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NGL production continues growth, pressures margins of some oil and gas producers

2013.02.14 - NGL ProductionEnlarge GraphOver the past several years, the production of natural gas liquids (NGLs) has accelerated immensely. Natural gas liquids are often present when natural gas is being drilled for and produced. Natural gas liquids are different from dry natural gas in that they have a higher molecular weight and can be found in liquid forms at lower pressures or higher temperatures than dry natural gas. Currently, NGLs also fetch more revenue than natural gas on an energy equivalent basis. That is, one MMBtu (millions of British thermal units) of an average mix of NGLs will sell for more than one MMBtu of dry natural gas.

Lately, given the low natural gas price environment, many upstream energy producers have been targeting natural gas with a higher NGL component, also known as “wet gas.” The result has been a rapid growth in the amount of NGLs produced from gas drilling as seen in the above chart.

NGL production grew 1.2% in November 2012 over October 2012. Investors holding stocks with a significant amount of NGL production such as Range Resources (RRC), Chesapeake Energy (CHK), SM Energy (SM), or Linn Energy (LINE) may want to monitor NGL production growth and prices, as recent high growth rates have caused some types of NGLs to experience price declines. Natural gas liquids can be one of several types of hydrocarbons including ethane, propane, butane, iso-butane, and pentane. While NGL prices had historically tracked crude, recent flush supply has caused the prices of ethane and propane to come under pressure since 2011.

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Though production of these NGLs had been increasing for some time before 2011, at first the excess supply was readily absorbed by petrochemical plants with excess capacity (or the ability to easily add excess capacity). Much of ethane and propane is used in the petrochemical business to produce ethylene and propylene which both have a variety of end uses such as the production of polymers and detergents. However, eventually the excess capacity was filled which created a supply/demand imbalance for ethane and propane and caused prices to drop.

The price drop has muted margins for producers who have a large component of production comprised of NGLs. For example, Range Resources (RRC), one of the most prominent companies producing in the wet gas region of the Marcellus Shale in Appalachia, has ~15% of its production from NGLs. The below chart shows that while in 2011, NGLs had largely received ~50% of the price of crude, this relationship has broken down over the past several quarters. This represents shrinking revenue from RRC’s NGL production. Despite lower NGL revenue, it does not appear as if RRC will stop drilling in the Marcellus anytime soon (for more please see “Natural gas production not likely to curb soon, bearish for dry nat gas companies”).

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Other similar companies with a significant percentage of production coming from NGL production include Chesapeake Energy (CHK), SM Energy (SM), and Linn Energy (LINE). Theoretically, continued increasing NGL production (that is, an increase in supply), as is occurring now, will continue to dampen prices and cause these companies to realize less revenue. However, investors should note that demand forces such an increased ability to export these NGLs also come into play, and that prices are the result of a complex interaction between the various supply and demand forces. Nevertheless, the growth of US NGL production is a factor that investors holding relevant upstream energy producer stocks may want to track.