The compression industry stands to benefit from the growing importance of shale basins to U.S. natural-gas production (See The Shale Gas Revolution and Compression Services), offering investors above-average yields and exposure to a powerful long-term growth trend. Investors should snap up our favorite names before these stocks get bid up and the yields compress.
Natural-gas compression is the mechanical process of increasing the pressure of natural gas in a pipeline, storage facility or processing plant. Compression services are a critical throughout the natural-gas supply chain, from upstream (production) to midstream (pipelines and processing) and downstream (marketing).
Source: USA Compression Partners LP
Let's start with natural gas produced at the wellhead. When a well first comes onstream, the natural reservoir pressure impels the natural gas into the small-diameter gathering pipelines for shipment to processing plants. However, these underground pressures dissipate as the field matures, leading to a natural decline in production.
With multiple wells feeding into a single gathering system, the reservoir pressure of each well must be high enough to overcome the pressure in the gathering system itself. A surfeit of gas in regional gathering lines and transportation systems can overwhelm the natural field pressure, forcing operators to shut in production until the line pressure is reduced to appropriate levels.
Installing compression capacity near the wellhead boosts the pressure of the gas stream produced from the field so that it can flow into the gathering system. Additional compressors in the gathering system itself ensure that the pressure on these smaller-diameter lines is sufficient for the hydrocarbons to merge into larger pipelines and travel to processing plants. In oil-producing basins, upstream operators rely on compressors to re-inject associated gas into the field to maintain underground pressures and enhance the rate of crude production.
Further down the value chain, pipeline pressure dissipates over longer distances because of friction and other factors; operators of long-haul pipelines install compression equipment at strategic junctures to keep the hydrocarbons moving toward their destination. Compressors are also needed to cycle natural gas in and out of underground storage facilities and figure into the process of removing natural gas liquids from the raw-gas stream.
As a general rule of thumb, the compression capacity required-usually measured in horsepower-increases the further you move from the wellhead. Wellhead applications often call for 250-horsepower compression units, while local gathering systems require up to 1,800-horsepower compressors. Regional gathering systems may use equipment as powerful as 5,000 horsepower. Long-haul pipelines and large storage facilities often feature massive 25,000- to 30,000-horsepower compression units.
Demand for compression hinges on natural-gas production volumes. When system throughput picks up, the horsepower required to impel the hydrocarbons from the wellhead and through the pipeline system also increases. Accordingly, this business line evinces some exposure to natural-gas prices: Producers tend to rein in drilling activity when price realizations shrink, which translates into fewer new wells to connect to gathering systems and less need for wellhead and pipeline compression.
Fortunately, system volumes tend to exhibit far more stability than natural-gas prices. Even though producers have dramatically reduced the gas-directed rig count, robust production from shale gas fields has offset declines elsewhere in the U.S.
And America's growing reliance on shale plays for its gas supply represents a secular tailwind for compression demand. Not only do compression providers stand to benefit as new demand outlets for natural gas emerge, but the steep decline curves exhibited by wells in unconventional plays also reflect a significant diminution in reservoir pressure.
At the National Association of Publicly Traded Partnership's annual MLP investor conference in late May, USA Compression Partners LP's (USAC) management team made a compelling case for the industry's growth prospects, asserting that wells in shale-gas plays require as much as three times as much horsepower as conventional wells.
Source: USA Compression Partners LP
What does this mean for the compression industry? Demand for additional horsepower will likely grow at a faster pace than natural-gas production because of the growing prominence of shale-oil and -gas plays in the U.S. production mix.
This table highlights the largest publicly traded names that generate a significant portion of their revenue from providing compression-related services and equipment to the oil and gas industry.
Source: Bloomberg, Energy & Income Advisor
Let's delve into the four names that provide pure-play exposure to this business.
Exterran Partners LP (EXLP)
Organized as a master limited partnership (MLP), Exterran Partners LP is the largest provider of contract compression in the US and owns 2.4 million horsepower worth of capacity. The MLP focuses on leasing equipment for use at the wellhead and in gathering and processing systems. About 40 percent of the partnership's compression units have a capacity of 1,100 horsepower to 1,500 horsepower, while another 40 percent weigh in at less than 800 horsepower.
Exterran Partners usually inks six- to 12-month initial contracts with customers, after which both parties can cancel the agreement with 30-days notice. Producers typically pay a fee to move compression equipment into place, an investment that helps to dissuade them from exiting the contract.
The MLP doesn't take title to any hydrocarbons, and customers supply the natural gas needed to power the compression units. The majority of the firm's contracts require customer to pay a monthly fee regardless of production disruptions; if adverse weather or excess gas supply force the producer to shut in wells, Exterran Partners still gets paid.
A tight supply-demand balance for compression services in liquids-rich plays such as the Eagle Ford Shale and the Niobrara Shale (see Niobrara Shale Comes into Its Own) have enabled Exterran Partners to push through price increases in two consecutive Januaries.
Nevertheless, drop-down transactions from the MLP's parent and general partner, Exterran Holdings (EXH), will drive distribution growth over the next two to three years. Since going public in 2006, Exterran Partners has completed six drop-down deals that were immediately accretive to distributable cash flow and enabled the MLP to hike its quarterly payout. The most recent deal, completed in April 2013, involved about 250,000 horsepower of compression equipment and associated contracts.
With a yield of 6.7 percent, units of Exterran Partners offer a superior current return to the average MLP and a clear path to distribution growth.
Exterran Holdings' assets about 1 million horsepower of U.S. compression capacity, the general-partner interest in Exterran Partners and 40 percent of the MLP's outstanding common units. In addition, the firm owns an international compression business that includes another 1.3 million horsepower in capacity and a fabrication unit that manufactures new compression units and services existing models.
The international market for compression services has its advantages and disadvantages. These installations tend to involve longer contract terms than in the U.S., insulating these cash flows against volatile commodity prices. At the same time, these complex multiyear projects are prone to delays-in the first quarter, the firm's international backlog actually declined because of postponements. Nevertheless, the company has about $40 million worth of revenue in its international queue, and spending on compression should remain strong in coming years. In fact, the firm has already negotiated contract extensions that include price increases in several key markets.
Fabrication accounts for 20 percent of Exterran Holdings' gross margin, while aftermarket services represent about 10 percent. Fabrication is a more cyclical business than contract compression but has recovered from the 2008-09 slump in demand. Orders for new equipment in North America-a market that faced an overcapacity of compression horsepower in the wake of the financial crisis-appear to be picking up. In addition, Exterran Holdings has implemented several cost-cutting initiatives that have paid off: First-quarter fabrication revenue surged 75 percent from a year ago, and gross margin was up more than 100 percent.
Exterran Holdings should benefit from strengthening demand for compression services in the US and in international markets. We prefer Exterran Partners to Exterran Holdings, which doesn't pay a dividend.
USA Compression Partners LP
With roughly 1 million horsepower of compression capacity, USA Compression Partners LP is a smaller player than Exterran Partners. Another difference between the two MLPs: USA Compression Partners focuses on larger compression units, with about 75 percent of its installed base comprising units of at least 1,000 horsepower. Accordingly, USA Compression Partners' business has more exposure to larger, regional gathering systems and processing plants.
This focus has several advantages. Demand for compression closer to the wellhead entails more exposure to fluctuations in commodity prices and drilling activity; USA Compression Partners' emphasis on bigger gathering systems and processing plants provides a degree of insulation against these vagaries. Moreover, the initial contracts that USA Compression Partners signs with customers usually involve terms of two years to five years, compared to the six to 12 months that's the norm for Exterran Partners and Exterran Holdings.
With an average age of less than five years, USA Compression Partners' relatively young fleet faces less downtime and upgrade costs to comply with new environmental regulations from the U.S. Environmental Protection Agency.
Private-equity outfit Riverstone owns a general-partner interest and about two-thirds of the MLPs outstanding common units. Riverstone may help USA Compression Partners grow by supporting the partnership in acquisitions, but we expect organic opportunities to drive distribution increases. Between 2006 and 2012, the partnership has expanded its horsepower capacity at an average annual rate of 17 percent. Based on the firm's current order book, management expects to capacity grow by another 20 percent in 2013.
USA Compression Partners went public in January 2013; the MLP's first, prorated distribution doesn't reflect a full quarter of operations. This gives savvy investors an opportunity to lock in a yield of about 7 percent on units of USA Compression Partners before the market realizes its full distribution potential. Many financial information and brokerage websites will display an incorrect yield for the stock because they annualize the MLP's prorated distribution.
Although USA Compression Partners' distributable cash covered this prorated payout by less than 100 percent, we expect this shortfall to disappear as the firm brings on new capacity. Meanwhile, Riverstone receives its distribution in the form of additional units, freeing up cash to disburse to public unitholders.
Units of USA Compression Partners trade at an unwarranted discount to Exterran Partners given its high quality fleet.
Compressco Partners LP (GSJK)
Compressco Partners LP operates compression equipment at the wellhead and focuses on niche markets such as separating liquids and sand from the raw natural gas stream. The firm also makes compression equipment used to boost oil production from mature fields.
The MLP's business mix entails more risk than that of its peers, with minimum contract terms of about one month. In the first quarter, project delays in Mexico forced Compressco Partners to reduce headcount and raises familiar questions about the nation's commitment to making the necessary investments in the oil and gas industry.
Although Compressco Partners' stock yields more than 8 percent, the MLP's limited prospects for near-term distribution growth and sensitivity to commodity prices warrant a discounted valuation.