Why frac spreads are up slightly, helping natural gas processors

Natural gas processors can be sensitive to commodity prices in the form of frac spreads

Some market participants view fractionation spreads (also called “frac spreads”) as one indication of the profitability of some natural gas processing companies. Frac spreads depend on natural gas liquids (NGL) and natural gas prices, and they 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). Generally, companies with natural gas processing operations such as MarkWest Energy (MWE), Targa Resources (NGLS), Williams Partners (WPZ), and DCP Midstream Partners (DPM) realize more profits when frac spreads increase.

2013.10.09 - Frac Spread STEnlarge Graph

Frac spreads were up last week, and remain up nearly 40% since late June

Last week, natural gas prices decreased, and most NGL prices increased. Ultimately, this resulted in higher frac spreads (as measured by a custom index created by Bloomberg, using assumptions provided by Ceritas Group).

2013.10.10 - Frac Spread TableEnlarge Graph

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 An in-depth look at the mechanics of fractionation spreads.

Frac spreads had generally decreased since mid-February, when they reached ~$30 per barrel. Since then, frac spreads declined to levels as low as ~$20 per barrel, mostly due to the strong rally in natural gas prices. Frac spreads have recovered strongly since then, as oil has seen significant gains while natural gas prices have stagnated. Plus, the natural gas liquids complex had been helped over the past few months by increases in propane prices, likely from increases in export capacity (see Why some MLPs are benefitting from increased propane exports for more information). Meanwhile, natural gas prices remained relatively low, which had caused a medium-term increase in frac spreads.

Background: Depressed ethane and propane prices have caused frac spreads to trade down over the longer term

For a period, frac spreads had increased to between $40 and $50 per barrel (compared to current levels of around $25 to $30 per barrel) due to depressed natural gas prices, while NGL prices had remained relatively robust. Over the last year, frac spreads had declined largely due to the sharp drop in prices in ethane and propane (see chart below), while natural gas prices have recovered somewhat. However, as we’ve seen, over July and August, frac spreads had recovered somewhat, as a sharp spike in oil prices and increased propane export capacity helped to improve NGL prices.

2013.10.09 - Frac Spread LTEnlarge Graph

The decline in ethane and propane prices has been a consequence of the “shale revolution” boom, as natural gas shales rich in NGLs have experienced rapid development, resulting in the market flooding 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.

2013.10.09 - NGL LTEnlarge Graph

More infrastructure for processing ethane and propane would support prices

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, as the recent increases in propane exports has demonstrated.

Several midstream companies have noted that they’re working on such projects. However, the timeline for the completion of these works is over the next several years. But 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 remain depressed.

Outlook

Last week, frac spreads traded up slightly, and the over the medium term, frac spreads are up significantly. This is a positive catalyst for natural gas processors such as MWE, NGLS, WPZ, and DPM, many of which are also components of the Alerian MLP ETF (AMLP).