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1 The U.S. Midstream Sector in Transition: Outlook and Implications Presented to The Canadian Institute’s 6 th Annual Conference: Midstream 2003 November.

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Presentation on theme: "1 The U.S. Midstream Sector in Transition: Outlook and Implications Presented to The Canadian Institute’s 6 th Annual Conference: Midstream 2003 November."— Presentation transcript:

1 1 The U.S. Midstream Sector in Transition: Outlook and Implications Presented to The Canadian Institute’s 6 th Annual Conference: Midstream 2003 November 25, 2003 Peter Fasullo En*Vantage, Inc. Houston, Texas

2 2 The U.S. Midstream Sector Is Undergoing a Transformation  Fundamental changes - upstream and downstream.  Excess capacity across most of the Sector’s value chain.  Independents* struggling to reduce margin volatility.  Tight credit hampering many Diversified Energy companies.  Major Integrated Oils reassessing if Midstream is core.  Assets being sold and new players entering the sector. * Independents: Midstream Companies who primarily serve 3rd Parties

3 3 Major Major Questions  Can U.S. Independent Midstream entities prosper?  How will relationships change between Midstream players and their customers, upstream and downstream?  What will be the factors for success?  Will a new and improved business model emerge for the U.S. Midstream Sector?  Will changes in the U.S. impact the Canadian Midstream Sector and how?

4 4 Topics to Be Covered  Broad Overview of the U.S. Midstream Sector  Structural History & Evolution  Current Players and Their Strategic Positions  Major Issues & Challenges  Factors for Success  Ideal Business Model and Future Ownership  Implications for the Canadian Midstream Sector

5 5 U.S. Midstream Sector: Broad Overview U.S. Midstream Sector: Broad Overview

6 6 The Midstream Sector is a collection of assets & services that help bridge the supply side of the value chain with the demand side for any type of energy commodity. As such… The Midstream Sector is only as strong as the linkages it has with energy producers and end users. Simple Definition Midstream

7 7 Typically U.S. Midstream Functions Are Considered Assets, Such As: Typically U.S. Midstream Functions Are Considered Deregulated Assets, Such As: Gas Gathering, Treating & Processing Gas Pipelines (Primarily Intrastate) Product Pipelines Fractionation Gas & Product Storage Inland Product Terminals Import/Export Facilities Presentation focuses mainly on the gathering, processing and downstream NGL functions.

8 8 The Sector Is Where the E&P, Gas, Refining and Intersect The Midstream Sector Is Where the E&P, Gas, Refining and Petrochemical Industries Intersect Downstream Petrochemicals Refining Propane Retailing Gas Retailing Power Retailing Power Distribution Gas Distribution Independent Power Generation Gas Storage Gas Transportation Gathering Exploration & Production Processing & Treating NGL Transportation NGL Storage Fractionation Midstream Upstream There are no distinct ownership borders Subject to challenges outside of its control

9 WCSB Rocky Mountains San Juan Permian Anadarko Arkhoma South Texas Gulf Coast & Offshore Major Processing Regions NGL Market Centers (Storage, Fractionation, Pipelines) NGL Product Flows Specific Transportation Corridors Link Major Processing Regions to NGL Market Centers NGL Flow Diagram River Conway Sarnia Mt. Belvieu Edmonton/ Ft. Saskatchewan

10 10 U.S. NGL Midstream Industry Highlights o U.S. Midstream/NGL sector is a $15 to $20 billion a year business, but pales in comparison to Power & Gas: 4 Electricity: $200 billion/year plus 4 Gas Transportation: $50 billion/year plus 4 NGL Transportation/Fractionation: $3 to $5 billion/year o Total U.S. NGL supplies (production and imports) are slightly below 3 million barrels per day (bpd): 4 Gas Processing -- 1.90 million bpd (68% market share) (Product Mix: Ethane 37%, Propane 29%, Butanes 18%, N. Gaso 16%) 4 Refinery Production -- 0.68 million bpd (24% market share) 4 Imports -- 0.23 million bpd (8% market share)

11 11 NGL Midstream Industry Highlights (Cont.) oUS NGL production from processing distributed within the major hydrocarbon basins in the country: 4Gulf Coast --- 24%. 4W.Texas/ Rocky Mtn. --- 53%. 4Mid-Continent --- 13%. 4Other --- 10%. oMajority of NGLs consumed along the Gulf Coast: 4Petrochemicals -- 56% of total NGL demand; 92% along G.C. 4Gasoline Production -- 15% of total NGL demand; 45% along G.C. 4Fuel Uses -- 29% of total NGL demand; SE, Mid-Cont., NE. ~ 590 processing plants - 72 BCFD cap. 56% of plant capacity is cryogenic 70 fractionators - 2.0 million BPD cap. 85 % of frac capacity is centralized at market centers

12 12 U.S. NGL Prices Are Set in Competition With Other Hydrocarbon Products in the Market NGL Primary Market(s) Competing Products Secondary Market(s) Competing Products Supply Regions Ethane Ethylene Propane N-Butane Naphtha Gas Oils Retained in Natural Gas Residual Fuel No 2 Fuel Oil Propane North America Propane Ethylene Ethane N-Butane Naphtha Gas Oils Space Heating Natural Gas No 2 Fuel OilGlobal N-Butane Gasoline I-Butane Other Gasoline Blendstocks Ethylene Other Ethylene Feedstocks Global I-Butane Alkylate MTBE Other Gasoline Blendstocks PetrochemicalsGlobal Natural Gasoline Other Gasoline Blendstocks Ethylene Other Ethylene Feedstocks Global

13 13 U.S. Midstream Sector: Evolution & Current Structure

14 14 Evolution of U.S. Midstream Sector Time PeriodRationaleComments Pre-’70s Major Oil Cos. Interstate Pipelines Petrochemical Cos. Main purpose of Midstream was to:  Bring equity production to market  Secure supplies & grow rate base  Secure fuel & feedstock supplies Utility Function Not geared for 3 rd parties Unwillingness to sell or rationalize assets The ‘80s Emergence of Independents Set up to be:  Profit driven, discretionary business  Serving 3 rd parties in major producing regions and/or market centers Price Deregulation of Gas Gas “Bubble” NGL Demand Growth Margin & Price Volatility Customer Relations Early/Mid ‘90s Independents Expand Driven to:  Achieve greater Scope & Scale  Acquire non-core midstream assets of E&Ps and Interstates Margins Expand Competition Increases Volatility Intensifies

15 15 Evolution of U.S. Midstream Sector (2) Time PeriodRationaleComments Mid/Late ‘90s “Feeding Frenzy” Independents acquired by: Energy Merchants Regulated Utilities M&A driven by need for:  Scope & scale in supply and/or market regions  Customer diversity  More products & services  Marketing & trading platforms  Higher returns Many midstream assets bought at: Peak earnings cycle EBITDA multiples of 10 times or more. - Single digit returns - Vulnerable to downturns By 2000/2001 Some recent acquirers admit failure and exit. Quick turnover of assets:  Failure to recognize and hedge risks  Inability to generate synergies  Deteriorating fundamentals  Tighter gas market & margins Many midstream assets sold at: Bottom of earnings cycle EBITDA multiples of 5 to 8 times

16 16 Evolution of U.S. Midstream Sector (3) Time PeriodRationaleComments Since 2000 MLPs greatly increase presence in Midstream - Independent MLPs - MLPs spun off from Diversified Energies Acquiring “fix fee” assets (pipelines, fractionators, storage and terminals) from:  Corporate Parents  Majors  Distressed Energy Merchants Net income taxed at shareholder level only. MLPs yield 6% -8% distributions with annual growth of 5% -10%. Sanctity of distribution very important. Currently New Entrants - Private Equity Funds Taking advantage of distressed sales:  Buy low and exit in 5 to 7 years achieving returns of 20% or more.  IPO assets into MLP. Not clear if they have a growth plan. Will they repeat the mistakes of previous acquirers?

17 17 1. DEFS* ---------------- 2. BP --------------------- 3. El Paso --------------- 4. Williams -------------- 5. ExxonMobil ---------- 6. Enterprise ------------ 7. ONEOK --------------- 8. ConocoPhillips** ---- 9. Devon ----------------- 10. Dynegy --------------- p Total Prod. ----------- p % of US NGLs - Top 5 p % of US NGLs - Top 10 1. GPM (Phillips) ------- 2. Amoco ----------------- 3. Texaco ---------------- 4. Enron ------------------ 5. Warren ---------------- 6. Valero------------------ 7. Conoco----------------- 8. Exxon ------------------ 9. Arco -------------------- 10. Shell -------------------- o Total Prod. - - - - - - - o % of US NGLs - Top 5 o % of US NGLs - Top 10 Top 10 U.S. Gas Processing Operators (In terms of NGL Production in MBPD) 1992 157 94 85 84 82 64 61 59 814 30% 49% 2001 396 199 158 121 120 75 74 66 62 59 1330 54% 72% * DEFS - Duke Energy Field Services ** ConocoPhillips owns ~ 30% of DEFS Source: Gas Processors Report

18 18 Current Top Players of the U.S. NGL Value Chain (Ranked According to Operating Position in 2001) Current Top Players of the U.S. NGL Value Chain (Ranked According to Operating Position in 2001) Gas Processing 1. DEFS* 2. BP 3. El Paso 4. Williams 5. ExxonMobil 6. Enterprise* 7. ONEOK 8. ConocoPhillips 9. Devon 10. Dynegy* Fractionation Koch Enterprise* ConocoPhillips Dynegy* Gulfterra ExxonMobil BP ONEOK DEFS* Williams Salt Dome Storage Enterprise* TEPPCO Dow Dynegy* Williams ConocoPhillips BP ExxonMobil Gulfterra ONEOK Product Distribution Enterprise* Dow ConocoPhillips TEPPCO Koch KinderMorgan ChevronTexaco Dynegy* Gulfterra ExxonMobil Raw Mix Pipelines Enterprise* TEPPCO Koch ChevronTexaco Dynegy* BP Gufterra ExxonMobil ConocoPhillips Waterborne Terminals Enterprise* Dynegy* Dow ChevronTexaco Trammo Publicly Traded MLPs Major Integrated Oils and Large E&P Companies Diversified Energy Companies * In Joint Venture or has Business Alliance with a Major

19 19 Majors and Large E&P Companies. – Focusing on E&P: offshore and international. – For many, Midstream is no longer core. Energy Merchants or Diversified Energies. – Repairing balance sheets in many instances. – In some cases, selling midstream assets; or, – Completing transfer of assets to their MLP. Large Independents (MLPs, Joint Venture Companies). – A few are actively growing their midstream business. – Some have business alliances with producers and customers. – However, most MLPs are risk adverse & avoiding processing. Small Independents... niche players. – Filling regional gaps created by the exit of larger players. – Many, being funded by Private Equity Funds. Despite Recent M&A Activities, Sector Remains Fragmented

20 20 U.S. Midstream Sector: Realities, Issues & Challenges

21 21 Current Realities & Issues  Price & Margin Volatility  High Priced Gas Environment  A Maturing Gas Resource Base  A Sluggish Petrochemical Industry  MTBE Phase Out  Excess Capacity Not Unique Not Entirely Mutually Exclusive Cause & Effect Not all participants affected equally

22 22 “Frac Spread” Volatile and Trending Downward

23 23 Fundamental Shift is occurring in North American Gas Markets Jan-02Jan-03 “Gas Bubble “ Early ‘80s to Early ‘90s “” Bursting of the Bubble” Late ‘90s to Now

24 24 On the Supply Side...A Structural Change Could Be Underway: Lower 48 basins are maturing with the exception of Gulf of Mexico and the Rockies. Drilling needs to accelerate to offset natural declines from conventional sources. Majors focusing on international prospects, unconventional plays & deep water GOM. Many producers less optimistic about accessing new & additional U.S. sources. Many producers limited by leveraged balance sheets.

25 25 Natural Gas Consumption: Electric Generation versus Industrial 2.00 3.00 4.00 5.00 6.00 7.00 8.00 19861988199019921994199619982000 Gas Consumption (TCF/Year) Repeal of the Fuel Use Act Source: EIA Electric Generation Industrial On the Demand Side...Industrials must compete with Electric Generation for Natural Gas

26 26 U.S. Midstream Sector Increasingly Dependent on the U.S. Petrochemical Industry US Market Share Demand for NGLs 1974 1984 1994 2002 Petrochemicals 32% 36% 52% 56% Refining 32% 25% 20% 15% Fuel & Other 36% 39% 28% 29% 92% of U.S. ethylene capacity along Gulf Coast Over 75% of that capacity directly accesses Mt. Belvieu. Over 90% of U.S. ethylene capacity connected to U.S. NGL transportation system Almost every ethylene plant accesses salt dome NGL storage

27 27 Ethylene Capacity Market Share 1997 Exxon......... 10.7% Dow............. 9.6% Shell............ 8.9% Phillips......... 8.1% Millennium... 7.2% Union Carb.. 7.0% Lyondell....... 6.8% OxyChem.... 6.5% Chevron....... 5.9% Amoco......... 5.7% Others......... 23.6% 2002 Dow*.............. 21.9% Equistar......... 18.1% ExxonMobil*... 14.4% Chv Phillips*... 12.0% Shell*............... 8.6% Formosa*......... 5.2% BP*.................. 5.1% Huntsman........ 4.0% Others.............10.7% Top 5 Ethylene Producers Control 75% of U.S. Ethylene Capacity 75% 44% * Own & Operate Midstream Assets

28 28 A High Priced Gas Environment Could Force the Ethylene Industry to Minimize Ethane Cracking. Feedstock Flexibility of US Ethylene Industry (MBPD) 44.5% 18.6% 46.5% NA 350 250 150 275 150 875* 450 150 675 230 525* 200 0 350 80  Ethane  Propane  N-Butane  Nat’l Gaso/ Naphtha's  Gas Oils Swing Vol. as % of US Supply Swing Volumes Max Demand Base Demand Feedstock 44% 19% 46% NA 350 250 150 275 150 825 450 150 675 230 475 200 0 350 80 Ethane Propane N- Butane Nat’l Gaso/ Naphtha's Gas Oils Swing Vol. as % of US Supply Swing Volumes Maximum Demand Minimum Demand Feedstock

29 29

30 30 U.S. Phase Out of MTBE Will Negatively Impact U.S. Midstream. Reduces need for butanes from US processors by 15% or about 50 MBPD. Shuts down discretionary butane isomerization units. Forces N-Butane into Petrochemical Feedstock Market. – Puts more competitive pressure on ethane. Impact can be mitigated with rapid conversion of world-. scale MTBE units to Alkylate or Iso-Octane. – Chances are unlikely rapid conversion will occur due to permitting problems and uncertainty of returns. – Some units being permanently dismantled or put into “deep sleep”.

31 31 Average Utilization Rate of U.S. Gas Processors at Very Low Levels Oil & Gas Journal

32 32 U.S. Has Surplus Ethane Extraction Capability Observations ~ 200 MBPD of ethane has been rejected in 2003. For the past 20 years, US Processors built cryogenic plants to maximize ethane extraction. Most processing plants lack de-ethanization capabilities, making ethane rejection inefficient. Surplus ethane extraction also implies that NGL downstream assets are under utilized.

33 33 In Summary: Upstream and Downstream Fundamentals Squeezing U.S. Midstream High Priced Gas Market U.S. Midstream Reduced NGL Demand Reduces Margins and Volumes Throughout the Value Chain

34 34 U.S. Midstream Sector: Factors for Success

35 35 The Convergence of a Number of Issues Is Challenging Midstream Participants To: Gain a Greater Understanding of Market Dynamics Adjust to Low Margins Across the NGL Value Chain Minimize Processing Risks & Margin Volatility Rationalize Underused Capacity Achieve Economies of Scale & Scope Lower Operating Costs Upgrade Plants to Reinject Ethane Improve Access to Upstream & Downstream Drivers Repair Balance Sheets, in some cases

36 36 Gas Aggregation Gas Processing NGL Transport NGL Fractionation NGL Storage NGL Marketing Key: Identify and Manage Profit Drivers & Risk Factors Along the Value Chain Drilling Reserve Life Location Gas Quality Gas Prices Power Costs Gov’t Regs Competition Counter Party Risks NGL Prices Gas Pipeline Specs Residue Gas & NGL Takeaway Capacity Price Liquidity Market Demand Market Location

37 37 U.S. Producers and Processors Must Recognize a Paradigm Shift Is Occurring. In a “Tight BTU Market” not all of the Liquids Extracted by Processing will always receive a Premium Price to their BTU Value in the Gas Stream. In a High Priced Gas Environment, having Rich Gas may reduce rather than enhance the Value of the Gas Stream.

38 38 Processing Agreements Must Be Retooled to Minimize Risks to Independents High Risk to Processor Low Keep Whole Margin Sharing % of Liquids (POL) % of Proceeds (POP) Economic Election Processing Fee Processor keeps extracted NGLs as fee for processing Must purchase and return to producer merchantable gas to replace fuel & shrinkage Producer and processor share value delta between NGLs and gas, i.e.. 50%/50%. Producer gets 100% of wellhead BTUs Processor paid a % of NGLs as processing fee. Producer keep their % of NGLs in kind or have processor sell NGLs and receive cash. Could have keep whole provisions Processor paid a % of NGLs & gas as processing fee Producer keep their % of NGLs & gas in kind or have processor sell NGLs & gas and receive cash. Could have keep whole provisions Under uneconomic conditions, producers either bypass plant or pay processor a fee. Fee could be POL or POP or cash Producer pays processor a processing or conditioning fee. Fee is market base and could be POL or POP or cash. Low Risk to Producer High

39 39 Gas Aggregation Gas Processing NGL Transport NGL Fractionation NGL Storage NGL Marketing Link & Leverage the Right Assets to Manage Risks and Maximize Value --- Avoid Stranded Assets. Ability to aggregate should exceed processing capacity. Reserve life should exceed the depreciated life of plant. Seek production dedications Network asset groups. Connect to logistics that yield highest netback prices. Diversify NGL supply sources. Secure volume dedications Have connectivity with highest value markets. Have sufficient scale to lower costs and attract customers. Know your competition and customers Recognize NGL markets are shifting. Market liquidity is poor. Counter party risks exist.

40 40 Care Must Be Taken When Forming Midstream Joint Ventures Pros. Joint Ventures can: Increase chances of making a project a reality. Distribute monetary burden and risks. Pool different resources. Diversify sources of supply. Provide opportunity to: – Build Critical Mass. – Achieve Economies of Scale. Cons. The Dark Side: Operator is usually in control. Decision making is more difficult and cumbersome. Conflicts of interest can and often occur. Preference rights can hamper a sale. Often one party wants to exit or buy out the other parties after awhile.

41 41 U.S. Midstream Sector: Business Model & Future Ownership

42 42 Although There Are Challenges, Midstream Opportunities Will Continue. The “Midstream Bridge” must exist because: Gas will continue to be the clean fuel of choice. N. American gas reserves can support demand growth: – LNG bridging supply/demand gaps. – North Slope and MacKenzie Delta potential long-term supply sources. 80% of gas produced will need processing or conditioning. U.S. and Canada have the World’s largest logistics infrastructure to handle NGLs and Gas. Petrochemical and Refining Industries remain the World’s largest, but it is imperative that both stay healthy.

43 43 “Back to the Past” Business risks so great that Midstream Activities, particularly Processing, revert to being functions of the Major Integrated Oil Companies. U.S. Midstream at Critical Juncture Midstream Functions “Back to the Future” Independents effectively manage risks, provide value added services and achieve greater cash flow stability to generate reasonable returns. Midstream Profit Centers ? Question: Who Can Best Manage the Risks and Capture the Opportunities in Midstream? - OR - Business Model Needs to Better Balance Risks & Returns Between Independent and “Customer”

44 44 The U.S. Midstream Sector Needs Diversified, Integrated Independents Across the Energy Value Chain. Currently, just a few US companies devoted to NGL Midstream as a core business. Majors focused on finding and producing Oil & Gas. Petrochemicals have their own issues to resolve. Many Diversified Energies still restructuring balance sheets. Opportunities exist to link complementary and strategic NGL Midstream assets that are in a “holding pattern” by current owners. But it takes vision, desire, capital, and the right approach to profitably grow a midstream business; …..and, the concerted effort of Producers, Midstream Players and End Users to insure that an Independent business model survives.

45 45 The Ideal Midstream Player Will Display the Following Characteristics: Long-term business alliances with upstream and downstream customers. Long-term fee-for-service and/or fixed margin contracts. Ownership in processing in one or more major producing regions. Access to high capacity gas take-away pipelines. Ownership in efficient T&F systems to link NGLs to major market centers and customers. Economies of scale and low cost operations. Ability to make selective, synergistic and accretive acquisitions. Ability to leverage along value chain with incremental deals. Achieve Greater Cash Flow Stability to Compete for a Broader Range of Opportunities

46 46 A Word to the Wise The more involved a company becomes in the U.S. Midstream Sector, the more leveraged its profits will be to the health of the U.S. Petrochemical Industry. A Company with a diversified portfolio of (complementary) midstream activities serving other energy commodities, offers better income stability during times when the Petrochemical Industry is in a downturn.

47 47 More Consolidated U.S. Midstream Sector in the Future Processing sector will be downsized and more efficient: – Number of plants will shrink --- smaller, marginal plants shutdown. – Less emphasis on max Ethane recovery plants (Cryogenic). – More of a fee-based service business rather than a margin based, discretionary one. Value chain ownership will rotate and consolidate: – Majors, E&Ps and Diversified Energies continue divesting non- core assets.... only involved in Midstream to protect franchise operations. – Diversified MLPs to be the most active players --- dominate T&F assets, gradual entry into processing as fee-based business develops. – Small Independents slowly consolidate into existing or new MLPs.

48 48 U.S. Midstream Sector: Implications for Canada U.S. Midstream Sector: Implications for Canada

49 49 In Many Respects, Canadian Midstream Is Better Situated to Handle Challenges Canadian Ethylene Industry lacks the feedstock switching capability of the U.S. industry, it’s mainly captive to ethane. – Competition is not with U.S., but foreign producers of ethylene. Canadian Midstream more dominated by Producers than Independents. Overall, Canadian Midstream is a more fee-based, fixed margin business than its U.S. counterpart. Canadian Processors less dependent on cryogenic plants with the exception of the large straddle plants. There are alternative uses for NGLs that are not found in U.S. – Miscible flooding. – Diluents for heavy crude production and transportation.

50 50 The Transformation of U.S. Midstream Will Have Limited Impact on the Canadian Sector Unlikely to see U.S. companies buying Canadian assets as was the case several years ago. – In fact, companies such as Williams and Dynegy are exiting the Canadian Sector as they repair their balance sheets. – Many rushed in too soon to position for “Northern” gas flowing through Western Canada. – U.S. MLPs are limited in investing in foreign assets. Although similarities with the U.S. exist, Canada must examine the profit drivers and risk factors shaping its Midstream industry and adjust accordingly. Like the U.S., the global competitiveness of the Canadian Petrochemical Industry can dramatically impact Canada’s Midstream Sector.

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