Natural gas processing contracts and how they affect profits and valuation

2013.01.18 MarkWest Contract Types w HedgingEnlarge GraphWhen energy companies produce natural gas, the raw stream which comes from the ground must first be processed before it can be effectively used. Many of the companies that process natural gas are MLPs such as MarkWest Energy (MWE), Targa Resources (NGLS), Regency Energy (RGP), and Crosstex Energy (XTEX). There also exists an ETF called the Alerian MLP ETF which is a cap-weighted composite of 50 energy MLPs, including some natural gas processors.

The procedure of natural gas processing “cleans” the raw gas stream by removing impurities, and also separating the stream into dry natural gas (also called methane, or CH4) and natural gas liquids or NGLs. NGLs are heavier hydrocarbons such as ethane (C2H6), propane (C3H8), and butane (C4H10). Currently, NGLs trade at a premium to natural gas. The main types of contracts employed by natural gas processors are (1) fee-based contracts; (2) percentage of proceeds contracts; and (3) keep-whole contracts.

(1) Fee-based contracts

Under a fee-based contract, processors receive a fee based on how much gas they process, also referred to as “throughput volumes”. Under this type of contract, the processor does not have any direct sensitivity to commodity prices since revenues are linked to volume and not prices. However, if natural gas prices undergo a sustained downturn, drilling may slow which causes throughput to decrease.

(2) Percentage of proceeds contracts

Under percentage of proceeds (POP) contracts, processors receive an agreed upon percentage of the actual proceeds of the sale of the dry natural gas and NGLs, or an agreed upon percentage based on index prices for the commodities (also called “percentage of index” or POI). Under this contract, the higher the price of natural gas and NGLs, the stronger the processors margins will be.

(3) Keep-whole contracts

Under keep-whole contracts, the processor retains the NGLs extracted and returns the processed natural gas or value of the natural gas to the producer. Under this contract, the processor benefits when the price of NGLs increases and the price of natural gas decreases.

Companies often have a mix of these types of contracts. For example, the below graph is from MarkWest Energy’s (MWE) company presentation. It displays the breakdown of its net operating margin by contract type for the first three quarters of 2012.

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Natural gas processors can also hedge a portion of their commodity exposure through derivative contracts. For instance, if a processor is naturally long NGLs through its natural gas processing contracts, it can enter into derivative contracts to take short positions and mitigate some of its exposure to commodity prices. In the following graph, one can see that though MarkWest only had 47% of its margin come from fee-based contract arrangements, it hedged 36% of its commodity exposed margins, leaving only 17% of its margins to be commodity exposed.

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Theoretically, a company with a larger percentage of fee-based contracts should have more stable margins as its revenue is not subject to as much fluctuation from commodity price swings. All else equal, the stocks of companies with more commodity exposed margins are riskier, and this is often reflected in the yields of MLP stocks. Riskier MLP stocks have higher yields because investors must be compensated for the additional risk. In this way, the structure of a company’s natural gas processing contracts can affect its valuation.