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Frac spreads flat, neutral for natural gas processing MLP names

Ingrid Pan, CFA

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 and An in-depth look at the mechanics of fractionation spreads). Generally, natural gas processing companies such as MarkWest Energy (MWE), Targa Resources (NGLS), Williams Partners (WPZ), and DCP Midstream Partners (DPM) realize more profits when frac spreads increase.

(Read more: Why MLPs provide excellent risk-reward for investors)

Frac spreads flat on the week

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

(Read more: Oil and gas industry overview: Midstream (Part 2))

Note: The custom frac spread is based on assumptions provided by Ceritas Group. To see how to calculate the custom frac spread, please refer to An in-depth look at the mechanics of fractionation spreads.

Natural gas prices decreased, as mild weather tempered demand for the commodity (see Natural gas prices remain depressed with no help from mild weather). Meanwhile, natural gas liquids prices ended up mixed, with ethane’s significant declines balancing out propane’s price increases. Ethane has been trading directionally the same as natural gas (see Why ethane stopped trading like crude and started trading like nat gas). Meanwhile, propane prices could have increased on idiosyncratic demand factors such as petrochemical demand for propane to make propylene.

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 somewhat since then, as oil has seen significant gains while natural gas prices have stagnated.

(Read more: MLP (master limited partnership) tax considerations)

Depressed ethane and propane prices have caused frac spreads to trade down over the medium-to-long term

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

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.

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. Several midstream companies have noted that they’re working on such projects. But the timeline for completing these works is over the next several years. Plus, even if demand for these NGLs grows as a result of completed infrastructure, the supply of NGLs also continues to grow. If supply meets or outstrips demand, the prices of ethane and propane may remain depressed.

Circling back to a short-term perspective, last week, frac spreads traded flat. This was a neutral catalyst. Despite some recovery over July, frac spreads have mostly trended downward over the past year, resulting in a negative medium-term catalyst for gas processors such as MWE, NGLS, WPZ, and DPM—many of which are also components of the Alerian MLP ETF (AMLP).

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