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  • Untitled Document
    Untitled Document

    Are we headed over the frac spread cliff?

    BY SANDY FIELDEN

    FOR RBN ENERGY LLC

    The values of the crude-to-gas ratio and the frac spread have fallen 50% from their highs this year. Frac spreads represent the difference between the value of natural gas and natural gas liquids (NGLs), which are heavily influenced by the price of crude. Thus the frac spread is in effect tied to the gas-to crude ratio. Current forward curves suggest that the crude-to-gas ratio will fall another 50% over the next few years. Today we ask whether the frac spread will continue its fall next year and beyond.

    Back in August, we looked at the relationship between crude and natural gas prices. At that point, the crude-to-gas ratio between NYMEX West Texas Intermediate (WTI) crude futures and NYMEX Henry Hub natural gas futures was around 32. After trading to a high of 54 in April 2012 when natural gas prices fell to below $2/MMBtu the ratio has drifted down 50%  to its current value of 26.

    Since April, natural gas prices increased through mid-November before falling back a little to $3.35/MMBtu. Crude oil prices have fallen from a high of $110/Bbl in February, recovered between June and September and then fell again to about $87/Bbl on Dec. 17. The overall decline in the crude-to-gas ratio has been caused by rising natural gas prices and lower crude prices since the ratio reached 54 in April.

    A high crude-to-gas ratio underpins strong natural gas liquid (NGL) processing margins. If natural gas is less expensive and crude oil is more expensive then NGL processing margins tend to be higher. That is because NGL processors transform hydrocarbons in a gaseous form (natural gas) into hydrocarbons in a liquid form (NGLs) that tend to track the price of crude oil – at least some of the time.

    A rule of thumb measure of the difference between the value of NGLs and natural gas is the frac spread. The frac spread has halved in value from about $12/MMBtu last December to $6/MMBtu this past week. The wider the frac spread the more favorable the market for natural gas processors (although there are a number of caveats to this – relating to the liquids content of the natural gas and the percentage makeup of the NGLs).

    To sum up we had a very high crude-to-gas ratio in April 2012 that has fallen off since then by about 50%, and we had a high frac spread last December that has also fallen off in the past year by about 50%. So why are both these measures falling?

    We identified rising natural gas and lower crude prices as the culprits for the lower crude-to-gas ratio this year a minute ago. The same rising natural gas prices have a negative impact on the Frac spread because natural gas is the feedstock for NGLs. The only piece of the puzzle we haven’t looked at yet is how the NGL liquids in the frac spread are related to crude. The NGL to crude ratio is defined as a basket of NGL prices converted to $/Bbl and divided by the WTI NYMEX crude price. Like the crude-to-gas ratio and the frac spread, the NGL to crude ratio has also fallen this year – from about 60% back in Dec. 2011 to 43% this week. That makes it look as though both NGLs and crude have been weak this year, but that is not the full story.

    Here’s why – all NGLs are not created equal. We have to look inside the NGL mix to really understand what is going on with both the NGL to crude ratio and the frac spread. The product basket in the NGL to crude ratio is the same as the frac spread (see paragraph 4 above and note for the NGL to crude ratio there is no conversion to btus). Seventy percent of the NGL mix is ethane and propane – the “light” NGLs. This year prices for light NGLs have been low because of an oversupply of propane and olefin cracker outages reducing the demand for ethane.

    The “heavy” NGLs - butanes and natural gasoline have fared better than the lights because they are used primarily for gasoline production (including diluent for heavy crude) and have mirrored higher gasoline and crude prices. The NGL to crude ratio has therefore been pulled down this year by weak prices for the lights that make up ~70% of the mix. That same weakness in light NGLs has pulled down the frac spread.

    So we have had a lousy year for both the crude-to-gas ratio and the frac spread in 2012, but what everyone wants to know is whether things are going to get better or worse in 2013?

    Let’s first try and answer that question by looking at the futures market. Futures tell us what the current market sentiment is for the crude-to-gas ratio going forward. The crude curve goes up until the end of 2013 and then falls until Jan. 2019 where it levels off at just over $84/bbl. The natural gas curve increases consistently through Dec. 2021 to $6/MMBtu. The trend for the forward curve crude-to-gas ratio is another 50% decline over the next nine years from 26 in Jan. 2013 to 14 in Dec. 2021.

    It would be easy to imply therefore that if the crude-to-gas ratio carries on downhill as the forward curve suggests and if natural gas prices are going to keep on rising, we might as well kiss the frac spread goodbye as well.

    Fortunately it looks like the decline in the gas-to-crude ratio we see in the forward curve is unlikely to take effect during 2013 and as a result the frac spread will be spared for next year at least. A number of factors suggest why this should be the case. For a start natural gas prices may not rise next year as far and as fast as the forward curve implies that they will. Storage levels are still at an all-time high. Production volumes are still increasing, or at least holding flat.

    The winter so far has done nothing to reduce the excess (last week there was an unusual gas storage injection in December). Continued record storage levels will mean weaker natural gas prices during 2013.

    The crude forward curve shows prices rising during 2013 in response to the Seaway and Keystone pipelines bringing additional crude to the Gulf Coast. If crude prices stay above $80/bbl and natural gas prices stay weak, the crude-to-gas ratio will not continue downhill and may even recover.

    For the NGLs, as we have seen the heavies should follow the crude price and stay higher in 2013. Thus the key to the frac spread is therefore going to be how the lights – propane and ethane perform. The NGL market is pinning its hopes on propane exports to soak up extra supply and bolster the frac spread by raising propane prices. Higher propane prices will bring ethane prices up as well because the two compete as feedstocks in olefin crackers. A great deal of hope therefore rests on the shoulders of the Enterprise Mont Belvieu export terminal coming online in Jan. 2013 to keep the frac spread buoyant next year.

    Just because we avoid the cliff in 2013 does not mean we are out of the woods. If the gas-to-oil ratio plays out as indicated, the downward pressure on the frac spread will continue. And there are real market threats that could push things in that direction. Consider the scenario where natural gas exports are permitted, resulting in higher gas prices, while at the same time crude oil exports are blocked, due to whatever political winds that are blowing at the time. That is definitely a recipe for the gas-to–crude ratio we see in the forward market today, which should be a serious concern for gas processors across the North America market.

    So we can conclude the following from all of this:

    ·         It looks like gas processing margins will be healthy in 2013 – not as good as this time last year, but considerably better than Q4 2012. The recovery in the frac spread will be primarily driven by propane exports pushing up propane prices and weaker natural gas prices due to continued production growth and high inventories.

    ·         The further out we look, the more bearish the frac spread looks, and there are forces working to make it play out that way. This weaker market for gas processors is far from a certainty, but it is something to worry about.

    ·         It will be very important to watch market relationships between the commodities closely, because that’s where it will be possible to spot any potential problems first. We’ll examine several of those relationships in a future article.

    Visit www.rbnenergy.com for further information about the frac spread and other critical issues facing the energy industry.

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