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Why Frac Spreads Affect Some MLP Stocks

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Companies in the natural gas processing space (many of which are master limited partnerships) keep an eye on the fractionation or “frac” spread, which is a measure in the difference between natural gas liquids prices and natural gas prices and a rough measure of gas processing economics.

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How natural gas processing works

Natural gas processors take raw natural gas, delivered by upstream oil and gas producers to a natural gas processing plant, and clean out its impurities. They then separate it into multiple components and sell it. And the sale of the processed gas should be more profitable than the cost of the unprocessed gas. Otherwise, it’s unprofitable to process it.

When natural gas reaches a processing plant, it usually contains a mix of different hydrocarbons. One component is methane (CH4), the lightest molecular component of the raw gas stream. The other hydrocarbon components are called natural gas liquids or “NGLs” and include ethane (C2H6), propane (C4H8), n-butane (C4H10), iso-butane (C4H10), and natural gasoline (C5 and C6 molecules).

Natural gas processors separate the raw gas stream into these various components. Some natural gas processors have contracts that are strictly volume-based. Under these contracts, they’re paid the same regardless of where NGL prices and natural gas prices are. However, oftentimes, processors have contract structures that are commodity-price-dependent. Examples are keep-whole and percentage-of-proceeds models.

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What are frac spreads?

Frac spreads are most relevant for processors with keep-whole contracts. Under keep-whole contracts, the processor retains the NGLs extracted and returns the processed dry natural gas (or if not the physical gas itself, the value of the dry natural gas) to the producer. Under this contract, the processor benefits when the price of NGLs increases and the price of natural gas decreases.

Because fractionation spreads represent the difference in price between NGLs and natural gas, they’re a relevant metric to monitor for natural gas processors.

Frac spreads’ impact on MLP stocks

Whenever fractionation spreads have been falling, it may be more prudent to invest in companies or MLPs with exposure to gas processing instead of MLPs that are overly exposed to fee-based contracts. Companies with significant gas processing operations include:
  • DCP Midstream (DPM).
  • Enterprise Products Partners (EPD).
  • Williams Partners (WPZ).
  • Targa Resources (NGLS).

Large-cap MLPs like Kinder Morgan (KMI) aren’t as exposed to frac spread trends. A diversified avenue to invest in the MLP space is to use the Alerian MLP ETF (AMLP). This ETF tracks a cap-weighted index of 50 energy MLPs with different exposures.

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Calculating frac spreads step by step

Now let’s break down the fractionation spread calculation step by step for investors who want to learn even more. The following example shows how the frac spread calculation works:

  1. The first factor is the current NGL price on a per-gallon basis.
  2. The next component of the calculation is the conversion factor, which converts between MMBtu and gallons for the various NGLs. And the numbers are different for each NGL because each natural gas liquid has a different molecular structure, giving it a different energy value for each gallon.
  3. Next comes the current natural gas price per MMBtu. Today, on December 11, that price stands at $2.25.
  4. What comes next in the frac spread calculation is the “natural gas shrink.” It’s Item 2 multiplied by Item 3. Let’s use ethane as an example to explain what the significance of the natural gas shrink is.
  5. The next factor is the margin per gallon. Today, the value of ethane is $0.17 per gallon, and for the same amount of MMBtus, the value of natural gas is $0.18 per gallon of ethane. So the margin right now for ethane specifically would be $0.18 minus $0.17 or $0.01.
  6. The next component represents what a sample mix of NGLs might look like within a raw gas stream. And this mix can vary. It depends on different factors, such as from what formation and geological area the gas is being extracted. But generally, ethane and propane make up the majority of these components.
  7. For the last step, the frac spread calculation simply converts from a per-gallon basis to a per-barrel basis. Note that there are 42 gallons in one barrel.

Contracts affect the impact on MLPs

Some natural gas processors have contracts called “keep-whole contracts.” Under this setup, they process the gas in return for the value of the NGLs removed, and they return to the gas producer the energy equivalent of the NGLs in dry gas—or the value of the dry gas. The frac spread most affects these natural gas processors. Higher frac spreads predict higher margins, and lower frac spreads predict lower margins.

As frac spreads fall, they can hurt MLPs with exposure to gas processing. Companies with significant gas processing operations—like DCP Midstream, Enterprise Products Partners, Williams Partners, and Targa Resources. And of course, that means falling frac spreads can also hurt the Alerian MLP ETF (AMLP).

Before we wrap up, let’s also take a closer look at how natural gas processing contracts can affect your investments.

Fee-based contracts

Under a fee-based contract, NGL processors receive a fee based on how much gas they process, also called “throughput volumes.” Under this type of contract, the processor doesn’t have any direct sensitivity to commodity prices since revenues relate to volume, not prices. However, if natural gas prices undergo a sustained downturn, drilling may slow, which causes throughput to decrease.

Percentage-of-proceeds contracts

Under percentage-of-proceeds (POP) contracts, processors receive a percentage of the actual proceeds of dry natural gas and NGL sales. Or they may receive a percentage based on index prices for the commodities, which is also called a “percentage of index” or POI model. Under this type of contract, the higher the price of natural gas and NGLs, the stronger the processors’ margins will be.

Keep-whole contracts

Under keep-whole contracts, the processor retains the NGLs extracted and returns the processed natural gas or value of the natural gas to the producer. With this type of contract, the processor benefits when NGL prices increase and natural gas prices decrease.

Mixing contracts to hedge risk

Companies often have a mix of these types of contracts. Natural gas processors can also hedge a portion of their commodity exposure through derivative contracts. For instance, if a processor is naturally long NGLs through its natural gas processing contracts, it can enter into derivative contracts to take short positions and mitigate some of its exposure to commodity prices.

Theoretically, a company with a larger percentage of fee-based contracts should have more stable margins since its revenue isn’t subject to as much fluctuation from commodity price swings. Everything else being equal, the stocks of companies with more commodity exposure for their margins are riskier. And trend often reflects in the yields of MLP stocks. Riskier MLP stocks have higher yields because investors need compensation for the additional risk. In this way, the structure of a company’s natural gas processing contracts can affect its valuation.

Want to learn more about investing in commodities? Check out A Trader’s Guide to the Commodity Market.

Originally published in January 2013 by Ingrid Pan, this post was substantively updated by Sybil Prowse on December 11, 2019.

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