30 June 2020
Water midstream model challenged by oil price downturn
Pressures brought on by the 2020 oil price crash have hampered water management market growth and raised questions about core tenets of the water midstream model.
Merger and acquisition (M&A) activity in the water management space in the first half of 2020 was muted compared to that of the same period last year. Asset valuations are expected to continue falling as the oil & gas industry struggles to rebalance, dimming the M&A outlook for the rest of the year and potentially into 2021.
In May, WaterBridge Resources and Centennial Resources parted ways on a deal that would have seen the water midstream company pay $225 million for some of the Permian Basin operator’s water infrastructure and a 15-year produced water acreage dedication. Industry analysts say the recent oil price downturn derailed the arrangement.
As with many water asset transactions over the past year, the Centennial-WaterBridge deal was priced for expected volume growth. With shale operators pulling back on drilling programs in 2020, the valuation expectation could have fallen by at least 25-30%, water expert Gabriel Collins told WiO.
“If the deal just busted as opposed to closing at a lower price, that suggests that the repricing of the asset was very significant and it left a gulf so wide that the parties could not negotiate the construction of a bridge over it,” he explained.
Long-term contracts with blue-chip operators have been highly coveted among water midstream companies, which have boasted about the financial security and operational stability they provide. However, the downturn is now challenging some of those assumptions.
“You can purchase your spreadsheet model assumption of a volume, but if operators decide not to drill at that level, whether it's due to commodity prices or tighter expectations being placed on them by Wall Street, you can't make them produce those volumes,” Collins said, explaining why valuations are coming down.
Water services providers can sue operators, but Collins believes some operators may be able to legitimately declare force majeure for some period, especially given that government-ordered lockdowns in response to COVID-19 contributed to reduced oil demand, pushing prices down.
Moreover, pursuing legal action could damage valuable business relationships, Paola Perez Pena, principal research analyst at IHS Markit, told WiO. Instead, some water companies are expected to renegotiate fees and other contract terms with clients to ensure they can keep as much volume as possible in their systems to remain competitive.
“Those that have more of a strong presence in the market, meaning they have a lot of infrastructure in place and [contracts with] multiple operators are being less flexible and trying to keep those contracts in place during this current market situation,” Perez said.
The downturn has also forced the private equity groups that have invested billions in the water midstream sector to adjust their expectations of how soon they can monetize assets and at what price. Firms will either have to sit on assets until the price environment improves or offer significant discounts to maintain their timelines.
“In the next three to four quarters, you're probably going to see not only lower prices, but it's going to take [investors] a while to emerge from their foxholes and be willing to really put capital at risk again,” Collins said. He added that investors with capital might spring for deals where the economics have become more favorable in light of recent market developments.
Any operator-owned water asset sales that do go through will also likely be driven by factors other than an opportunity to refocus spending on core exploration & production activities. The operators that can are expected to wait out the depressed market so they can fetch a better price for their assets, while struggling producers that need fast cash to plug balance sheet holes will have to accept much lower bids.
“We've seen snippets of that, but I think that theme is likely to be laid bare in 2020 and early 2021 in a much starker fashion than we've seen so far,” Collins told WiO. He added that operators selling at lower prices may increasingly seek to recover value by structuring deals to include equity stakes in purchasers, just as Concho Resources did last July with Solaris Water Midstream.
The M&A market is also anticipated to remain restrained as it concerns deals among water services providers. Many companies in this space have been hit hard by the activity downturn. Perez said that IHS estimates that the market for pre-fracturing water services will shrink by 50% and that the market for post-fracturing services will decline by 25-30%.
The larger players facing financial troubles are likely to undergo restructuring before selloffs, but there may eventually be scope for smaller, distressed firms to be acquired if financiers are supportive and amenable to the terms.
“I think the deal window is not really open yet. […] If oil prices stay in the current range or go down again if there’s a resurgence of Corona, then my guess would be that it would really kick off probably four to five months from now,” Collins concluded.