Energy infrastructure is differentiated from other energy subsectors by its long-term, fee-based contracts, which typically include protections for the midstream service provider and annual adjustments for inflation. These long-term contracts provide cash flow visibility and stability, which support attractive dividends from many midstream companies. But, how long is long-term? Do contract lengths vary by asset type? How do companies manage risk around their contract maturities? Leveraging company commentary, today’s note provides an overview of midstream contracts. For those that prefer video, a recent 30-minute LiveCast a discussion of midstream contracts and complements the content of this note.
Long-term contracts provide visibility to cash flows and support project returns.
Long-term contracts are a fixture of the energy infrastructure space. Midstream contracts often include minimum volume commitments or take-or-pay features to ensure that the midstream provider is paid even if the customer has a change of plans. These contract features were particularly important in 2020 and supported stable cash flows for midstream despite a challenging market environment (see related research below).
Understandably, companies require visibility to cash flows and returns in order to proceed with constructing new infrastructure, particularly more expensive projects like a large pipeline. Customers sign long-term agreements for capacity, and construction proceeds when a sufficient portion of the pipeline’s capacity (85-100%) is contracted. Similarly, building a new natural gas processing plant or developing an export facility will be supported by long-term customer commitments before construction proceeds. Contracts that justify construction of new assets may have a longer term to ensure an adequate return on investment for the midstream service provider relative to a new contract for existing infrastructure.
Contract tenures vary by company and asset type. Typically, the more expensive the infrastructure is to build, the longer the related contracts. Accordingly, storage contracts tend to be shorter in nature (~3 years) while pipeline contracts tend to be upwards of a decade. Gathering and processing (G&P) contracts can vary from a couple years to the expected life of the producing area, which could be more than 10 years. To be clear, these are generalizations. Some companies have storage contracts that are more than ten years in length, because the storage is critical for the operation of a refinery, for example.
Contract terms will vary by asset and by company, and investors can often glean more detail from digging into company materials.
Contracts related to liquefied natural gas exports tend to be even longer.
Contracts related to liquefied natural gas (LNG) export facilities tend to be 20+ years for both purchase agreements from the LNG facility and for the pipelines supplying the facility with natural gas. For example, Cheniere (LNG) disclosed in its latest annual report that its agreements had a weighted average remaining life of 17 years at the end of 2021. TC Energy’s (TRP CN) Coastal GasLink pipeline, which will supply the LNG Canada facility in British Columbia, has a 25-year contract. Long-term contracts are necessary for securing the financing required to build these multi-billion-dollar export facilities.
What happens when long-term contracts expire?
Eventually, long-term contracts expire, and the customer can choose to renew, negotiate a new agreement, or walk away. Midstream companies will typically stagger their contract maturities for different assets, and even on a single pipeline, different customers likely have different contract tenures. This helps mitigate recontracting risk, which is the risk that a midstream provider will not be able to secure an agreement with similar terms and rates when an existing contract expires. While companies actively manage recontracting risk by staggering contract expirations, diversified midstream exposure from an exchange-traded product or mutual fund, for example, largely mitigates recontracting risk. At the asset level, recontracting risk will vary based on customers’ alternatives and other factors. For example, a pipeline that supplies an individual refinery or moves the gasoline or diesel from a refinery to end markets probably has little competition from another pipeline and little recontracting risk.
What have companies said about their contract tenures?
Company disclosures around contracts vary, but annual reports and investor presentations tend to provide some color. Some companies give detail by asset, while others provide contract tenures by business line. To give some examples, Crestwood Equity Partners (CEQP) noted in its annual report the weighted average remaining life of its natural gas and crude gathering contracts were 9 years and 8 years, respectively, as of year-end 2021. In its annual report, Magellan Midstream Partners (MMP) provided the weighted average remaining life for contracts on its Longhorn, BridgeTex, and Saddlehorn pipelines, which ranged from four to six years at the end of 2021. For Holly Energy Partners (HEP), contracts their parent HF Sinclair (DINO) tend to be for 10-15 years, and their weighted-average remaining contract duration is six years. In its January 2022 investor day presentation, Kinder Morgan (KMI) provided a comprehensive overview of its contracts by business segment as shown below.
