1 key profitability measure for natural gas processors such as DCP

Market Realist

Natural gas processing in brief

One function of natural gas processors (many of which are midstream master limited partnerships or MLPs) is to process the raw natural gas stream into separate components, namely dry natural gas (methane, or CH4) and natural gas liquids, which are heavier hydrocarbon molecules such as ethane (C2H6), propane (C3H8), isobutane/butane (C4H10), and pentane (C5H12). The natural gas liquids are removed from the dry natural gas stream for several reasons. One reason is because natural gas liquids can fetch a higher price in the market than dry natural gas on an energy equivalent basis. So it’s economic to separate them out and sell them separately. Plus, natural gas must meet certain specifications to travel through pipelines, which means it’s necessary to remove most of the natural gas liquids from the raw gas stream.

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

There are several different methods under which natural gas processors are paid for their services. Under one method, called a “keep-whole” contract, processors retain some or all of the natural gas liquids extracted as compensation and replace the energy content of the retained NGLs with natural gas purchases. Under this scenario, processors are inherently long natural gas liquids and short natural gas. One way to keep track (at least directionally) of the profitability of natural gas processors with keep-whole contracts is through fractionation spreads (also called “frac spreads”).

The frac spread is simply the value gained from the sale of NGLs (C3, IC4, NC4, and C5+) less the cost of the natural gas used to fractionate the liquids. It’s a profit margin for a gas processor, whereby your input price (natural gas) is subtracted from your output (NGLs). For processors, this is extremely important, because if natural gas prices increase dramatically while NGL prices remain stagnant (as we saw post-Katrina), your frac spread could decrease dramatically—sometimes even becoming negative.

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.

Frac spreads finished roughly flat last week

Last week, the price of a representative barrel of natural gas liquids (which includes ethane, propane, butane, iso-butane, and pentane) decreased from $48.37 per barrel to $43.87 per barrel, a 9% decrease on the week. Prices of ethane and propane, two of the largest components of a representative NGL barrel, dropped almost 20% on the week. As a result, the price of the composite NGL barrel declined by more than 9%. Henry Hub natural gas spot prices, which are used to calculate the frac spread, also traded low on the week, to close at $4.71 per MMBtu compared to $5.64 per MMBtu the previous week. This decrease in natural gas spot was largely driven by expectations of warmer weather following a cold spell that had boosted prices temporarily. Finally, frac spreads finished at $26.32 per barrel, compared to $26.45 per barrel the prior 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.

Summary

Last week, frac spreads traded flat compared to the previous week, which is a neutral signal for natural gas processors such as MWE, NGLS, WPZ, and DPM—many of which are also components of the Alerian MLP ETF (AMLP). However, over the medium term, frac spreads are still up significantly from lows of ~$22 per barrel in mid-2013, which is a positive catalyst for the midstream energy names mentioned above.

To learn more about investing in MLPs, see the Market Realist series Must-know: 1 important way Fed tapering affects MLPs.

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