Capital markets are reopening for US infrastructure assets, and midstream gas assets are leading the way. Oil and gas pipelines, liquefied natural gas terminals and gas storage facilities provided the means by which 144A and institutional loan markets recovered after the Enron collapse. As in 2002, when gas infrastructure operators rushed to meet demand in the southeastern US and California, changes in demand and supply patterns are spurring a new wave of development. Newly-discovered shale gas formations, and rapid improvements in drilling technology, have led to increased production.

The MLP meltdown

One big factor has changed – the drastic decline in the master limited partnership market – and this has had some profound effects on how pipeline operators finance themselves. An MLP is a tax-advantaged means by which investors can gain exposure to resources production and transportation assets. Their limited partnership units are traded and they must distribute the bulk of their cashflow to unit-holders, but MLPs do not pay tax, and can pass through depreciation benefits to investors.

MLPs emerged from the credit crunch in bad shape. Their mandate to distribute cash made them poor project equity sponsors, and many used revolving credit facilities to buy or build assets, in the hope that this debt could be refinanced either with the issue of long-term debt or additional partnership units. Both links in the chain – bank finance and unit issues – broke down at once.

"The master limited partnership market has corrected," says Matt Harris, a partner at Global Infrastructure Partners (GIP). "Some large institutions that had come to the market late – most importantly hedge funds – pulled back from the market, which created a liquidity crunch. A lot of partnerships relied upon ready access to debt and equity to meet promises to their limited partners, especially in terms of distributions. A lot of them were extremely highly leveraged. And when oil, gas and liquids prices headed down, a lot of them encountered difficulties."

MLPs proved to be somewhat inflexible vehicles for project development, and will probably return to being more modestly-leveraged vehicles. "The days of MLPs taking on excessive commodity risk are probably over. The business will move back to being predominantly services- and fee-based," says GIP's Harris. "Until recently there were maybe five to seven MLPs that could still raise debt, though the smaller ones have, of late, had much more success in debt markets," says one banker focusing on capital markets issues.

Funds flood in

Into the gap created by the MLP implosion have stepped other equity providers. Harris' GIP is one of the more recent entrants, an infrastructure fund staffed in part by former bankers at Credit Suisse and GE Capital. In September, GIP formed a joint venture with Chesapeake Energy to buy Chesapeake's gas gathering assets, paying $588 million for a 50% stake in Chesapeake Midstream Partners. In July it put together a more complex deal to provide equity funding for El Paso's proposed Ruby pipeline.

The deal is structured, at least initially, as a debt financing, though mostly to protect GIP from the risks attached to pipeline development. It consists of a $405 million secured note, which would convert to convertible preferred equity in the project post financial close, a $145 million preferred equity interest in El Paso's Cheyenne Plains pipeline, which would become Ruby convertible preferred equity when the pipeline is complete, and a $150 million contingent commitment, if El Paso cannot close a construction financing.

The financing is not an attempt by GIP to replace the project finance market. In fact, GIP's prospects of a solid return will be much higher if El Paso can put together a project financing for Ruby, a 1,086km 1.5 billion cubic feet per day pipeline running from southern Oregon into south-western Wyoming. The debt is priced at 7%, and the preferred equity at 13%, and after completion, GIP will have a 50% stake in the pipeline. The package allows El Paso, whose credit quality is still recovering from its merchant adventures earlier in the decade, to convince lenders it has the resources to go ahead. El Paso, at Ba3, has the lowest rating of any pipeline operator, according to a recent Moody's report.

GIP was not the first infrastructure fund to plunge into the sector. Alinda, staffed by former Citigroup project finance bankers, owns SourceGas, a gas distributor with substantial pipeline interests, including the Rocky Mountain pipeline. In May 2009 it paid $526 million, funded with equity, for a 50% interest in the general partner of the Haynesville pipeline. Regency Energy Partners, which used the cash to expand the project, contributed the existing project, worth $400 million, for a 35% stake, while GE Energy Financial Services, contributed $126.5 million for 12%.

It is very early in their involvement to make solid predictions about the long-term impact of infrastructure funds and financial investors on the midstream gas industry. Moody's rates Alinda's SourceGas, El Paso, which brought in GIP on Ruby, and Knight Inc, which owns the general partner of Kinder Morgan Energy Partners, and was the subject of a private-equity-funded management buyout, all below investment grade. Some observers are not convinced that financial sponsors are going to become a major and permanent feature of the market. "These funds all have a point at which they will try and exit their investments, and we assume that their involvement has a finite time horizon," says Mihoko Manabe, an analyst at Moody's. MLPs like Kinder Morgan are adamant that their low-tax regime provides the best holding structure for pipeline assets in the long term.

Building on the margin

But the capital demands on pipeline developers can be hefty. Many projects have come in heavily over budget, and while there are indications that construction costs are falling back. The Pipeline and Hazardous Materials Safety Administration, an agency of the US Department of Transportation, recently introduced tougher regulations for pipeline integrity, which can limit the pressures at which pipelines operate and reduce the capacity that the owners can make available to shippers.

The next wave of pipeline construction is likely to feature a much more varied set of shippers. Moody's Manabe broadly divides pipeline construction spurts into pre-2009 and post-2009 booms, with the construction from the last four years concentrated around gas from the Rockies and Barnett Shale, and designed to serve larger shippers, and that of the next four years concentrated around Haynesville and Marcellus shale reserves and designed to serve smaller producers. The next four years are also likely to see a larger number of pipelines driven by demand from end-users, says Manabe, although few of these customers, mostly power generators and retail gas distributors, are likely to want to sign up for long-term ship-or-pay agreements.

Pipelines nearer to newer reserves are likely to be shorter, more dependent on smaller producers, and designed to connect to larger interstate pipelines. Even if they are contracted, they may not be contracts that are strong enough to appeal to project banks or the bond market. Several producers suffered during the recent spell of low commodity prices, even as technological advances allowed them to reach harder-to-drill shale reserves more cheaply.

Shale proved to be much more lucrative for bankers financing gas infrastructure than for those financing upstream producers. Volumes have been strong, though pricing has been highly variable. Some of the traditional measurements that are applied to upstream gas need some adjustment. "Analysts, both on the equity side and at the ratings agencies were concentrating on rig count, without noticing that the latest generation of rigs is much more versatile and productive," noted one oil and gas banker based in New York. "Recent declines in rig numbers did not, despite what many analysts predicted, lead to decreases in production anywhere like their predictions."

"I think the place to be right now is in natural gas gathering," adds the banker. "You get access to the liquids, which are incredibly valuable, because they're being sold into markets where oil sets the price. You're sitting on a big basis differential." Chesapeake's deal with GIP is designed to exploit this investor enthusiasm.

Some operators, however, are trying to reduce their dependence on the potential price volatility. Targa Resources is selling its downstream business to its master limited partnership, Targa Resources Partners, to which it had already spun off many of its gas-gathering assets. The MLP is paying $530 million, of which $397.5 million is cash, and will be used to pay down Targa's corporate debt, and the rest is the MLP's partnership units. The use of an MLP as owner of these assets might look perverse, though Targa's high levels of leverage and low rating made a sale to the MLP necessary.

Bonds back on

But the bond market offers the most attractive terms to pipeline operators, part of a $1 trillion in corporate bond issuance that has taken place so far in 2009. "I thought there was a role for banks in financing at least gas gathering assets. After seeing how the market's digested pipeline issuance, I'm not so sure now," said one project finance lender.

One of the keenest-priced deals to date was the Southeast Supply Header refinancing, which Deutsche, Barclays and RBS closed for Spectra Energy and Centerpoint on 13 August. The pipeline issued $375 million of five-year senior unsecured bonds at a coupon of 4.85%, or 212bp over the five-year treasury, benefitting from low leverage and the sponsors' unwillingness to pay a premium for ten-year money.

SESH runs 440km from Louisiana to Alabama, connecting with the Carthage-Perryville and CenterPoint Energy Gas Transmission pipelines in the west and the Gulfstream pipeline in the east. The shippers on the line are primarily utilities based in Florida, which are looking to reduce their dependence on offshore infrastructure that has proved vulnerable to extreme weather events. The shippers' high ratings, as well as, perversely, cost overruns that sucked in sponsor equity and make the project look less levered allowed the bonds to reach a pricing low.

Other issuers have not been as fortunate. In May the Maritimes & Northeast pipeline, which recently completed a $1.2 billion expansion designed to serve LNG infrastructure in eastern Canada, priced a $535 million private placement that is believed to have been 200bp wider than SESH, through Credit Suisse and Bank of America. Martimes, like SESH, was delayed a little by the crunch, and Maritimes tried in January, without success, to access the 144A market. The project's sponsors are Emera, ExxonMobil and Spectra Energy, while the main shipper for the expansion is Repsol, which controls the capacity of the Canaport LNG terminal.

In mid-September, Midcontinent Express, which has, in Kinder Morgan Energy Partners and Energy Transfer Partners, strongly-rated MLP parents, issued $350 million in five-year bonds at 5.45%, and $450 million in ten-year notes at 7.6%. Alongside BBB ratings from S&P and Fitch, Moody's rated the bonds at Ba1, based in large part on Chesapeake owning 47% of the project's capacity, and the split rating meant that the pipeline had to be marketed in different ways to different types of investors by Deutsche, Morgan Stanley and RBS. Nevertheless, the deal ended up oversubscribed and attracted 50 investors, notes a source close to the underwriters.

Next up is a roughly $500 million financing for FPL's Pipeline Funding Company, to be led by Credit Suisse. The bond issue is designed to replace a loan from FPL to Citrus Corp, which used the proceeds to fund the 777km phase VIII expansion of the Florida Gas Transmission Pipeline. The loan cannot be prepaid, so the issue essentially shifts the risk of the loan from FPL's balance sheet to bond investors. The 20-year issue has a preliminary rating of Baa2/BBB- (Moody's/S&P).

New steel

These expansions, as well as new projects designed to serve smaller producers, could strain the balance sheets of even the larger pipeline companies. In this context, Moody's warning about the financial burden of the next generation of projects is timely. Operators will probably listen. "The pipeline operators are acutely aware that having an investment grade rating, and then losing it, is a kiss of death," says the project finance banker active in the industry.

Carving out new pipeline sections and financing them on a non-recourse basis, if it mollifies the agencies, is one way project lenders could carve out a role. "We went through a significant period when project debt, like everything, was much harder to come by. Lenders now will be more focused on risks and pricing is going to be tougher. But I definitely think there will be role for them on high-quality projects, and there are signs that things are starting to recover," says GIP's Harris.

The final promising area for operators is building new pipeline capacity to transport gas liquids to refiners and chemical companies in the Midwest and northeastern US. These liquid fractions tend to be produced at Middle Eastern facilities, and are produced using oil, but command sufficient premiums to be valuable. Lenders and sponsors will be wary, however. The last import-led infrastructure boom – LNG – has yet to pay off.

But another boom – in gas storage facilities – proved to be very profitable. "We looked at a few gas storage projects during the boom, but felt that the market was overbuilt," says one financial sponsor active in the market. "We were probably wrong. When prices plunged, storage operators made very healthy returns as owners of gas stocks looked to hold them in storage."