Midstream Contract Structures: Fee-Based, Percent-of-Proceeds, and Keep-Whole

Introduction

The contract structure between a midstream company and its producer customers is the most important determinant of the midstream company's risk profile, cash flow predictability, and valuation multiple. Two midstream companies with identical assets and volumes can have very different valuations if one operates under long-term, fee-based, take-or-pay contracts and the other operates under commodity-exposed percent-of-proceeds agreements. Understanding the mechanics of each contract type, the commodity exposure each creates, and the industry trend toward fee-based structures is essential for midstream financial analysis and is frequently tested in energy interviews.

Under a fee-based contract, the midstream company receives a fixed dollar amount per unit of volume gathered, processed, transported, or stored. The fee is typically expressed as dollars per MMBtu (for gas gathering and processing), dollars per barrel (for crude oil gathering and transportation), or dollars per gallon (for NGL fractionation).

Fee-Based Contract

A midstream service agreement in which the gathering and processing (G&P) provider receives a fixed fee per unit of throughput (e.g., $0.50 per MMBtu gathered, $0.25 per MMBtu processed) regardless of the prevailing commodity price. Under a pure fee-based structure, the midstream company has no direct commodity price exposure. Revenue equals the fixed fee multiplied by the volume of hydrocarbons flowing through the system. The primary risk is volume risk: if the connected producers reduce drilling activity and volumes decline, fee-based revenue declines proportionally.

Commodity exposure: Minimal direct exposure. The midstream company earns the same fee whether Henry Hub is $2.00 or $5.00 per MMBtu. However, there is indirect exposure through volume: sustained low commodity prices cause producers to cut drilling, which eventually reduces gathering and processing volumes (with a 6-12 month lag).

Enhanced protections. Many fee-based contracts include minimum volume commitments (MVCs) or take-or-pay provisions that guarantee baseline revenue even if actual volumes fall below contracted levels. Under an MVC, the producer commits to delivering (or paying for) a minimum volume of gas through the gathering system, typically set at 75-85% of expected production. If the producer delivers less than the minimum, it pays a deficiency fee equal to the shortfall multiplied by the contracted rate. This MVC structure transforms the contract from "fee-based with volume risk" to "quasi-fixed revenue" for the minimum committed volume.

Industry trend. The midstream sector has shifted dramatically toward fee-based contracts over the past decade. In the early 2010s, many G&P companies operated under POP or keep-whole contracts that exposed them to commodity price swings. After experiencing severe margin compression during the 2014-2016 and 2020 commodity downturns, the industry renegotiated contracts toward fee-based structures with MVCs. Today, large midstream companies like Williams, Enterprise Products, and Kinder Morgan report 85-95% fee-based revenue, with commodity-exposed contracts representing a diminishing share.

Under a POP contract, the midstream company processes the producer's raw gas and, as compensation, retains an agreed percentage of the proceeds from selling the processed products (residue gas and/or NGLs).

How it works: Suppose a POP contract specifies that the processor retains 15% of the proceeds from NGL sales and 12% of the proceeds from residue gas sales. If the processing plant sells $100,000 in NGLs and $200,000 in residue gas on a given day, the processor earns $15,000 (15% of NGL proceeds) + $24,000 (12% of gas proceeds) = $39,000. If commodity prices double, the processor's revenue roughly doubles. If prices halve, revenue halves.

Variations. Some POP contracts include a fee floor (a minimum per-unit fee that applies even if commodity prices fall below the level that would generate the contracted percentage). This floor provides downside protection while maintaining upside participation. Percentage-of-index (POI) contracts are similar to POP but reference an index price rather than actual sales proceeds, reducing the impact of marketing inefficiencies.

Under a keep-whole contract, the processor retains the extracted NGLs as compensation for processing services but must return enough natural gas (or its cash equivalent) to the producer to "make the producer whole" for the energy value of the NGLs removed from the gas stream.

How it works: The processor receives raw gas, extracts NGLs, and sells them at Mont Belvieu prices. The processor then returns residue gas to the producer (or pays the cash equivalent based on the Henry Hub price) equal to the energy content of the gas before processing. The processor's margin is the difference between the NGL revenue earned and the cost of replacing the gas returned.

Keep-Whole Margin (Frac Spread)

The margin earned by a midstream processor under a keep-whole contract, calculated as the revenue from selling extracted NGLs minus the cost of replacing the natural gas returned to the producer. This margin is essentially the frac spread: when NGL prices are high relative to gas prices, keep-whole margins are attractive. When NGL prices fall or gas prices rise (narrowing the frac spread), keep-whole margins compress and can turn negative. Under negative frac spreads, the processor may reject certain NGLs (particularly ethane) to avoid processing at a loss.

Commodity exposure: Keep-whole contracts create a unique double commodity exposure. The processor is long NGLs (benefit from higher NGL prices) and short natural gas (harmed by higher gas prices, because they must return more expensive gas to the producer). This creates a directional bet on the NGL-to-gas price ratio. When this ratio is favorable (high NGL prices, low gas prices), keep-whole margins are strong. When it inverts (low NGL prices relative to gas), margins evaporate.

The mix of contract types directly affects how the market values a midstream company. Energy bankers evaluate contract mix as part of every midstream engagement.

A midstream company reporting 90% fee-based revenue with MVCs might trade at 10-12x EV/EBITDA. A similar-sized company with 50% commodity-exposed revenue (POP + keep-whole) might trade at 7-9x, a 20-30% valuation discount reflecting the greater cash flow uncertainty.

The industry-wide shift from POP and keep-whole toward fee-based contracts has been one of the most significant structural changes in midstream over the past decade. It has made the sector more predictable, more infrastructure-like, and more attractive to the income-oriented and infrastructure fund investors that now dominate midstream equity ownership. For energy bankers, the contract mix analysis is one of the first due diligence workstreams in any midstream engagement because it determines the cash flow risk profile that underpins every valuation output.