Improving returns on midstream investment in capital projects. kpmg.com

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1 Improving returns on midstream investment in capital projects kpmg.com

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3 Improving returns on midstream investment for capital projects 1 Introduction The boom in U.S. shale oil and gas production over the past decade has resulted in a significant increase in capital expenditure for U.S. midstream oil and gas operators. This has brought its own set of challenges, as more than 68% of operators are currently unable to achieve a positive return on invested capital. KPMG studied a peer group of 36 publicly traded U.S. midstream operators to answer two key questions: How effective are operators in selecting and developing strong projects and new assets? Which operators deliver new projects and assets at a competitive cost? Based on our research, KPMG concluded that challenges experienced by U.S. midstream operators in 2014 are very similar to those experienced in the industry from Industry data suggests that selecting good projects and delivering them at a competitive cost continues to drag down U.S. midstream returns. This is increasingly important as the midstream business is primarily, a fee-based industry where project overruns reduce a projects net present value. In the decade ending in 2004, the average annual capital expenditure across the entire U.S. midstream industry was approximately $2 billion to $2.5 billion. In the period, most of this capital expenditure was maintenance capital and new laterals or other pipeline connections made for natural gas power plant expansions. New projects and asset additions were relatively small. In 2014, more than $38 billion was invested in new asset construction by the 36 operators in KPMG s study alone a staggering amount. Based on KPMG s observation working in the midstream, operators have added many new people into their organizations, but their project delivery strategies, operating models, and investment in organization design have not kept pace with the two main industry challenges identified above. Poor financial results suggest a call to action midstream operators must invest in developing the skills and providing specialized training to their project organizations to meet the challenges. At risk of oversimplification, the same people and project organizations from the last decade are being tasked to deliver today s large and complex projects, and it seems to be not working well. More than 68% of U.S. Midstream Operators are unable to return their Cost of Capital. A call to action more internal investment in the project organization is required to meet industry challenges.

4 2 Improving returns on midstream investment for capital projects Midstream industry highlights KPMG analyzed the performance of 36 peer midstream operators within the U.S. based on 10-K filings with the Securities Exchange Commission along with market data collected by Morningstar, Inc. The analysis measured the effectiveness of the operators financial results ultimately, their cash flow. The analysis focused on long term assets and capital investments to eliminate variances resulting from working capital differences. For an impartial comparison of the peer group, we focused on earnings before interest and taxes (EBIT) to remove any further bias due to the companies borrowing costs. The financial performance highlights of the 36 member peer group, collectively, as of December 31, 2014 are the following: PEER GROUP METRICS $301 Billion Capital Assets in Service $15.4 Billion Net Income $443 Billion Total Long Term Assets $39.1 Billion Capital Expenditures $432 Billion Total Invested Capital 6.2% Peer Group Return on Assets $27.4 Billion Total Earnings before Interest & Taxes 6.4% Peer Group Return on Invested Capital

5 Improving returns on midstream investment for capital projects 3 36 PUBLIC O&G MIDSTREAM PEERS (Based Upon Earnings Before Interest & Taxes) CAPITAL ASSET PERFORMANCE 25 % 20 % 15 % 10 % 5 % 8.84 % 5.48 % 9.10 % 5.60 % Quartile 1 Quartile 2 0 % 3.37 % 3.54 % 1.24 % % Quartile 3-5 % % -10 % -15 % Quartile 1 Quartile 2 Quartile 3 Return on Assets 8.84% 5.48% 3.37% Return on Invested Capital 9.10% 5.60% 3.54% Return on Invested Capital, Less WACC 1.24% -1.30% -5.67% Even after recent declines in oil prices in the last half of 2014, the midstream industry has continued a very aggressive build out of well gathering systems, processing plants, and long-haul transmission pipelines. But, as the charts above demonstrate, the race to develop and install new infrastructure has not been particularly rewarding in terms of the real economic value add for capital invested in the short term. In the longer term, this will likely lead to more asset transactions, as underperforming operators become insolvent. The jury is still out as cash flows ramp up for newly completed assets. The whisker tails in the charts indicate the extreme best and worst performer in the analysis. The performance quartiles show fairly consistent returns on assets and invested capital between the operators with a few having significantly higher returns. Yet, in terms of capital costs, the invested capital of the highest performing quartile returned only 1.24 percent on an EBIT basis after subtracting their weighted average cost of capital (WACC). Only 7 operators out of 36 analyzed had positive returns greater than 2%. The second quartile operators lost 1.3%. Although some adjustment can be made for the impact of market beta on calculating WACC, the real economic results of the peers suggests weak performance.

6 4 Improving returns on midstream investment for capital projects What is the link to project development and delivery? How do these financial metrics apply to our thesis that midstream operators must be good at both selecting projects and delivering them at a competitive cost that does not erode capital? The continued pace of investment raises several questions for investors, management, and their boards of directors: Do current asset management strategies, goals, and decisions result in sustainable shareholder returns? How effectively have midstream operators selected, developed, and delivered capital projects? Are capital investments and projects delivering expected financial returns? How much at risk are operators if their current projects coming on line underperform with lower than expected cash flows? For midstream operators struggling to meet expected financial returns, do they have good assets that might be acquired by other operators on favorable terms? Return on assets and return on invested capital information presents a sufficiently precise proxy to compare each peer and begin to answer these questions. This approach takes into consideration an operators total capabilities to identify and select growth projects that create value (ROA) as well as its capabilities to deliver them in a timely and cost effective manner (ROIC). Plotting each peer operator along both axis provides one relative measure to compare each operator based upon their actual financial outcomes. The chart to the right depicts a comparison of ROA and ROIC where, ROIC is net of each operators WACC. The leading operators stand out from among their peers only 4 operators have returns greater than 5% and 24 operators are negative. Interestingly, the top performers have high quality assets (i.e., selected good projects); but are in a lower quartile in terms of total invested capital (i.e., smaller organizations presumably less complex). Early risk indicators to consider include identifying organizations that are growing rapidly in a resource constrained environment. Each are in this environment. Might these operators continue their strong returns as they continue to expand? Typical midstream benchmarking efforts tend to highlight compression costs per horsepower, pipeline costs per diameter inch, project team headcounts per total installed costs, or similar type measures all important. However, it seems a measure not as subjective should consider the cash flows both the costs and timing to install assets and the revenues received. All of the project management disciplines, when properly used, address the scope and costs, and timing of cash flows to place an asset in service. The financial evaluation disciplines in asset management focus on the timing, volumes, and cash flows locked in during deal development. Return on Assets % 20 % 15 % 10 % 5 % 0 % LEADING MIDSTREAM OIL & GAS PEER OPERATORS ANALYSIS OF CAPITAL ASSET PERFORMANCE Fiscal Year Ended December % -10 % -5 % 5 % -15 % 0 % 10 % 15 % Return on Invested Capital, Net of WACC Source: Computed from SEC 10-K Filings,MorningStar Filtering for the Top 15 largest operators, a deeper storyline is suggested. The operators appear to split into three groupings with one notably weak outlier. Higher costs of capital increase the difficulty in obtaining strong margins as noted comparing at 5.84% for Group A and 8.67% for Group C. Their comparative returns on assets shows significantly weaker performance in Group C at 3.02% indicating assets are not generating sufficient cash flows and margins.

7 Improving returns on midstream investment for capital projects 5 TOP 15 MIDSTREAM OIL & GAS PEER OPERATORS Analysis of CAPITAL ASSET PERFORMANCE Comparison of KEY METRICS BY GROUPING Fiscal Year Ended December 2014 Return on Assets 12 % 10 % 8 % 6 % 4 % C B A 10 % 8 % 6 % 4 % 2 % 0 % -2 % 2 % -4 % 0 % -14 % -12 % -10 % -8 % -6 % -4 % -2 % 0 % 2 % 4 % 6 % Return on Invested Capital, Less WACC -6 % Group A Group B Group C Weighted Average Cost of Capital Return on Assets Return on Invested Capital, Less WACC 5.84% 8.15% 2.79% 6.27% 6.48% 0.39% 8.67% 3.02% -5.60% Source: Computed from SEC 10-K Filings, MorningStar ASSET DEVELOPMENT AND SELECTION (RETURN ON ASSETS) HIGH Superior Development & Selection Poor Planning & Delivery Poor Development & Selection Superior Development & Selection Superior Planning & Delivery Poor Development & Selection Poor Planning & Delivery Superior Planning & Delivery LOW (RETURN ON INVESTED CAPITAL) PROJECT PLANNING AND DELIVERY EFFICIENCY HIGH

8 6 Improving returns on midstream investment for capital projects Ramping up scalable business processes The reference points suggest it is difficult to consistently select and deliver projects as effectively once the operator exceeds $7.5 Billion in total invested capital. KPMG s observations suggests a correlation between the total quantity of active projects and their types in terms of size, complexity, and cost. These result in total work volumes overwhelming the operator s processes. At this point, project teams have insufficient capacity to effectively manage the emerging risks and issues that arise during planning and delivery. In summary, as work volume goes up, effective risk management goes down yielding behind schedule completions and significantly over budget economics. Interestingly, the Top 15 operators account for $33 billion of the $39 billion in new capital assets placed in service by KPMG s peer sample in At the same time, the Top 15 had negative unlevered cash flow of $14 billion, indicating that cash flow from operating assets is insufficient to fund the projects and run the company. Additional debt and equity is required to meet growth targets and fund dividend or unit distributions. This will likely increase stress on already challenged operators in the longer-term.

9 Improving returns on midstream investment for capital projects 7 Based upon the weak performance highlighted in our analysis, we suggest that management consider a data led approach to drive toward high-impact solutions. 1. Assess your project delivery capabilities Project delivery capabilities include project management, organization structures, methods, and tools. This assessment can enable you to deliver projects consistently and preserve the value proposition identified during the project development stage. With capital investment likely to exceed $25-30 billion annually in the next five years, operators must determine if they are able to handle this increased investment. Formal processes are highly correlated to improved project returns 2. Assess the level of integration across your organization and sophistication This includes the methodologies deployed to measure performance across both business development and project delivery to identify actions that improve project selection and provide higher IRR and NPV on pursued projects. This could also include implementing predictive data analytics processes to assess your project portfolio against future economic returns beyond simple IRR and NPV measurements; for example, using cycle times between internal hand-offs and departments that lead to less effective decision-making. 3. Improve your portfolio management Midstream operators should consider enhancing their portfolio management capabilities and taking into consideration how to use high volume rollout and other non-traditional oil and gas industry strategies to optimize the portfolio not just individual projects. Operators should consider asset deployment strategies used outside traditional oil & gas situations. 4. Employ data analytics Companies should perform detailed data analytics to understand which assets are providing value and which are dragging them down. This can help management consider what acquisitions or divestitures might improve their asset mix and economic returns. In addition to asset management, data analysis of process performance and outcomes may provide keen insights into the root causes of a company s weakest links in both its asset management and project delivery activities.

10 8 Improving returns on midstream investment for capital projects Conclusion Many midstream oil and gas companies have operating models and procedures that were designed for maintenance projects, plant upgrades, and relatively short pipeline projects that were prevalent a decade ago. With the boom in shale oil and gas development, the same organizations are now being tasked to deliver large, complex projects in a shorter timeframe and at an increasing volume. These changes put pressure on midstream companies to deliver strong financial results for investors. To find opportunities for improvement, midstream operators may benefit from developing a clear understanding of how project value is created and preserved. By focusing on improving the project development phase, in tandem with strong project delivery processes and controls, companies can find a source of leverage needed to improve shareholder returns.

11 The development phase is critical to delivering project value for new investments Project Value Creation Development PROJECT SANCTION DECISION Construction Project Value Preservation In responding to investor pressure, companies are often faced with the challenge of finding various methods and practices to improve capital project assessment and selection. While there are many different approaches, companies first need a clear understanding of how they create and preserve project value. Managers should understand that once a project is sanctioned and receives Federal Energy Regulatory Commission approval, their company s focus must change from creating value to preserving value. Detailed engineering and construction planning is a value preserving activity. Excessive coordination, hesitation on key decisions, disjointed capture, and failure to use relevant data to focus decision making all lead to late task completion, excessive costs, and inability to meet in-service dates. During development, typical activities include open season, shaping shipper and offtake contracts, performing early engineering to lock the basic data, route selection, and acquiring regulatory permits. Once financial commitments are made to obtain rights-of-way and issue purchase orders for long-lead items, like pipe and equipment, the need for value preservation increases. Not changing scope during engineering and entering full scale construction turns to time management and rework due to quality issues becoming significant drain on the projects economics. The time to complete a development project is a key attribute that most impacts a company s internal rate of return and net present value on its portfolio of investments. Midstream capital projects follow a duration ratio of approximating 6:1 of project development to construction; i.e., a 30-month development period typically requires five months of construction. This implies that a company s core competency should be focused on project controls around schedule, quantity, and risk management. Project controls must be initiated early during project development, not only during construction, to maximize economic returns on invested capital.

12 Contact us John Herzog T: E: Todd Boley T: E: kpmg.com