An in-depth look at the mechanics of fractionation spreads and how they affect MLPs
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The following example shows how the frac spread can be calculated:
Line A represents current NGL prices on a per gallon basis.
Line B represents a conversion factor, which converts between MMBtu and gallons for the various NGLs. The numbers are different for each NGL, because each NGL has a different molecular structure giving it a different energy value for each gallon. For instance, ethane currently trades at $0.26/gallon, but it trades at $0.26/0.0657 per MMBtu or $3.99/MMBtu.
Line C represents the current natural gas price per MMBtu, which is currently $3.65.
Line D represents the “natural gas shrink”, which is Line B multiplied by Line C. Let us use ethane as an example to explain what the significance of the natural gas shrink is. Natural gas is currently trading at $3.65/MMBtu. To get the energy equivalent basis per gallon of ethane we multiply that by the conversion factor of 0.0657 to get $0.24/gallon.
Line E represents the margin per gallon. Since the value of ethane is $0.26/gallon and for the same amount of MMBtu’s the value of natural gas is $0.24 per gallon of ethane, the margin is $0.26 minus $0.24 or $0.02.
Line F represents what a sample mix of NGLs might look like within a raw gas stream. This mix can vary depending on different factors such as from what formation and geological area the gas is being extracted, but generally ethane and propane make up the majority of the components. According to a presentation given by the Midstream Energy Group based on information from the EIA, of the average NGL barrel produced in December 2011, ethane comprised 43% and propane comprised 28%. The mix used here is based on assumptions provided by the Ceritas Group.
Lines G through I simply convert from a per gallon basis to a per barrel basis (there are 42 gallons in one barrel). Line G represents Line A x 42; Line H represents Line D x 42; Line I represents Line G x 42.
On the far right, is a “Composite” column. Given this particular mix of NGLs and the current price environment, a barrel of NGLs would fetch $41.61/bbl. Given where natural gas prices are, the cost of natural gas to buy what would be the energy equivalent of this barrel of NGLs is $13.20/bbl. The margin (or frac spread) for this barrel of NGLs would therefore be $41.61 – $13.20 or $28.41/bbl.
Some natural gas processors have contracts called “keep-whole contracts” in which they process the gas in return for the value of the NGLs removed, and return to the gas producer the energy equivalent of the NGLs in dry gas (or the value of the dry gas). The frac spread most affects these natural gas processors, with higher frac spreads predictive of higher margins and lower frac spreads predictive of lower margins. The chart above shows frac spreads over the past several years.
As frac spreads fall, this can be negative for MLPs with exposure to gas processing. Companies with significant gas processing operations include (but are not limited to) DCP Midstream (DPM), Enterprise Products Partners (EPD), Williams Partners (WPZ), and Targa Resources (NGLS). Many companies in the gas processing space are MLPs and fall into the Alerian MLP ETF, an ETF which tracks a cap-weighted index of 50 energy MLPs.