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Midstream's Fortunes Wane on Market Trends

A handful of economic, market and meteorological factors have reshaped the outlook for natural gas liquids (NGL), building stocks of ethane in the face of an evaporating market and potentially adding to downward pressure on natural gas prices in the first quarter should the coming winter be one of modest temperatures.

"If we have a mild or possibly even a typical kind of a winter, there's a good likelihood that we're going to come out of the winter with high amounts of gas in storage, and then it's going to get pretty ugly, I think. But if we consume a fair amount of gas during the winter then we'll probably be OK," Ron Gist, senior principal with Houston-based consultants Purvin & Gertz told NGI.

Ethane is the only one of the NGLs that is fully discretionary, meaning it does not need to be removed from the natural gas stream for operational reasons. Unlike the other constituents of the NGL barrel -- propane, normal butane, isobutane and natural gasoline -- operators let economics dictate whether they sell ethane to the ethylene market or leave it in the gas stream to increase heating value and volume. Operators have some discretion over whether they extract propane. Fractionation (frac) spreads for the non-discretionary NGLs are positive, and should remain so, Gist said. "[B]ut the one knob that these guys are going to probably turn is the extraction of ethane," he said. "Ethane is very compatible with natural gas, and they can choose to leave it in the gas stream and have no particular problems."

Ethane frac spreads went negative this month, Gist said, meaning the commodity is worth more to producers as part of the natural gas stream. "All of a sudden, we've got a lot of ethane trying to push into a market that is declining," he said. This is the result of a number of factors.

September's Gulf Coast region hurricanes -- Gustav and Ike -- shut down a number of ethylene producers in the region. While the storms also crimped ethane production, it was not to the same extent. In fact, Gist said according to industry research, four ethylene plants are still shut in: two due to the storms, one for maintenance and one for economic reasons. "[W]hen the ethylene plants stopped running for a while...the demand essentially went to zero," Gist said. "Our analysis shows that ethane inventories went from the bottom of the range to the top of the historical range in one month."

The current economics of gas processing were highlighted recently when Texas Gas Transmission reported to customers that the Eunice Gas Processing Plant in South Louisiana was shut in for economic reasons. The pipeline said plant operator Crosstex Energy Services told it that declining NGL prices made plant operation "uneconomical and/or unprofitable at this time." Crosstex Energy confirmed the shut-in but could not predict its duration.

While noting that processing margins have retreated from historical highs of 2007 and earlier this year, Fitch Ratings said in a note last week that it expects the sector to "maintain credit quality over the long term given relatively low leverage, discretionary capital spending and the expectation that NGL pricing will remain within historic norms similar to those experienced in 2005 and 2006."

Fitch also noted that a migration to fee-based contracting in the midstream sector has reduced sensitivity to commodity price fluctuations. "However, it is not uncommon for keep-whole [processing] contracts to return a negative margin during periods of high price volatility...At particular risk are activities supported by keep-whole arrangements in more traditional areas, such as the Gulf Coast, as operations in the Rockies continue to benefit from lower natural gas costs basis due to lower takeaway capacity in the region."

Meanwhile, the global economic crisis has ravaged demand for ethylene, which is used to make numerous products, such as paints, adhesives, antifreeze, packaging, flooring, clothing, electronics, etc. And worldwide ethylene production capacity is growing as plants in the Middle East and China come on-line this year and next and into 2010. "Now all of a sudden, the products that we were exporting like polyethylene are going to be produced elsewhere," Gist said. "We're not only seeing a downturn in the domestic demand but also the exports of ethylene derivatives."

And then there is the plummeting price of oil, which has fallen more rapidly than natural gas prices, which were up around $13 earlier this year. NGL prices tend to follow oil prices, Gist said, and the current direction is down. Gas prices, though down, have shown strength relative to oil, therefore diminishing the value of the gas liquids.

"Increased U.S. gas production, coupled with the completion of NGL takeaway pipelines, has resulted in increased NGL supply, just as the U.S.economy is entering a recession and chemical [industry]/NGL demand is falling," notes a recent midstream update from analysts at Tudor, Pickering, Holt & Co. LLC in Houston. "Worldwide, companies are idling propylene and ethylene plants...and chemical companies are issuing cautious outlooks for 2009."

The analysts report that NGL prices, which have traded historically at 65-70% of crude oil have more recently traded at about 45% of the price of crude. Frac spreads that are now negative were as high as $11 last July. Naphtha, an alternate feedstock to ethane, which is used by China's ethylene producers, for instance, has fallen from about $1,200/ton this summer to less than $300/ton in some places. Ethane prices have seen a 75% decline from July as well. "With the recent collapse in commodity prices and economic conditions, everything has been turned on its head," the Tudor Pickering analysts wrote.

"The ethylene industry is just cratering, domestically and globally," said Gist.

The Tudor Pickering analysts are suggesting that the down cycle for NGLs may last a little longer than previous cycles "because of the potential depth of this recession and the amount of new NGLs coming on-line..." For the next couple of years the firm is modeling that NGLs trade at about 50% of the price of crude oil, compared to the historic 65-70% and current 45%. New ethylene and propylene plants not yet under construction will likely be tabled, they said.

For the natural gas market, winter is the biggest wild card, and its effect won't be fully known until the second half of February or possibly as late as March, Gist said. Abundant storage balances will spell trouble for prices. "And then throw in for good measure that there's a lot of LNG [liquefied natural gas] plants that are going to be starting up in 2009," he said. "They've been delayed a little bit, but they'll be cranking up [liquefaction], so we're going to have more LNG, and if it doesn't find a home anywhere else it's going to the U.S.

"I think there is some potential that if we have a lot of gas in storage and we have all this prolific production in the shale gas plays and potentially some LNG later in the year, I think as we get further down into the summer period and the inventories begin to fill up, we may see some folks shutting in production."

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