Why investors should understand frac spreads’ effect on MLP names

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 (NGLs) 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.

2014.04.18-Frac spreadEnlarge Graph

Frac spreads traded higher last week, to close at $25.40 per barrel

On the week of April 11, natural gas spot prices traded higher, finishing at $4.59 per MMBtu compared to $4.49 per MMBtu the previous week. Meanwhile, the price of the composite NGL barrel also traded higher due to an increase in all components’ prices. Ethane traded up 3%, from $0.28 per gallon to $0.29 per gallon. Propane finished at $1.10 per gallon, compared to $1.08 per gallon the previous week. Butane finished slightly up by 1.5%, to close at $1.23 per gallon, compared to $1.21 per gallon the previous week. Natural gasoline traded higher by 3%, from $2.24 per gallon to $2.29 per gallon. Given the rise in all components’ prices, composite NGL prices finished higher last week, to close at $42.51 per barrel compared to $41.52 per barrel the previous week. As a result, frac spreads finished 3% higher, to close at $25.40 per barrel, compared to $24.78 the previous week.

Note: The custom frac spread is based on 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.

Historical performance

Supported by strong crude and propane prices, frac spreads had kept increasing from $20 per barrel in June 2013 to around $35 per barrel in December 2013. Since January 2014, however, frac spreads dropped significantly due to the steep rise in natural gas prices. During the past few weeks, frac spreads gradually trended upward as natural gas prices retreated, and are currently around $25 per barrel.

Outlook

Last week, frac spreads traded higher, which was a short-term positive signal for natural gas processors. Over the medium term, while frac spreads are still up from mid-2013 lows, they’ve retreated significantly over the past few months, given higher natural gas prices. This is a negative medium-term catalyst for natural gas processors such as MWE, NGLS, WPZ, and DPM—many of which are also components of the Alerian MLP ETF (AMLP).

To learn more about investing in energy MLPs, see the Market Realist series Why rising propane and butane exports affect some US energy MLPs.