so far, second-quarter 2012 has been marked by steep losses across the board. A host of disappointing economic data from the U.S., Europe and China undermined the markets with the single biggest culprit being the U.S. May jobs report, which indicated that the unemployment rate climbed unexpectedly to 8.2% from 8.1% in April.

The energy sector, which was already one of the biggest laggards year-to-date, underperformed the broader equity market dramatically with the benchmark S&P Energy Index falling 10.62% in May as compared to the S&P 500 Index, which had a more modest decline of 6.27%.

Amid the sell-off in equities, the yield on the 10-year treasury benchmark fell 32 basis points to close at a new record low of 1.46%, reflecting the widespread risk aversion. Front-month West Texas Intermediate (WTI) crude oil fell 17% in May to $86.53 per barrel (bbl.), moving meaningfully below $90 for the first time since October 2011. Meanwhile, front-month Henry Hub gas prices rose 6% to exit the month at $2.42.

Oil-gas divergence

The divergence between the two commodities compressed margins for natural gas liquids (NGLs), with NGL prices dropping 26% to $34.24 per bbl. at Mont Belvieu, the coastal benchmark, and to $27 at Conway, its inland counterpart. The Conway market is now at a 27% discount to Mont Belvieu as compared to the 10-year average discount of 5% as it is awash with supply from burgeoning inland liquids production.

For reference, ethane and propane prices, as a proportion of Brent crude, were 25% and 60%, respectively, at the beginning of 2011, but fell to 13% and 30% at the beginning of June 2012, thus outpacing even the oil price decline, according to analysts at Alliance Bernstein.

Under pressure

NGL prices have been under pressure all year, hurting the liquids-oriented upstream producers as well as those in the midstream space, particularly the gathering and processing master limited partnerships (MLPs), which is the worst-performing MLP sub-industry. Within this segment, MLPs with the highest commodity price exposure, such as MarkWest Energy Partners LP and Atlas Pipeline Partners LP, have suffered the most in second-quarter 2012, down 18% and 15%, respectively.

Meanwhile, large caps partnerships, particularly the diversified majors which operate under fee-based contracts with minimal commodity price exposure, such as Enterprise Products Partners LP (-3%), and Plains All American Pipelines LP (+0.10%), have outperformed.

Despite upbeat comments from most exploration and production (E&P) companies and MLP management teams regarding NGL price forecasts, Wall Street analysts expect NGL weakness to persist into 2013.

Enterprise Products, the largest pipeline MLP, forecasts NGL supply to rise 25% by 2015 to about 3 million bbl. per day, driven by ethane. However, investors are concerned that all this ethane production will exceed the near-term demand that can be spurred from petrochemical steam-cracking capacity until new ethylene crackers come into service in about 2017.

To that end, shorting a basket of NGL-exposed stocks has become one of the most common strategies for short-term-oriented traders.

NGL exposure

The question for longer-term investors is how to determine NGL exposure and the impact of compressed fractionation spreads. Lower NGL prices would harm cash flows for E&Ps, but would have mixed implications for energy infrastructure companies, depending on whether they operate under volume- and fee-based processing contracts with minimal commodity price exposure, or other agreements, such as percent-of-proceeds or keep-whole contracts, which would expose them to price risk.

With Conway ethane prices of $1.40 per million Btu below regional cash gas prices, some producers are already rejecting ethane from the processing stream. In other words, it is now more economic to sell ethane as Btus in the gas stream than to separate the liquids from the dry natural gas. Removing ethane from the market should help balance the NGL supply-demand balance, which would be bullish for NGL prices.

No safe haven?

However, ethane rejection is bearish for natural gas prices in that it increases produced gas volumes and increases the Btu value of the gas stream, meaning that 1 Btu of demand could be satisfied by a lower quantity of gas.

Going forward, the Mont Belvieu-Conway spread will dictate capital flows. If the spread remains wide, investor capital will remain with producers and processors that deliver NGL volumes to the premium markets on the Gulf Coast. But if Mont Belvieu comes under pressure and the spread narrows, the Gulf Coast may no longer be considered a safe haven.

Tamar Essner is associate director of Energy Advisory Services for Thomson Reuters and can be reached at tamar.essner@thomsonreuters.com, 646-822-3646.

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