Drop in frac spreads bearish for gas processing MLPs
Some market participants view fractionation spreads (also called “frac spreads”) as one indication of the profitability of some natural gas processing companies. Frac spreads are dependent on natural gas liquids (NGL) and natural gas prices, and increase when NGL prices increase relative to natural gas prices (for a detailed explanation of fractionation spreads please refer to “Why fractionation spreads affect some MLP stocks” and “An in-depth look at the mechanics of fractionation spreads”). Generally, natural gas processing companies such as MarkWest Energy (MWE), Targa Resources (NGLS), Regency Energy (RGP), and DCP Midstream Partners (DPM) realize more profits when frac spreads increase. Last week, natural gas prices rose while most NGL prices fell, ultimately resulting in a decrease in frac spreads which was a negative for gas processing names such as the ones mentioned above. The above chart displays frac spreads over the past 12 months.
Last week, natural gas prices rose 4%, while butane, isobutane, and natural gasoline fell by 5%, 6%, and 4%, respectively. Propane prices stayed flat week-over-week, and ethane prices rose 7% (see table below).
Note: The custom frac spread is based upon assumptions provided by Ceritas Group. To see how the custom frac spread is calculated, please refer to the article “An in-depth look at the mechanics of fractionation spreads”.
The commodity price movement ultimately resulted in a lower frac spread week-over-week. Natural gas prices rose on the week as last week’s inventory report showed a slightly larger than expected decline in inventories. This figure meant that either natural gas demand was more than expected, natural gas supply was less than expected, or both. For more on natural gas inventories, please see “Nat gas inventory draw slightly above expectations, positive for nat gas names”. Additionally, expectations of colder weather provided a boost to natural gas prices last week as one of the uses of natural gas is for home heating.
The movement in NGL prices was more complex. Natural gasoline, isobutane, and butane all fell on the week, likely due to the week-over-week drop in crude prices as these particular NGLs tend to track crude. In contrast, ethane prices rose 7% on the week. Historically, ethane prices had tracked crude oil prices but that relationship has broken down as in recent years the amount of ethane produced has grown significantly and for certain reasons, ethane prices now are more closely related to natural gas prices. Propane prices were unchanged on the week, and like ethane, propane prices have also decoupled from crude prices. Additionally, propane can experience certain special supply and demand dynamics during the winter as it is also used as a home heating fuel, and bouts of abnormally cold weather can cause propane prices to spike. Overall, the movements in all of the NGL prices and natural gas prices last week resulted in a negative change in frac spreads.
Fractionation spreads moved down on the week, and despite some recovery from June 2012 lows, frac spreads are still significantly below where they were a year ago as seen in the below graph.
For a period, frac spreads increased to $40-50/bbl due to depressed natural gas prices while NGL prices had remained relatively robust. Over the last year, frac spreads have declined largely due to the sharp drop in prices in ethane and propane (see chart below).
This has been a consequence of the “shale revolution” boom, as natural gas shales rich in NGLs have experienced rapid development, resulting in the market being flooded with new NGL supply. While the excess supply of ethane and propane had been absorbed at first by the chemicals industry, much of the capacity for chemical companies to process ethane and propane has been soaked up.
Once more capacity for processing ethane and propane comes online or more NGL export capacity is constructed, this could provide additional long term demand for these commodities and result in higher frac spreads. Several midstream companies have noted that they are working on such projects, however, the timeline for the completion of these works is over the next several years. Additionally, even if demand for these NGLs grows as a result of completed infrastructure, the supply of NGLs also continues to grow and if supply meets or outstrips demand, the prices of ethane and propane may continue to be depressed. Circling back to a short-term perspective, last week’s movement in frac spreads resulted in a negative short-term catalyst for gas processors such as MWE, NGLS, RGP, and DPM, which are also components of the Alerian MLP ETF (AMLP). The medium-to-long term perspective will depend on the increase in demand as a result of new petrochemical and export projects compared to NGL production growth.
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