Third consecutive weekly drop in frac spreads hurts gas processing MLPs
- Many natural gas processors have contracts that are sensitive to prices in natural gas and natural gas liquids (NGLs).
- The past several weeks’ movement in nat gas and NGL prices was generally bearish for gas processors with commodity sensitive contracts.
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. The top chart displays frac spreads over the past 12 months.
Last week, natural gas prices rose 5%, while ethane, butane, isobutane, and natural gasoline fell by 1%, 2%, 1%, and 2%, respectively. Propane prices rose 2% (see table below).
Note: The custom frac spread is based upon assumptions provided by the 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 “Natural gas bounces to highest point of 2013 on surprisingly large inventory draw.” Realized and expected colder than normal weather in late February and early March has boosted natural gas prices to their highest points of 2013. The commodity was trading as low as $3.15/MMBtu (millions of British thermal units) as recently as mid-February and currently trades at ~$3.70/MMBtu.
In the NGL space, ethane, butane, isobutane, and natural gasoline all experienced slight price declines on the week. Usually butane, isobutane, and natural gasoline track crude oil movements, however, crude prices increased slightly over the same time period. Additionally, ethane and propane are used to track crude prices as well, but a supply surge of these two NGLs over the past few years due to a frenzy of shale drilling has caused the relationship to breakdown somewhat. Additionally, propane can experience certain special supply and demand dynamics during the winter as it is also used as a home heating fuel. The movements in NGL prices over this past week may have been due to special dynamics in supply and demand for each fuel (ex: propane prices may have increased due to recent cold weather and therefore higher propane demand).
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 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).
As mentioned, 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 will also continue to grow; 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).
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