For the past several quarters, M&A activity in the midstream energy sector has been fast and furious. Growing oil and gas demand and new plays have pushed many midstream companies to expand their gathering, pipeline and storage infrastructure as much as their capex budgets have allowed, which bumped many organic growth initiatives to the back seat in early 2005. But some say the M&A cycle is turning a corner, and organic growth plans will have a higher priority for many midstream companies this year. "Organic growth is more appealing," says John Freeman, vice president of energy equity research at Raymond James & Associates Inc. "Organic growth projects are usually done on a five- to seven times EBITDA (earnings before interest, taxes, depreciation and amortization) multiple, while recent acquisition multiples in the [Raymond James] midstream space have been 10 times EBITDA. That being said, sometimes acquisitions spur significant organic growth projects." Kirk Blackim, vice president, business development, for Tulsa-based Clear Creek Energy Services, a midstream service company, says a large portion of midstream M&A activity today is driven by a large, pent-up demand from the capital markets for good energy transactions and a number of aggressive master limited partnership (MLP) buyers that can take advantage of that dynamic. "Since the M&A market has already heated up, companies have begun to focus on organic growth plans," he says. "The value proposition is pretty convincing when organic projects cost four- to seven times EBITDA and M&A transactions can require nine- to 11 times EBITDA." Capital sources are supportive of both growth strategies, and Blackim says the private-equity sector is a prime example. Dallas-based Energy Spectrum Partners IV LP provided an equity commitment for privately held Clear Creek to invest in new and existing gas-gathering and -treating assets in producer-generated, new-field development projects in the Powder River Basin region, and elsewhere in the Rockies and U.S. Clear Creek was formed with Tulsa-based Clear Creek Natural Gas LLC's (CCNG) existing gathering assets that were acquired during 2003-04, and Energy Spectrum's initial investment. CCNG's focus prior to the transaction was on developing assets in the Powder River Basin. Clear Creek Energy Services' management is currently reviewing opportunities with producers which, when completed, will significantly increase the size of the company, Blackim says. "Clear Creek is more focused on organic growth than M&A. That said, we do look to do M&A work in the context of acquiring midstream assets from producers in a fashion that allows them to monetize their midstream assets, generate capital to drill more aggressively and have a partner continue to operate, optimize and expand their systems." Dave Schulte, managing director of Overland Park, Kansas-based Tortoise Capital Advisors, which invests in the midstream, also sees a reduction in M&A's share of capex. Growing oil and gas product demand is driving internal growth initiatives, he says. "There is more than $13.5 billion of [internal] projects slated for 2006 through 2009. [They] span across refined products, crude oil and natural gas networks. A small portion includes coal and marine transportation. We understand that these projects have customer commitments for transportation volumes under long-term contracts." Schulte says product demand may grow around 1% per year for the foreseeable future, and this is a great incentive for capital providers to support the midstream's shift toward internal growth. "Product demand is driven both through economic and demographic factors and 1% volume growth translates to much greater earnings growth due to the fixed-cost nature of business." Tortoise's three public investment funds, Tortoise Energy Infrastructure Corp., Tortoise Energy Capital Corp. and Tortoise North American Energy Corp., recently participated in an equity placement with Plains All American Pipeline LP, for its planned acquisition of Andrews Petroleum Inc. and Lone Star Trucking Inc. for $205 million. Schulte says large gas-gathering and -processing networks appear to be the most desirable acquisition targets these days due to the predicted growth in production, given higher natural gas prices. Raymond James' Freeman adds, "Storage assets have [also] been particularly hot recently, especially with the market in contango." Blackim expects to see larger acquisitions at high EBITDA multiples continue. "However, I will not be surprised if M&A takes a bit of a breather sometime soon. There have been so many midstream transactions lately that acquirers need to digest their purchases. Part of this process involves companies investing in organic projects to expand their recently acquired assets." Midstream assets are still highly coveted for their lower-risk profile (compared with E&P assets), attractive cash flow from operations, and low level of commodity-price risk. "In 2005, we saw $5.3 billion of acquisitions in the midstream sector," Schulte says, "and for the first quarter of 2006, the volume was $3.9 billion." Several E&P companies decided to shake themselves free of midstream assets in late 2005-06, giving midstream companies and private-equity firms more assets to bid on. New midstream infrastructure is also being built in the U.S. and beyond, creating additional assets that may eventually change hands. "In the E&P space, there are substantial midstream assets that are being undervalued in the marketplace," analyst Freeman says. "In most cases, the E&P companies could either sell those assets to a midstream MLP or spin off the assets as an MLP and realize 25%-plus in value. In addition, it makes a lot of sense in this robust commodity-price environment to monetize a midstream asset, and take that money and put it to work finding oil and gas-[which is] what the market is really paying an E&P company to do and where your returns are much higher." M&A activity retains some appeal, he adds. "MLPs have a lower cost of capital so they can bid more for the same midstream asset than a C-corp. Therefore, MLPs have been very aggressive making midstream acquisitions and putting significant capital into organic growth projects recently." Englewood, Colorado-based MarkWest Energy Partners LP plans to continue building its partnership and distributions by pursuing a multi-tiered and risk-weighted strategy. "This includes both an acquisition- and organic-growth platform that increases utilization of existing facilities, expands operations through incremental investment in core areas, strategic, accretive acquisitions and stable margins with long-term, fee-based contracts," says James Ivey, chief financial officer. The MLP gathers, transmits and processes gas and transports, fractionates and stores natural gas liquids. It is the largest gas processor in the Appalachian Basin. Through six acquisitions in 2003-04, the partnership more than doubled its asset base by expanding its gathering, processing and transmission area to the southwest U.S., primarily Texas and Oklahoma. In November 2005, MarkWest doubled again with the purchase of the $355-million Javelina gas-processing and -fractionation facility in Corpus Christi, Texas. Funding was from a $100-million revolving credit facility and a $400-million term loan through Royal Bank of Canada and other banks. "These assets provide us with high-quality service to six strategically located Gulf Coast refineries," Ivey says. "We believe that these refineries will continue to play a key role in supporting U.S. demand for refined petroleum products. The acquisition of the Javelina assets also contributed $9.3 million of segment-operating income for the two months that MarkWest owned them [in 2005]." A lack of infrastructure investments during the past several years is likely to contribute to a substantial amount of organic growth in the sector, he adds. Through 2007, Schulte expects midstream MLPs will continue to play a larger role in the energy-investment network, as the group, through acquisitions and other growth, has gone from zero market share in the early 1990s to almost one-third today. Blackim says development of unconventional U.S. resources will create new reasons for the midstream sector to grow, organically or otherwise. "Many midstream companies will find clear niche opportunities in the emerging-resource plays in areas where there is essentially limited or no midstream infrastructure in existence. As a result, some of these ventures will have difficulties if the play fizzles, while others will achieve outstanding success that may ultimately create some of the major midstream companies in the industry five years from now."