By Avi Feinberg
It's no secret that in recent years natural gas liquids have become a top focus for natural gas producers in North America, and in turn for many midstream operators. NGL prices, which correlate closely with crude oil prices, have been marching upward pretty steadily since the depths of the financial crisis. Meanwhile, natural gas prices have languished thanks to a combination of tepid demand and shale-driven supply growth. U.S. petrochemical operators have benefited from low-cost ethane, which is among the most competitive feedstocks globally. But will these trends continue, and if so, which master limited partnerships are best poised to take advantage?
NGL Value Chain Overview
Before digging into our outlook for North American NGLs and the potential impact on key midstream players, we'll review the NGL value chain. The diagram below illustrates the entire midstream natural gas value chain, which begins with gathering natural gas into pipelines at the producer's wellhead. Next, midstream operators may treat the natural gas to remove impurities like sulfur and carbon dioxide and then process the gas to strip out the NGLs. The lower leg of the diagram illustrates how mixed NGLs are transported to a fractionation facility and then separated into individual liquid components in order of weight: ethane, propane, butane, iso-butane, and natural gasoline. Finally, midstream operators store the NGLs and transport them via pipeline, barge, or truck to petrochemical companies, refiners, propane wholesalers, and so on.
These expansions make sense in light of the low-cost position of U.S. petrochemical operators. As an ethylene feedstock, U.S. ethane has become extremely competitive globally. According to Enterprise (EPD) and Chemical Market Associates, Inc., U.S. ethane is a cheaper feedstock than any Asian or European feedstock, Saudi propane, or Saudi condensate. Only Middle East ethane and Alberta ethane are cheaper. We think that the petrochemical industry will continue to find ways to absorb incremental ethane production for several years to come through further debottlenecking and conversions of remaining naphtha crackers to ethane. Beyond that, petrochemical demand for ethane will depend on the health of the U.S. and global economies. For heavier NGL chains such as propane, we expect midstream operators to further boost exports as they have each year since 2008.
Implications for Midstream MLPs
Growing NGL supply and demand bode well for midstream MLPs that participate in the NGL value chain. New processing plants, NGL pipelines, fractionation facilities, storage, and export capacity will translate to attractive investment opportunities that yield largely fee-based cash flows for MLPs. Below we highlight the four MLPs we think are best positioned to benefit from growing demand for NGLs: Enterprise, ONEOK (OKS), Targa (NGLS), and MarkWest (MWE). While others will certainly develop midstream NGL infrastructure, we think these MLPs are poised to benefit most thanks to uniquely entrenched, well-integrated NGL footprints with access to growing sources of supply.
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Enterprise Products Partners
Enterprise, with the largest and best integrated NGL footprint of any MLP, should capture more than its fair share of NGL growth opportunities. The partnership's unrivaled fractionation operations include 619,000 bpd of net capacity, with 253,000 bpd of capacity at Mont Belvieu. A fifth 75,000 bpd fractionator at Mont Belvieu should come on line by early 2012, a sixth was recently permitted, and plenty of land remains for further expansion. Enterprise also has 100 million barrels of storage at Mont Belvieu and is currently expanding its industry-leading import-export terminal so that it can handle up to 10,000 barrels per hour--second only to a Saudi facility. We particularly like Enterprise's dominant gathering, processing, and NGL transportation and fractionation position in and around the Eagle Ford shale, which should provide attractive investment opportunities for many years.
ONEOK Partners
ONEOK has a dominant position at the mid-Continent NGL hub in Conway, Kan., and a beachhead at Mont Belvieu, with fractionation and storage at both market centers. Moreover, ONEOK controls key pipelines that link the two market hubs, giving the partnership an opportunity to arbitrage NGL prices between the two. We think ONEOK's current Bakken investment program is a savvy move that will build a strong franchise in a growing producing region, where natural gas gathering and processing and NGL takeaway capacity are all currently constrained. By building processing plants and NGL pipelines from the Bakken south to its Overland Pass pipeline, we think ONEOK is strengthening its asset footprint and establishing a claim on a greater share of the midstream value chain.
Targa Resources Partners
Targa also operates a diverse and integrated NGL system, somewhat akin to Enterprise's though not quite as flexible and not nearly as large. Targa has the second-largest NGL fractionation footprint in Mont Belvieu and Louisiana combined, with 385,000 bpd of net capacity. Over the next two years, the partnership plans to phase in another 218,000 bpd of gross fractionation capacity. This integrates with shipping docks on the Houston Ship Channel, 1.4 million barrels of storage capacity, and other logistics and marketing assets scattered around the country. With a solid downstream marketing and logistics operations and a marine export terminal, Targa should be a major participant in increasing NGL exports. Finally, we note that Targa's gathering and processing operations in the Permian Basin and the core of the Barnett should continue to see strong volumes thanks to the liquids-rich nature of these plays.
MarkWest Energy Partners
MarkWest makes our top four thanks to its first-mover advantage in the potentially enormous Marcellus. Through its Liberty joint venture with a private equity firm, MarkWest is building the largest processing footprint and NGL fractionation complex in the Northeast United States. After bringing its 60,000 bpd fractionator in Houston, Penn., on line in 2012, MarkWest will have 84,000 bpd of fractionation capacity in Appalachia to support nearly 1 billion cubic feet per day of processing capacity. The partnership's potential Project Mariner with Sunoco Logistics (SXL) could further expand its NGL footprint by providing an ethane transportation solution for the Marcellus. While MarkWest's NGL operations are the smallest of this group, they have the potential to grow the most in our view.
Source: Enterprise Products Partners
NGL Price Relationship to Crude Oil
Historically, NGL prices have closely tracked the price of crude oil, as illustrated in the chart below. Over the past five years, through the ups and downs of a full commodity price cycle, the median NGL-to-crude price relationship was 60%, with a standard deviation of 6.4%. The correlation coefficient between NGL and crude oil prices over this period was strong at 0.93, which makes sense given that NGLs can act as substitutes for various crude-oil derivatives.
Most notably, ethane can substitute for crude-based naphtha as a feedstock to create ethylene, used to make plastics, films, detergents, synthetic lubricants, etc. Also, refiners can blend butane with gasoline at times, making each barrel of crude oil go a little bit further toward ultimate gasoline production. While there's no guarantee that the NGL-to-crude relationship will remain the same going forward, we think the 60% range is a reasonable assumption as we expect North American supply and demand to grow in tandem for years to come.
North American NGL Supply-Demand Fundamentals Remain Attractive
On the supply side, there's no doubt that producers have collectively allocated their budgets toward liquids-rich plays in recent years. Perhaps the most conspicuous example of this trend is Chesapeake Energy (CHK), which directed only 10% of its capital expenditures to liquids in 2009 and 30% in 2010 but plans to allocate 50% of 2011 capex and 75% of 2012 capex to liquids.
The company estimates that this help boost liquids from 12% of realized revenues in 2009 to 44% in 2012. While other examples may be less extreme, producers as a whole are clearly focusing on oil and liquids-rich natural gas plays over dry-gas plays.
Recent and forward-looking commodity price dynamics illustrate why we've seen such a shift and why we expect it to continue. In the most attractive liquids-rich plays, such as the Bakken, Eagle Ford, and Marcellus shales, producers could give away the gas for free and still make midteens-plus aftertax returns from the NGL content alone. Given our outlook for a continued wide spread between crude oil and natural gas prices on a Btu-equivalent basis--even with some improvement in natural gas prices--we expect that producers will continue to target liquids-rich shale plays to maximize returns for years to come.
Moving to the demand side, the petrochemical industry has absorbed ethane production increases in recent years with no signs of slowing down. According to the Energy Information Agency, ethane production increased by approximately 180,000 barrels per day from 2005 to 2010, and crackers have increased consumption at a similar pace, eclipsing 1 million bpd of ethane cracking at the end of 2010.
Petrochemical operators such as Dow (DOW), LyondellBasell, Shell (RDS.A), and others continue to expand and debottleneck crackers. For instance, in December Dow said that it plans to boost its ethane cracking capacity along the Gulf Coast by up to 30% over the next three years, as it expects a favorable oil/gas ratio to continue. Shell even announced the possibility of a newbuild ethane cracker in Appalachia to handle growing ethane production out of the Marcellus shale.
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