Oil and natural gas prices are facing a “third variable” on plentiful natural gas liquids (NGL), which appears to be creating the next domestic supply glut, a KeyBanc Capital Markets (KBCM) analyst said Wednesday.

David Deckelbaum, who was in Pittsburgh to speak at Hart Energy’s Marcellus-Utica Midstream Conference & Exhibition, said the NGL market is a “big ‘what if,'” today. Economics make it a “tough place to make money.”

KBCM’s NGL-weighted coverage universe is down 16% since the beginning of 2012, while the “actual NGL barrel is down 25% over the same period. Meanwhile, gas-weighted names are down 23% versus spot gas prices up 10% after a spring recovery…”

To some extent, NGL activity is “tracking crude growth,” and analysts expect NGL supply to grow this year by 33% to more than 765,000 b/d versus 400,000 b/d in 2009.

“Anecdotally, we see even greater capital efficiencies potentially leaving our 2013 growth estimate of 27.5% as understated as more operators shift to horizontal exploitation in areas like the Permian and the Eagle Ford…Bakken names have exhibited zero desire to slow down.”

Natural gas prices have been the whipping boy and for the past three years they’ve taken the gassy exploration and production (E&P) companies to the woodshed with them. KBCM estimated that 2012 dry gas supplies jumped 8.9% within its coverage universe, and will grow 8.8% this year and 21% in 2014.

“Investors aren’t paying me to go out and explore anymore; they don’t care if there’s a new shale play out there,” said Deckelbaum. Investors worry that unconventional plays they’ve already put money into are “pumping out too much gas and even too much ethane, propane and other liquids, that supply has outpaced demand and the prices of everything, including the liquids that everyone rushed to drill over the past two years, are far too low to make returns.

“We see more risk for natural gas liquids than any other commodity.”

Most of KBCM’s companies have dropped “all gas rigs except for marquee areas of the Marcellus,” but volumes continue to build from “ample” associated gas and byproduct gas in the Eagle Ford, Permian, Bakken, East Texas and in the Gulf of Mexico.

“We could see more with added NGL fractionation,” said Deckelbaum. And as “liquids-rich correlations break down relative to crude, we wonder if NGLs are the next domestic supply glut.”

NGLs have created a “third variable to worry about,” a “trifurcation” between oil, natural gas and NGLs. “Bifurcation becomes ‘trifurcation’ this year.”

Of the estimated 434 onshore natural gas rigs now operating, “roughly 150 are actually drilling for NGLs, a number that keeps growing,” said Deckelbaum. “We estimate that in many cases, the [NGL] pricing uplift has compressed to $1.00/Mcfe from $2.50/Mcfe last year in aggregate…”

A problem that KBCM analysts see developing for many E&Ps “is not the fear of a crude weakening from $96/bbl levels. Instead, it’s the malaise of another year of abysmal gas pricing and potentially persistent weakness for NGL pricing, a product whose correlation has broken down significantly to crude pricing…”

The “trifurcation” also is creating a “hedging conundrum,” he said. About one-third of the 32 companies in the KBCM E&P coverage universe “are at least attempting to hedge portions of the heavier NGL barrel…” such as natural gasoline and butane.

However, even though NGL prices are down 25% year/year, operators still are directing beaucoup capital to liquids. “The situation shouldn’t be as dire as the natural gas market, but it likely isn’t correcting itself anytime soon.”

The average NGL barrel is about 43% ethane, 29% propane, 16% butane and 11% natural gasoline. Propane and natural gasoline are driving about half of the NGL economic equation. And ethane rejection is “teetering in most areas…” The Conway hub ethane “is almost being given away.”

U.S. ethane output is roughly 1 million b/d, while average annual demand runs about 900,000 b/d, said Deckelbaum. The market looks “tenuous at best” until 2016.

An abundance of propane may prove to be a stickier wicket since it makes up about 29% of the NGL barrel. Mild winter temperatures “have led to huge inventory builds,” said Deckelbaum. Supplies are “over 80% above last year’s levels…Sound familiar?”

Ultimately, crude prices still will help NGL prices, he said, and there’s not “truly a disincentive” to drilling until oil prices fall by around $20 from their current price. That scenario, at this point, is looking less likely every day.

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