural gas. By 2012, the
US had an abundance of natural gas, leading to lower prices, but gas production
continued to grow. In 2014, rapid growth in US oil production had led to a global
crude oversupply and weakness in oil prices.[1]
A multi-decade ban on US crude exports was lifted by Congress in December 2015.
Oil prices gradually recovered since their relative bottoming in February 2016,
and US oil production continued to increase.
By
2018, the US had become the world’s largest oil producer and is now exporting
millions of barrels of crude each day. The term “energy renaissance” refers to
the overwhelming growth in US energy production that has occurred. In 2020, oil
prices collapsed in the wake of unprecedented decline in demand stemming from
measures taken to prevent the spread of Coronavirus. While oil production in
the US is likely to temporarily decline as producers respond to the lower price
environment, the world is expected to need growing volumes of oil and natural
gas from the US in the years ahead.
Long-Term Growth Expected for US Energy Production
For
illustrative purposes only.
The
North American Energy Landscape
Energy
infrastructure companies are not the ones engaging in horizontal drilling or
hydraulic fracturing. Instead, they are typically focused on the more stable
businesses within the energy complex.
The
midstream company that provides transportation, processing, and storage
facilities for multiple producers has diversified its revenue stream and
benefits broadly from US energy production and exports. Simply put, energy
production from the US, coupled with increasing demand domestically and
overseas, requires energy infrastructure to connect supply with demand.
Increased
oil production has created a number of opportunities for midstream companies to
build new pipelines connecting producing regions with demand centres, including
the coast for export. MLPs are also building crude export terminals.
On the
natural gas side, growing production and rising demand have created many
opportunities for MLPs. For example, several companies have built or are
constructing liquefaction plants in the US where natural gas can be cooled and
pressurized to a liquid form. This liquefied natural gas (LNG) can then be loaded
onto ships for export. US LNG exports will help meet increasing demand for
natural gas overseas. Energy infrastructure companies build the pipelines to
LNG export facilities, natural gas-fired power plants, and necessary storage
facilities. They also build and operate the processing plants necessary for
transforming raw natural gas into a usable form.
Complementing
the growth in oil and natural gas, production of natural gas liquids (NGLs) has
also grown. Natural gas liquids must be processed into their component parts to
be usable, creating more demand for fractionation facilities (the formal term
for plants that process NGLs). Midstream MLPs and companies build NGL-dedicated
pipelines and fractionation facilities as well as NGL export facilities to meet
global demand.
Shale
Revolution
Shale is a type of geological
formation found in sedimentary rocks. The amount and type of natural resources
found in that layer will depend on what sort of life form, water, or lack of
water existed during the period in which that rock was formed.
For many decades, producers
drilled for oil and gas in rock formations such as carbonates, sandstones, and
siltstones. These formations, known as conventional formations, have multiple
porous zones that allow the oil and gas to flow naturally through the rock. This
ability of rocks to allow fluids to flow is known as permeability.
Conventional formations have
higher permeability than unconventional formations like shale rock. Vertical
drilling, which involves drilling straight into the ground, worked for many years
on conventional formations because once the drill bit hit a particular area,
the high permeability would allow for the hydrocarbons to be extracted easily.
For quite some time, the energy industry has known that oil and gas existed in
shale. But because shale rock is not as permeable, using old techniques with
vertical drilling did not make it economically feasible to recover resources
because it would only capture a limited amount. Three technologies together
truly changed the game for extracting shale resources:
1. 3D seismic imaging
2. Horizontal drilling
3. Hydraulic fracturing
While seismic imaging in 3D
may be the least well-known component of the shale revolution, it plays a vital
role when it comes to drilling a successful well. Seismic technology uses
acoustic energy, vibrations, and reflected signals to determine the location
and density of rock formations. Think of it like an underground map. While
considerably more expensive than 2D seismic imaging, 3D seismic imaging results
in fewer dry holes[1]
and more productive wells.
[1] A dry hole is a well that is
drilled but produces no oil or natural gas. It may produce water or small
amounts of oil and gas, but not enough to recoup drilling costs.
Advanced 3D Visualisation
Source: www.geomore.com/seismic
Horizontal drilling is another
technology that has drastically improved the success rates and economic
viability of shale drilling. Horizontal drilling allows the operator to drill a
well, and then manipulate the drill bit underground to make a 90-degree turn
and cover a much larger area. Multiple (up to 20 or more) horizontal wells can
be drilled from a single drill pad, lowering drilling costs, increasing
efficiency, and minimizing the impact to the environment. After the well is
drilled and lined with casing, a second technique called hydraulic fracturing
is used.
Then
Vertical Drilling[2]
Now
Horizontal Drilling
Hydraulic fracturing describes
the process in which a mixture of water, sand, and other chemicals is pumped
into a well at a very high pressure to break up shale rock. The highly
pressurized mixture lets a driller open all those tiny pockets. The water is then
removed, and the remaining sand props open the rock, allowing hydrocarbons to
flow freely to the surface.
Hydraulic Fracking
In short, 3D seismic drilling
tells producers where to drill, horizontal drilling increases the amount of
area drilled, and hydraulic fracturing solves the issue of low permeability.
The
map below shows some of the major natural gas, crude oil, and NGL plays in the
United States.
Image Source:
EIA, Design: HANetf
The Alerian Midstream Energy Dividend UCITS ETF Dist
In July 2020, HANetf and Alerian launched the Alerian Midstream Energy Dividend UCITS ETF Dist (MMLP)which seeks to track the price and yield performance , before fees and expenses, of the Alerian Midstream Energy Dividend IndexTM (Total Return).
The fund offers diversified exposure to energy companies involved in the processing, transportation and storage of oil, natural gas and natural gas liquids in the US and Canadian market and includes MLPs and C-corps.
It is the first UCITS ETF to provide exposure to the energy infrastructure sector via an Alerian index. By employing a synthetic strategy, MMLP enables efficient replication of the index.
The index is fundamentally-weighted by dividends in a transparent, straightforward process. Each company’s total distribution is calculated as shares outstanding multiplied by its annualized dividend based on the most recent dividend.
Each constituent’s weight is then calculated by taking its total distribution and dividing by the sum of all in index constituent distributions. Finally, a 10% cap is applied to constituent weights.
Simply put, companies that pay out more cash flow per share are weighted higher relative to peers that distribute less. MMLP is rebalanced quarterly and reconstituted annually. Quarterly re-balances occur in January, April, July, and October, with only the weightings of constituents adjusted.
Excluding spin-offs, companies can only be added to Alerian Midstream Energy Dividend UCITS ETF during the annual reconstitution in October. However, constituents can be removed from the index between reconstitutions due to special situations such as mergers, acquisitions, or bankruptcies.