FINANCE:

A startup fund seeks midstream deals in the heart of shale plays

You are a newly launched investment firm, flush with $1.65 billion in capital from institutional and pension fund backers, and you are trying to get into a fast-changing energy infrastructure area. Where do you jump?

A gas-fired power plant with long-term contracts looks fine, but a utility-scale solar plant may be iffy, and a merchant generator selling into day-ahead markets is not on the list, said Michael Dorrell, a senior managing director of Stonepeak Infrastructure Partners in New York, whose firm announced the closing of its initial fund this week.

Major transmission line investments are scarce but interesting, but the prime candidate is a midstream pipeline project in the heart of a tight oil or shale gas play, Dorrell said.

That kind of investment is just like the $750 million acquisition announced yesterday, in which privately owned Arrow Midstream Holdings LLC agreed to sell itself to Crestwood Midstream Partners LP of Houston, an $8 billion energy firm, following its just-completed merger with Inergy LP of Kansas City, Mo.

Tulsa-based Arrow Midsteam, through its subsidiaries, owns and operates crude oil and natural gas gathering systems on the Fort Berthold Indian Reservation in North Dakota, anchored by long-term delivery contracts with 1,000 potential drilling sites, according to Crestwood's announcement.

According to news accounts, the Fort Berthold development began in 2007 with lease acquisitions funded by the Ochs-Ziff Capital Management LLC hedge fund and oil services giant Schlumberger Ltd., which later sold its interests, and the venture was pushed forward by Arrow. Representatives of Och-Ziff and Arrow declined to discuss the ownership changes, which have been accompanied by controversy over tribal shares in the project.

In any case, it is an investment by venture capital that has turned out well for buyers and sellers, Dorrell said, and one he and his Stonepeak partners hope to emulate.

"In this current environment, where interest rates are incredibly low and probably on the way up, we really look for midstream growth assets," Dorrell said.

They aren't alone, he acknowledged. "There is a ton of growth capital going into the midstream infrastructure space.

"It's changing so rapidly," he said of the shale play development that is transforming the U.S. gas industry with midstream pipeline and processing investments by master limited partnership (MLP) firms like Crestwood in key roles.

"New basins are being explored; old basins are being exploited. So there's a continuing build of infrastructure. There are a lot of very entrepreneurial people who are willing to break out of MLPs and start their own businesses," Dorrell said. A lot of the midstream infrastructure is being built by smaller, private equity-backed groups. They are very successful at outmaneuvering the bigger MLPs, putting in $50 million to $200 million, which hardly moves the needle for the big outfits, Dorrell said.

Opportunity and risk

Dorrell, who was a senior managing director with the Blackstone Group co-heading its infrastructure investments before starting Stonepeak, said the new company is seeking a niche that strikes the right balance between opportunity and risk.

"We are a lower-risk investor," he said. The firm is looking for investment returns somewhat lower than traditional private equity seeks, but also carrying a risk that's lower. "We will trade off upside to get greater downside protection. ... That's what our investors want to see."

That enabled the firm to win business from more conservative investors, led by its anchor client, TIAA-CREF, a $523 billion national financial services organization, whose participation led public pension funds to join, Dorrell said.

In choosing plays in which to invest, the quality of the oil and gas resource is the key, he said. "There are big differentiations between the basins. At $100-a-barrel oil, a lot of basins looked good. If oil goes to $60, the basins you want to be in is drastically reduced. You want to be sitting in the heart of the Bakken, or the Permian, not on the fringes.

"As a lower-risk infrastructure investor, we always assume that at some stage, oil is going to $60, so how do we protect ourselves?" he said. Because of that, the firm takes somewhat lower returns than it would get buying into a fringe area in the Bakken Shale.

That's what he likes about the Crestwood acquisition.

Robert Phillips, chairman and president of Crestwood, said his firm prized the Arrow project because of its location in what it believes is the richest oil resource in the play, close to a major oil shipment hub.

"There is significant amount of growth left in the Bakken Shale, and we are buying a business that is located in the core," Phillips told analysts yesterday.

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