By Stacey Morris
When you think of a commodity gaining over 60% in a matter of eight weeks, the story may read more like that of an agricultural product being plagued by some exotic beetle. In Texas, we were well aware of the price spike in limes in 2014 and the consequences for Texas staples like guacamole and margaritas. This time, the dramatic gain doesn't relate to an agricultural product, but to ethane - a natural gas liquid (NGL).
Today, we shift our attention to NGLs and, specifically, ethane. We look at the drivers behind ethane's meteoric price performance recently. We also discuss MLPs and midstream companies with exposure to NGLs and how ethane fundamentals may create opportunities for midstream companies.
NGL production has been up and to the right
Production of NGLs in the US has grown alongside the production of oil and natural gas, as shown below. Much of this growth is coming from the Permian and Eagle Ford, requiring more fractionation capacity on the Gulf Coast. Enterprise Products Partners (NYSE:EPD) cited forecasts for Permian NGL production to more than double in the next four years in a recent release. This growth will not only require pipelines but also fractionation capacity to convert unprocessed NGLs (also referred to as "Y-grade") into usable products.
Ethane no longer a reject? Depends where it is
Ethane is one of the NGLs produced through fractionation. Propane, butane, isobutane, normal butane, and natural gasoline round out the list of NGL purity products. Ethane is arguably the humblest of NGLs given its lower value relative to other NGL products and the mere existence of the term ethane rejection. Ethane rejection is energy parlance for leaving ethane in the natural gas stream instead of extracting it, often due to insufficient economics to justify the processing.
Ethane is typically used as a feedstock for ethylene crackers. Simply put, cracking is a process that uses high temperatures to manufacture desired petrochemicals from certain feedstocks. Ethylene crackers process ethane into ethylene1, which can be used to produce plastics like polyethylene (the most used plastic globally) and PVC. On the heels of the shale revolution, petrochemical companies began making plans to build ethylene crackers in the US to take advantage of anticipated growth in NGL production and the cost-competitive nature of the supply. As shown in the slide below from the Phillips 66 (NYSE:PSX) August presentation, North American NGLs are at the low end of the ethylene cost curve.
Like most energy projects, ethylene crackers have been years in the making, with projects announced in 2011-12 starting to come on-line now. Project examples are highlighted in the map below. The EIA forecasts that consumption of ethane/ethylene will increase from 1.24 to 1.62 MMBpd on average from 2017 to 2019, while ethane production is expected to increase from 1.43 to 1.93 MMBpd for the same time frame (exports account for the difference - discussed later).
The recent startup of Exxon's (NYSE:XOM) ethylene cracker in Baytown on the heels of CP Chem's2 startup has led to increased ethane demand on the Gulf Coast. Meanwhile, fractionation capacity required to separate ethane and other NGLs has also been tight at Mont Belvieu - the NGL hub in Texas - due to increased production. In short, ethane supply has struggled to keep up with incremental demand contributing to the price spike. In its 2Q earnings call, Targa Resources' (NYSE:TRGP) management indicated that they expect fractionation capacity at Mont Belvieu to remain tight through next year, even with the startup of their 100-MBpd fractionator in 1Q19.
To be clear, the current tightness and ethane price strength is specific to the Gulf Coast. Per Bloomberg, the ethane/propane price mix at the Conway hub in Kansas is only 13 cents per gallon, or roughly a quarter of the ethane price at Mont Belvieu as of Friday. ONEOK (NYSE:OKE) noted in a recent investor presentation that ethane rejection at Conway is expected to continue until its Arbuckle II pipeline is placed into service, which is anticipated in 1Q20.
How do these ethane trends relate to midstream companies?
Clearly, growing NGL production necessitates more energy infrastructure - pipelines, fractionation capacity, and export terminals. We don't have the real estate to detail every NGL pipeline project or expansion, but there are plenty of examples3. Increased volumes are also supporting high utilization on existing NGL pipelines. For example, OKE indicated that its Sterling pipeline was operating at 80-90% utilization, and its Arbuckle pipeline was at 85-90% on its 2Q earnings call. DCP Midstream (NYSE:DCP) indicated on its 2Q call that increased ethane recovery supported higher pipeline volumes, resulting in an incremental $6 million of distributable cash flow from 1Q18 to 2Q18.
Rising prices and tightness in fractionation capacity create a constructive backdrop for signing up customers for new fractionation plants and potentially negotiating more attractive processing economics. Last week, OKE announced a new 125 Mbpd fractionator at Mont Belvieu, its fifth at the hub, and the potential to add a sixth fractionator in the future. In early September, EPD announced that construction had started on its tenth fractionator at Mont Belvieu, with the 150-MBpd addition bringing EPD's total capacity at Mont Belvieu to 905 MBpd.
As a reminder, fractionation contracts can be fee-based, based on a percentage of proceeds (POP), or based on a percentage of liquids (POL). POP and POL contracts provide exposure to NGL prices, which midstream companies may or may not choose to hedge. The nature of the contract and hedging may impact any benefit from the improvement in NGL prices, but higher NGL prices should be positive for those with POP and POL contracts. In its investor presentation, DCP provides its sensitivities to commodity prices on an annual basis as shown below, as well as the percentage of its margin that is hedged.
Exports of ethane also on the upswing
Ethane exports from the US have also grown from less than 100 MBpd in 2015 to approximately 250 MBpd in 1H18. Energy Transfer's (ETP) Mariner West system can export ethane to Canada, as can Kinder Morgan's (NYSE:KMI) Utopia pipeline, which began service in January. In terms of overseas exports, ETP's Marcus Hook facility in Pennsylvania began exporting ethane in 2016. EPD's Morgan's Point ethane export terminal on the Houston Ship Channel, which is supplied by its Mont Belvieu assets, also began operations in 2016. Earlier this year, ETP announced plans to partner with Satellite Petrochemical for a new Gulf Coast ethane export facility that would supply Satellite's crackers in China upon start-up expected in 4Q20. The export facility would be supplied via an ethane pipeline from Mont Belvieu.
While normally taking a backseat to oil and natural gas, natural gas liquids have garnered increased attention as production growth has tightened fractionation capacity on the Gulf Coast and new ethylene crackers have increased demand for ethane. The result has been a sharp increase in ethane prices to levels not seen in more than five years - a benefit for those midstream companies providing fractionation under POL and POP contracts. Much like the imbalance between Permian crude production and pipeline takeaway capacity, the industry seems to be facing an imbalance between Gulf Coast NGL production and fractionation capacity, with increased ethane demand further complicating the picture. For midstream, the situation highlights the growing demand for NGL-related infrastructure and supports high utilization for existing assets.
1 Ethylene can also be produced from other feedstocks such as naphtha.
2 CP Chem is a joint venture of Chevron (NYSE:CVX) and Phillips 66.
3 DCP’s Sand Hills, Front Range, and Texas Express expansions, OKE’s Sterling III expansion, West Texas LPG expansion, and Arbuckle II expansion and extension, EPD’s Shin Oak NGL pipeline, MPLX’s Liberty NGL Pipeline in Appalachia (currently in open season).
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Stacey Morris is the Director of Energy Research at Alerian, which equips investors to make informed decisions about Master Limited Partnerships (MLPs) and energy infrastructure. Ms. Morris engages with the investment community to increase awareness of the Alerian Index Series and support broader understanding of the role that midstream assets play in North American energy markets. Ms. Morris was previously the Investor Relations Manager for Alon USA Energy, overseeing investor communications for the corporation and its variable distribution MLP, Alon USA Partners. Prior to Alon, she covered the integrated majors and refiners at Raymond James as a Senior Associate in the firm’s Equity Research Division. Ms. Morris graduated summa cum laude with a Bachelor of Science in Business Administration from Stetson University, and is a CFA charterholder.