The midstream sector is a key part of the oil and gas industry’s value chain and experiences frequent mergers and acquisitions that necessitate purchase price allocation (PPA) valuations for the purposes of financial reporting and taxation. Herein, we discuss certain unique considerations applicable to PPA valuations in this industry.
Midstream companies provide the below services.
Midstream companies provide an array of transportation, processing, and storage services. Besides the usual considerations for size, growth, risk, and certain other factors, careful consideration should be given to the underlying assets and services footprint of the comparable companies that are selected and the business being valued. In addition, consideration should be given to the geographic areas where the comparable companies operate, as the production risk profiles vary by regions of oil and gas production. For example, a natural-gas-focused midstream company operating in the Marcellus Shale would not be considered a good comparable for a midstream business that operates in the crude oil-focused Permian Basin in West Texas.
Comparable company selection has an impact on the development of the discount rate, or the weighted average cost of capital, which is used in performing PPA valuations. Key inputs to the discount rate, such as stock beta and cost of debt, for publicly traded midstream companies can vary based on their operational and oil-and-gas-basin focus. Other market-participant considerations, including growth rates, margins, and capital requirements, may also differ materially depending on the characteristics of the comparables.
The most common identifiable intangible assets observed in the midstream industry are contractual customer relationships. Midstream companies sign multi-year contracts with upstream companies, the terms of which can last for up to 20 years (and longer, in some cases).
Significant investment is required to develop the infrastructure needed to transport oil and gas. A disruption in any part of this system can severely impact profitability. To mitigate this risk, midstream companies require guarantees tied to production for the life of the long-term contracts they sign with upstream companies. This guarantee is called a “dedication” and is frequently tied to the acreage under exploration. That is, in return for building out the needed infrastructure, the upstream company guarantees that all production from a defined “dedicated” acreage will only flow to the midstream company with which the contract is drawn. Dedicated acreage contracts can also contain minimum volume guarantees for a specified time period.
In evaluating the riskiness of said contractual relationships, it is important to understand the fee structure of the underlying contracts, which is set out below.
Understanding the mix of customer contracts and relationships is very important in analyzing the risk profile of the cash flows used in a PPA valuation.
In the past, valuations, including PPAs, for midstream companies did not incorporate the tax-affecting of cash flows. Historically, a number of publicly traded midstream companies were organized as pass-through entities, or master limited partnerships (MLPs), and since the most likely market participant would have also been a pass-through entity, incorporating taxes in cash flows were not employed in the valuation procedures using an Income Approach. However, in more recent years, a number of midstream companies have simplified their corporate structures and now operate as C corporations, and new IPOs for midstream companies are coming to market as C corporations. As a result, it has now become important to appropriately analyze who would be the likely market participants for the subject under valuation and whether the cash flows and discount rate should be tax-affected.
Historically, numerous publicly traded midstream MLPs incorporated incentive distribution rights (IDRs) in their corporate structures. An MLP’s operations are overseen by its general partner (GP), while the limited partners (LP) supply capital. The GP would also have IDRs associated with its ownership. IDRs were frequently structured to give the GP an increasing share of a MLP’s incremental distributable cash flow.
Depending on the structure of the transaction and the subject business under valuation in a PPA exercise, the fair value of any associated IDRs may also have to be determined. The optionality associated with the asymmetrical payoff due to the waterfall structure of the IDRs necessitates the use of complex, option-based valuation techniques, including Monte Carlo simulation.
As is the case with all PPA valuation analyses, a careful analysis should be made to identify and differentiate between market-participant and buyer-specific synergies. Besides the usual elimination of the redundant headcount, synergies in the midstream space are frequently due to the combination of the unique footprints of acquirer and acquiree assets. However, if, for example, the potential incremental volumes on the combined system are due to the acquirer’s unique ability to connect to an interstate pipeline or a regional interconnection point, then this could be considered a buyer-specific synergy that cannot be included in the valuation analyses for the identifiable assets. The value of such synergies may be captured in goodwill.
Other typical identifiable assets in midstream PPA valuations are storage facilities, rights of way (ROW) assets related to the real estate on which the pipelines are laid, and personal property, consisting primarily of pipelines, gas processing, and fractionating facilities.
Personal property assets typically tend to have long lives, and the pipelines can have remaining useful lives of up to 40-50 years. However, in performing a PPA valuation, one must analyze the expected remaining lives of the underlying oil and gas reserves that support the pipeline assets. As oil and gas reserves deplete and have a declining curve, if additional reserves supporting the pipeline system are not identifiable or economically practical, the remaining economic life of the personal property assets may be lower than the implied useful life, which is longer, resulting in potential economic obsolescence that must be considered in a valuation exercise.
Valuation professionals with real estate appraisal expertise typically perform the valuation of ROW assets. ROW assets are valued under a Market Approach whereby comparable transactions in that specific geographic area are analyzed in order to determine the value of such assets. In highly active oil and gas basins such as the Permian Basin in West Texas, where currently there is significant activity and a shortage of pipeline/transportation options, there is significant new pipeline construction, resulting in higher demand for ROW assets. One must appropriately analyze upstream activity and the corresponding market demand for transportation assets when analyzing the market-based values of ROW assets.
Presented in Figure 1 is the allocation of acquired assets for some recent transactions in the midstream industry. As can be observed, goodwill is not significant, as most of the purchase price can be attributed to identifiable assets. While facts and circumstances can vary across transactions, one would typically not expect to see other identifiable intangible assets (like trade names, technology, and non-competition agreements) for midstream companies.
The oil and gas midstream industry is expected to continue to see heightened transaction activity. In addition to consolidation activity involving strategic parties, private equity capital is a significant investor in this segment, with such investors eventually looking for an exit. PPA valuations for financial reporting and tax purposes are an important and required exercise in such transactions, and appropriately considering the unique characteristics and underlying assets for each transaction is important in eventually ascertaining the values for such assets.