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Why fractionation spreads affect some MLP stocks

2013.01.22 - Frac Spread HistoricalsEnlarge GraphCompanies in the natural gas processing space (many of which are master limited partnerships) keep an eye on the fractionation or “frac” spread, which is a measure in the difference between natural gas liquids prices and natural gas prices and a rough measure of gas processing economics.

Natural gas processors take raw natural gas, delivered by upstream oil and gas producers to a natural gas processing plant, and clean out its impurities, then separate it into multiple components and sell it. The sale of the processed gas should be more profitable than the cost of the unprocessed gas, otherwise it is unprofitable to process it.

When natural gas reaches a processing plant, it usually contains a mix of different hydrocarbons. One component is methane (CH4), the lightest molecular component of the raw gas stream. The other hydrocarbon components are called natural gas liquids or “NGLs” and include ethane (C2H6), propane (C4H8), n-butane (C4H10), iso-butane (C4H10), and natural gasoline (C5 and C6 molecules). Natural gas processors separate the raw gas stream into these various components. Some natural gas processors have contracts that are strictly volume based, under which they are paid the same regardless of where NGL prices and natural gas prices are. However, oftentimes processors have contract structures that are commodity price dependent such as keep-whole and percentage of proceeds (see an explanation of processing contract structures here “Natural gas processing contracts and how they affect profits and valuation“).

Frac spreads are most relevant for processors with keep-whole contracts. Under keep-whole contracts, the processor retains the NGLs extracted and returns the processed dry natural gas (or if not the physical gas itself, the value of the dry natural gas) to the producer. Under this contract, the processor benefits when the price of NGLs increases and the price of natural gas decreases. As fractionation spreads represent the difference in price between NGLs and natural gas, it is a relevant metric to monitor for natural gas processors. For further details on how frac spreads are calculated please read the article titled “An in-depth look at the mechanics of fractionation spreads“.

As seen in the chart above, in recent months fractionation spreads have come off their highs of $40-50/bbl to $20-30/bbl as the prices of ethane and propane have decreased and natural gas has rebounded.

Since  fractionation spreads have been falling recently, it may be  more prudent to invest in companies or MLPs with exposure to gas processing, versus MLPs that are overly exposed to fee-based contracts. 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). Large cap MLPs like KMP are not as exposed to fractionation trends. A diversified avenue to invest in the MLP space is to use the Alerian MLP ETF, an ETF which tracks a cap-weighted index of 50 energy MLPs with different exposures.

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