Although the mainstream media tends to focus on natural gas and crude oil when discussing the energy sector, natural gas liquids (NGL) are an important, if often overlooked, part of North America’s energy landscape.
Processing plants extract NGLs from the gas stream, while fractionation facilities separate these hydrocarbons into discrete components for their various end-markets.
Our table breaks down a typical US barrel of NGLs, each component’s contribution to the overall price and their primary applications.
Despite their esoteric nature, NGLs have played an important role in the US shale oil and gas revolution.
After surging domestic output of natural gas weighed on the commodity’s price after the Great Recession, upstream operators shifted their drilling activity to “wet” plays that also produced significant volumes of higher-value NGLs that enhanced wellhead economics.
The price of a mixed barrel of NGLs, some of which can replace naphtha and other oil derivatives in industrial and petrochemical processes, historically has tracked movements in the price of crude oil.
However, surging NGL production from prolific shale oil and gas fields swamped the domestic market and sent prices tumbling in early 2012. Oil prices, on the other hand, continued to hover around $100 per barrel until growing US output and declining imports catalyzed a precipitous selloff that began in summer 2014.
This downswing in West Texas Intermediate (WTI) also hit NGLs and restored the traditional price relationship between crude and natural gas liquids. To this end, the recent rally in oil prices likely accounts for much of the recovery in NGL prices since the end of the third quarter.
US NGL output has increased at a steady pace since prices first tumbled in early 2012, though monthly production declined negligibly (about 0.5 percent) on a year-over-year basis in August and September 2016.
Although the Energy Information Administration’s Short-Term Energy Outlook estimates that growth in US NGL output slowed to 4.2 percent last year, this forecast calls for production to surge by about 12 percent in 2017.
This strength stands in sharp contrast to the Energy Information Administration’s projection for US oil production to slide again in 2017. (We expect actual output to surprise to the upside.) The report also calls for US natural-gas volumes to tick up by about 3 percent after suffering their first annual decline in 2016.
The rise in oil and gas prices, coupled with accelerating drilling and completion activity in US onshore plays, will contribute to some of the outsized growth in NGL production.
But other factors are at work and should drive additional output gains in 2018 and 2019, especially for ethane, the most abundant NGL by volume. These forces could also create the potential for a temporary uptick in ethane prices in coming years, a development that would elicit a supply response from US upstream operators.
Eye on Ethane
The US ethane market has three primary release valves: the domestic petrochemical industry, cross-border and seaborne exports, and ethane rejection at gas-processing plants—a phenomenon that occurs when the margins associated with separating the NGL from the gas stream turn negative.
Ethane rejection has been rampant over the past half-decade, with the energy-equivalent price of the NGL trading at or below Henry Hub natural-gas prices for an extended period.
The spot price of natural gas sets a floor US for ethane prices. With ethane prices at the hub in Mont Belvieu, Texas, hovering near the equivalent price of natural gas, Enterprise Products Partners LP (NYSE: EPD) estimates that processing plants reject about 600,000 barrels of the NGL per day.
DCP Midstream Partners LP (NYSE: DPM) has pegged the rate of ethane rejection even higher, at 650,000 barrels to 700,000 barrels per day.
The rate of ethane rejection increases the further you move from the Gulf Coast, an area that’s home to the preponderance of existing and under-construction ethane crackers in the US and the bulk of the fractionation capacity that separates the mixed NGL stream into purity components.
Note that midstream operators in the Utica and Marcellus Shale have built out fractionation capacity within these basins to supply local propane demand and extract ethane for shipment to the petrochemical complex in Sarnia, Ontario, and international markets.
The Shipping News
Increasing export capacity and a wave of cracker start-ups on the Gulf Coast are expected to shift the US ethane supply-demand balance over the next few years, providing an uplift in prices and creating regional arbitrage opportunities.
The US began exporting ethane to Canada in 2014, when Sunoco Logistics Partners LP’s (NYSE: SXL) Mariner West project and International Portfolio holding Pembina Pipeline Corp’s (TSX: PPL, NYSE PBA) Vantage pipeline came onstream.
Both systems provide takeaway capacity to shale plays that are a long way from the Gulf Coast petrochemical complex: Mariner West transports ethane produced in Appalachia’s Marcellus Shale to Nova Chemicals Corp’s crackers in Sarnia, Ontario, while the recently expanded Vantage pipeline supplies the feedstock to Nova Chemicals’ operations in Alberta.
Kinder Morgan’s (NYSE: KMI) proposed Utopia pipeline, which would carry 50,000 barrels of ethane per day from Ohio’s Utica Shale to Sarnia, has secured a long-term contract with Nova Chemicals but has encountered legal obstacles regarding its right of way in Ohio. The delayed project was expected to come onstream in 2018, though this timeline likely has moved to the right.
Mexico could also emerge as a market for piped ethane exports. Petroleos Mexicanos’ insufficient investment in natural-gas development has resulted in a steady decline in domestic production of the thermal fuel and associated volumes of ethane.
This trend, coupled with the start-up of Braskem (Sao Paulo: BRKM5, NYSE: BAK) and Idesa’s Ethylene XXII petrochemical plant, has tightened Mexico’s ethane market to the point that incremental supplies from the US could be an option.
More recently, seaborne ethane exports have started to ramp up, though significant approach work was necessary to make this outlet economically viable.
Consider the history of Sunoco Logistics Partners’ Marcus Hook facility in the Philadelphia area, which shipped its first ethane cargo in March 2016.
Switzerland-based petrochemical outfit Ineos Group in fall 2012 inked a 15-year ethane supply agreement with Range Resources Corp (NYSE: RRC), a leading producer in the liquids-rich portion of Pennsylvania’s Marcellus Shale. Privately held Borealis likewise signed a long-term contract to bring volumes to one of its petrochemical plants in Sweden.
In addition to the investment made by Sunoco Logistics Partners in the export and associated pipeline infrastructure, shipping outfits Evergas and Navigator Holdings (NYSE: NVGS) needed to build customized vessels to transport the ethane overseas. Ineos also expanded its ethane storage capacity in Norway.
Enterprise Products Partners’ long-awaited export facility on the Houston Ship Channel shipped its first ethane cargo this fall. Committed throughput at this facility will ramp up to more than 100,000 barrels per day in 2017 and about 150,000 barrels per day in 2018. If customers exercise the optional volumes under their contracts (as expected), ethane throughput could exceed 180,000 barrels per day. The facility has a nameplate capacity of 200,000 barrels per day.
Customers that have committed to offtake ethane from the export facility include Saudi Basic Industries Corp (SABIC), Reliance Industries (Mumbai: RIL) and Braskem (Sao Paulo: BRKM5, NYSE: BAK). These cargos will head to crackers in the UK, India and Brazil.
A Cracking Good Time
Over the past several years, oil and gas companies’ overzealous production of natural gas and NGLs has restored the fortunes of domestic chemical producers, an energy-intensive industry that relies on these commodities to generate power and as feedstock. Within this space, olefin producers have benefited the most thus far.
The two most prominent olefins, ethylene and propylene, serve as the building blocks for three-quarters of all chemicals, plastics and synthetic fibers. Petrochemical firms produce these commodity chemicals in cracking facilities that heat ethane and propane with steam. The bulk of US olefin capacity is located on the Gulf Coast.
An impending wave of incremental petrochemical capacity on the Gulf Coast—projects approved in 2011 and 2012, when the price spread between oil and NGL remained at historically wide levels—will come onstream and ramp up over the next few years.
Although expected cracker start-ups in 2017 imply an incremental 300,000 barrels per day in ethane demand at a utilization rate of 90 percent, much of this capacity will come onstream in the back half of the year. These facilities also take time to ramp up.
These factors, coupled with plans for turnarounds at 14 percent of the Gulf Coast’s existing cracking capacity in the back half of 2017, suggest that the call on rejected ethane will be strongest in 2018 and 2019.
Brave New World
Based on Enterprise Products Partners’ assertion that US gas processors reject about 600,000 barrels of ethane each day, an estimated 150,000 barrels per day in exports from Morgan Point and 300,000 barrels per day of additional petrochemical demand would pull about two-thirds of these volumes from the gas stream.
However, Dow Chemical Corp’s (NYSE: DOW) under-construction cracker in Freeport, Texas, has the flexibility to shift 30 percent of its feedstock to propane if that NGL offers superior profit margins. Some legacy olefin producers could also follow suit, reducing the call on ethane.
In any event, meeting this incremental ethane demand will require the NGL’s price on the Gulf Coast to reach levels that incentivize producers and midstream operators to pull these volumes out of rejection.
And as new US olefin crackers come onstream and ramp up their operations, ethane prices on the Gulf Coast will need to increase incrementally to pull volumes out of rejection in production areas that are further away by offsetting transportation and fractionation costs.
This upside in ethane recovery rates and prices could bolster profit margins on percent-of-proceeds processing contracts where the midstream operator retains some exposure to commodity prices.
And given that ethane can account for as much as 40 percent of the NGL stream when spreads discourage rejection, an uptick in the price of this hydrocarbon can move NGL prices.
However, given the myriad factors that influence NGL prices and the rapidly evolving global and North American energy landscapes, investors shouldn’t necessarily regard pricing-related developments as a durable trend.
One of the most important lessons of the shale oil and gas revolution is that market imbalances and blown-out price differentials eventually correct themselves. We prefer to focus on the volumetric opportunity first and foremost, while highlighting names with significant leverage to any uplift in ethane and NGL prices as a shorter-term trade.
How to Play It
Although we haven’t played up developments in the US NGL market to the same extent as the rate-of-change opportunities in the Permian Basin and the emerging SCOOP and STACK plays in Oklahoma’s Anadarko Basin, we did highlight this trend in July 2016 as one of three growth themes for MLP investors.
The earliest beneficiaries of growing demand for US ethane and a potential uplift in the price of this commodity will be in Texas and the Midcontinent region, areas that benefit from robust NGL output and their relative proximity to the Gulf Coast fractionation and petrochemical complex.
Enterprise Products Partners estimates ethane transportation costs at $0.10 to $0.12 per gallon from the Permian Basin and Eagle Ford Shale, compared with about $0.22 per gallon in the Rockies or Marcellus Shale.
We prefer to profit from the transition from ethane rejection to recovery via the midstream segment, where master limited partnerships (MLP) offer above-average yields and upside leverage to growing NGL volumes.
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Elliott and Roger on Sep. 27, 2018
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