The Slippery Slope for Liquids Pricing

While many operators have become accustomed to viewing the E&P world as one of oil vs. gas—and the resultant comparative economics—2012 has introduced a new variable into the equation: natural gas liquids.

Historically, operators have experienced a static 55% to 60% yield of natural gas liquids (NGLs) to West Texas Intermediate (WTI) pricing that perhaps was taken for granted. That return certainly helped justify drilling in primarily gassy plays, in which a glut has suppressed natural gas prices, that could be enhanced through liquids extraction. But last March began a period of lower seasonal demand, infrastructure downtime and over-drilling that catalyzed an NGL price drop of 30% from March to October, primarily led by ethane and propane.

In a world of $3-per-thousand-cubic-feetequivalent (Mcfe) gas, all operators high-graded drilling efforts to liquids-oriented targets. The gas rig count dropped from near 800 rigs at the end of 2011 to about 400 currently, with roughly 150 of those rigs actually drilling liquids-rich targets.

What’s transpired has been a classic case of overproduction and waning demand that compressed a generic NGL uplift from $2.50 per Mcfe toward $1 per Mcfe, providing a much slimmer incentive to drill in a $4.50-per-Mcfe world than perhaps at $6 plus. What this likely means is a gut check for operators. They need to re-examine drilling incentives in areas like the wet portion of the Eagle Ford, Woodford Cana and Granite Wash plays.

More NGLs coming

KeyBanc Capital Markets estimates that of its 34 E&P companies under coverage, NGL production will grow 31% in 2012 and another 26% in 2013, vs. 9.7% and 13.8%, respectively, for natural gas, as most companies have rationed all dry-gas-related activity save for areas like the Marcellus. Additionally, the firm cautions that more NGL capacity is coming online, particularly in the Appalachian and Permian basins, where additional fractionation and cryogenic capacity is being added as soon as yearend 2012.

Classically, the rig count has been observed to grow as long as the blended Btu of oil and gas was above $8 per Mcfe. With NGL pricing enduring several quarters of weakness, which may persist well into 2013, we could see another 100-plus rigs leave the market. Maybe anecdotally this would help compress associated gas volumes, but it would also marginalize operators that may be left without pure crude options.

Ultimately, crude pricing is going to help NGL pricing, as the correlation hasn’t completely broken down. But at 35% of current WTI pricing, several plays can start to generate returns below 15% pre-tax internal rates of return (IRR), generally a blanket hurdle to pull the trigger on rig activity. KeyBanc estimates various returns for several domestic plays at current strip pricing, illustrated in the accompanying chart. These economics shift dramatically with either changes in crude pricing down to $75 per barrel of oil, or NGL pricing down to 25% of WTI.

Above left, the price of a barrel of NGLs compared with West Texas Intermediate has slipped 30% year over year. Far right, while demand lags, targeted NGL drilling and associated production from oil plays has supply on the rise, foreboding longer-term weakness.

Currently, KeyBanc Capital Markets research expects NGL pricing to average 40% of WTI in 2013 at Conway and 35% at Mont Belvieu, and it highlights risk particularly for propane and ethane. Most important, propane, along with natural gasoline and other heavier parts of the NGL barrel, are driving 50% plus of NGL economics, despite generically comprising 40% of the barrel.

Last year’s mild winter led to huge inventory builds in propane that have continued to all-time highs of 75 million barrels of oil equivalent (BOE), 80% above year-ago levels. Production of propane has skyrocketed to 1.24 million barrels per day, compared to normalized demand of 1.1 million barrels per day, a phenomenon that has catalyzed the U.S. to become a net exporter of propane for the first time since 1973.

The export savior

Near-term, working down the propane supply glut has been limited by export capacity that is maxed out at roughly 175,000 BOE per day. But help is on the way. Total U.S. export capacity of propane is expected to triple by the end of 2014, led first by Enterprise Products Partners’ expansion of the Houston Shipping Channel, providing 115,000 BOE per day of greater export capacity in early 2013, and then by another expansion of 120,000 BOE per day by Targa Resources at Galena Park sometime next summer.

Based on the observation that the rig count tends to grow as long as the blended Btu of oil and gas is above $8 per Mcfe, further weakness in NGL pricing could lead to another 100 rigs being dropped.

The Enterprise expansion alone should at least be able to bring balance to supply/demand mathematically, though excess supply likely won’t be worked off until mid-2014. The wild card to the export-savior argument is the backdrop of weakening LPG (liquefied petroleum gas) pricing globally. This is driven by lower Saudi Arabia contract prices that, nevertheless, still provide an incentive to export more propane.

However, should demand fail to materialize in new regions like Latin America, and new export capacity begin to flood the European markets, we could see global LPG and propane pricing falter and drive domestic pricing back down below $0.85 per gallon or $28 per BOE.

What is apparent is that with propane and ethane now enduring independent supply gluts in the U.S., the global appetite for propane will dictate much of possible NGL economics and could potentially disincentivize export as more capacity comes online. This feedback effect could create further risk into 2013 and beyond, and it means that the oil and gas industry isn’t necessarily out of the woods with NGL pricing.

A new normal

Just like natural gas, demand can be seasonal, but with pure supply outstripping domestic demand, the export market has to be the inevitable savior—but this may not pan out the way analysts, investors and operators expect. Instead, they should be conditioned for a “new normal” where NGL pricing is less correlated to crude, and liquids-uplift economics create a less robust return profile for natural gas-heavy plays with liquids components.

While heavier components of the NGL barrel remain strong in the marketplace, the more predominant ethane and propane continue to suffer a supply glut in the U.S.

Ultimately, perhaps the NGL situation will end up saving the price of natural gas, as more rigs leave the market. Key-Banc estimates that if NGL pricing averages 35% of WTI in 2013 vs. the current 45% levels, then $1 billion of capital would be destroyed from its 34 companies alone, and that 10 of its companies’ rigs would need to be laid down.

Most interesting is the lack of confidence that investors have shown for NGL-weighted names, down 10% since early 2012, vs. crude-weighted names up 5%. This is despite NGL commodity pricing being down 29% over the same time frame and crude being down 10%.

A natural solution for operators may be to pursue hedging, at least on the propane side, where the market is liquid enough to provide some protection. KeyBanc estimates that 10 of its companies currently employ hedging around some portion of the NGL barrel, and would advocate that more pursue at least a partial hedging plan to help increase confidence around cash-flow profiles, returns and resulting growth. These would otherwise be sacrificed with the need to lay down rigs should a harsher reality for propane, ethane and broader NGL pricing come to fruition.

David Deckelbaum is director, exploration and production, KeyBanc Capital Markets Inc. Equity Research