by Aaron Levitt | September 24, 2012 8:00 am
It seems that hydraulic fracturing is truly an efficient way to extract hydrocarbons. Use of the advanced drilling technique has surged over the last few years as exploration and production (E&P) firms have raced to exploit shale formations dotting North America.
As firms such as Chesapeake Energy (NYSE:CHK) have extracted unprecedented amounts of gas trapped in rocks, swelling inventories of the fuel have driven prices down to historic lows. At one point this year, natural gas futures slipped below $2 per million British thermal units (Btu) — a level not seen since January 2002. While natural prices have bounced back some, hitting those lows spurred many producers to curtail dry-gas production and switch to more profitable natural gas liquids (NGL) and shale oil.
Well, as they say, “No good deed goes unpunished.”
As the E&P industry has rushed into NGLs, such as ethane and propane, it seems that this market is now facing its own glut. Following a similar path as regular dry gas, the oversupply of NGL fuels is causing prices to plummet. For investors, that could lead to some pain ahead, as well as opportunity.
NGL fuels are a group of heavier hydrocarbons that occur underground with natural gas and tend to revert to their liquid phase once brought to the surface. The price of a mixed barrel of these commodities — usually quoted as ethane/propane mix — have tended to track movements in the market value of crude oil. That is, until more focus was placed on the group.
It seems that producers have just spread the glut of dry gas over to NGLs. With supplies seen outstripping demand until new plants start production in 2015, prices for NGLs have fallen by the wayside.
Ethane prices have halved in 2012 — benefiting chemical manufacturers — while propane and butane have fallen nearly a third. The price of a barrel of ethane-propane mix was down nearly 58% from its January highs. That’s outpaced the roughly 19% drop in crude oil from a February peak. Analysts at Tudor, Pickering, Holt dubbed the current pricing situation the “NGL bloodbath,” and it seems to be holding true for producers.
The low NGL prices have many explorers cutting production and reducing cash flow projections. The oil service firms have also forecasted lower demand for their drilling rigs and supplies, while the pipeline owners suffer falling revenue for their gas liquids processing plants.
A virtual who’s who of the natural gas industry appears to be suffering. Pipeline companies Targa Resources (NASDAQ:NGLS) and Enbridge Energy Partners (NYSE:EEP), which own facilities that process gas to separate NGLs, warned of lower earnings because of the price collapse. Likewise, producers like Spectra Energy (NYSE:SE) and Devon () have also blamed the glut for lower quarterly profits.
Perhaps the biggest shift were recent comments from unconventional energy superstar EOG Resources (NYSE:EOG). This independent E&P firm plans to switch production to shale oil-rich plays and move away from the dry-gas/NGL combo fields because it’s “not as sanguine about what’s going to happen in 2013 for NGL prices.”
For investors, the fall of NGL prices poses an interesting dilemma. In the short run — perhaps the next two years or so — there’s definitely going to be plenty of pain for producers without any shale oil exposure. Analysts peg a healthy NGL price at about 55% of WTI crude oil prices. Today, NGL trades for only 40% of crude, and analysts expect NGL prices to trade at about 42% of crude in the second half of the year.
For a firm like Quicksilver Resources (NYSE:KWK), which gets about 96% of its production from natural gas and NGLs, that’s certainly a huge issue. I expect there to be a continued shakeout for the rest of the fall across the sector as some of the truly pure players may not make it.
However, for the survivors there’s some hope on the horizon. The petrochemical industry accounts for roughly 54% of U.S. NGL demand and substantially all of the nation’s ethane consumption. What happens in this end market has significant implications for the prices of these commodities.
Two recent developments could help turn the tide in the long run. Royal Dutch Shell has (NYSE:RDS-A, RDS-B) announced that it will build a world-scale ethylene plant in Pennsylvania that would source its ethane feedstock from the Northeast’s Marcellus Shale. And a Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP) joint venture will build a major ethane cracker and ethylene derivatives facility in the Texas Gulf Coast region.
Also, gas and NGL prices are higher outside North America, and that could lead to plenty of exporting opportunities. Yet, it will take time to develop those markets, and the new ethylene crackers are just in the initial stages of development.
For investors, shifting short-term focus to the firms with some sort of shale oil production, like SandRidge Energy (NYSE:SD) or Bill Barrett (NYSE:BBG), could be in order. At the same time, keeping some powder dry to snatch up the quality natural gas firms that survive the shakeout seems also prudent given the more hopeful longer-term scenario for NGLs.
As of this writing, Aaron Levitt is long RDS-A and RDS-B.
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