The Year of Déjà Vu

It’s not exactly out with the old and in with the new as the midstream rolls into 2013. Rather, the outlook for the year ahead appears in many ways to be a facsimile of 2012. The industry will continue growing at a steady pace and is expected to invest heavily in new infrastructure projects. However, it’s not all good news, as the year is expected to be wrought with storage and takeaway challenges, weak commodity prices and regulatory obstacles.

It’s not all old news, either. Surprising infrastructure trends, creative solutions for sluggish prices and a stronger shift toward liquid-rich plays could all be in the cards for 2013, according to Standard & Poor’s panel of experts. As well, companies will continue to tackle the oversupply dilemma while waiting for demand to catch up with supply.

This is all according to S&P’s midstream services team, which provided an outlook for the industry during a recent briefing in Houston.

Price pains

Perhaps it’s no surprise that natural gas and natural gas liquid (NGL) prices are likely to remain stagnant in the near future. Bill Ferara, a director of S&P’s midstream energy and merchant power group, said he expects gas to sit idling between $3 and $3.50 per million British thermal units (MMBtu) for the next few years. To put this into perspective, he said many dry-gas plays are profitable at $2.50 per MMBtu.

“But I think, as many people know, it’s not really the natural gas they’re drilling for, it’s the NGLs,” said Ferara, who added that rig count is down while production is up.

“The reason being is that not only are producers much more efficient when they drill, (they’re) really drilling for NGLs, and natural gas is a byproduct. You can say gas is really an afterthought. It’s really [about] the economics of the NGL supply.”

While gas prices aren’t expected to improve anytime soon, Ferara said that could change under certain macroeconomic—or liquefied natural gas—conditions. But of course, it’s impossible to predict how this could play out.

Meantime, S&P director Michael Grande said NGL prices have recovered well since the 2008 financial crisis, with the typical barrel (bbl.) priced about $60 at the beginning of 2012. However, as the year unfolded, NGL prices began tumbling and dropped down as low as $32 per bbl. last summer.

“While most of that was demand driven, we also think a big factor was the increasing supply of NGLs,” said Grande. “At one point, ethane in Conway was about $0.02. I don’t care how efficient your processing plant is—Conway price-takers aren’t making any money on ethane when it is that low. It was literally just being given away.”

Ethane and propane faced the most headwinds in 2012, said Grande. Ethane has struggled because the petrochemical industry is virtually its only outlet for sale. This creates volatility among ethane prices, he said, since when there’s a demand decline or supply disruption, “it really upsets the whole apple cart.”

Grande believes ethane prices will remain somewhat weak for the near future.

Meantime, propane prices have been suffering largely due to an unseasonably mild winter in early 2012. While a colder winter this year would, no doubt, help boost those prices, Grande said that won’t solve the problem entirely. Instead, he said, another factor could be key.

“You have about 76 million bbl. of propane right now, about 30% higher than it was last year,” said Grande. “I think one of the solutions besides weather is exports. Exports are really essential… We think this is a big solution, and we think export-capacity expansion is going to continue to grow.”

Grande believes oversupply will continue to be an important factor moving forward. NGL supply could increase about 30% through 2016 while demand takes some time to catch up, he said. And with low gas prices, Grande added that producers are shifting to liquid-rich plays for uplift and better returns.

“That’s something we think is going to continue. The fact that producers need to make their return, [means they] have to shift to liquid-rich plays. It’s really no surprise that the areas where we see the biggest increase in NGL supply is in areas like the Bakken, where they’re drilling for crude, and the NGLs are just gravy.”

Shifting dynamics

The low gas-price environment was caused by a sharp spike in shale gas production during the past few years, said Nora Pickens, an associate director with S&P. Production has increased 35% since 2005. A 25-year record for year-over-year increase was broken when production increased 7.5% from 2010 to 2011. This surge was preceded in 2008 by a large capacity build-out which helped relieve bottlenecks.

The enormous amount of gas coming online has been met with a lessened need to transport it cross-country. The Marcellus is playing a huge role in northeastern supply dynamics, said Pickens, given its close proximity to high-demand centers such as New York, Boston and Philadelphia. The Marcellus is currently producing about 8 billion cubic feet (Bcf) per day and that number is expected to rise to 17 Bcf per day by 2017.

“This would really make it one of the most prolific regions in the world,” said Pickens. “We’re seeing a directional change in the way gas is flowing across the U.S. One of the main drivers behind this change is the Marcellus region."

In 2005, the Northeast region sourced about 35% of its supply from Gulf offshore production and Canadian imports. By 2015, this is expected to change drastically. The aforementioned sources will likely be largely replaced by Marcellus and Utica production, which is expected to meet about 60% of northeastern demand. That figure could climb to about 80% by 2030.

“As we see the marginal gas supply is being pushed out, and it’s being replaced by closer-located production in the Marcellus,” said Pickens. “It’s of course important to note that in order for the Northeast to make this transition, infrastructure is a key variable.”

However, timing has proved to be a challenge. Pickens pointed to Spectra Energy Corp.’s New York-New Jersey pipeline expansion project. The 15-mile extension onto Spectra’s existing Texas Eastern system is meant to serve customers in New Jersey and Manhattan. Although it’s a small project that Spectra began its due diligence on in 2009, it’s not expected to go into service until late 2013.

“If you think about how this entire project took five years to complete, it could indicate some challenging times to get pipeline built in the Northeast going forward,” said Pickens. “Unfortunately in the Northeast, it takes a long time to get projects done.”

Rail reliance

Transportation infrastructure will continue to play a major role as the year surges forward, according to S&P director Mark Habib. As the midstream continues waging the decades-old supply-demand battle, companies are leaning more heavily on infrastructure to cope with oversupply. And in the case of crude, this is resulting in an unprecedented reliance on rail, according to Habib.

“The real story for 2012 is that we expect rail for the first time will surpass pipelines (in the Bakken) in terms of takeaway capacity,” Habib said. “That has a couple of impacts. First, obviously it would help to clear the market. But also, rail may have certain destination or flexibility advantages over pipeline. To the extent that differentials merit it, we would expect a lot of that crude to move further afield toward the coast rather than accumulate in Cushing.”

Increasingly high volumes of North American production will continue to spur pipeline and rail infrastructure, Habib added. The challenge for companies, he said, will be to invest in capital spending without overstretching balance sheets.

Of course, with oversupply comes the need to pair that with adequate infrastructure. It’s expected that rail will become key to helping alleviate oversupply in the Bakken, said Habib. While there are numerous pipelines in the works in the region, rail has become the Bakken’s avenue of choice for crude production. It was expected that by the end of 2012, about 700,000 bbl. of the play’s 1.3 million bbl. takeaway capacity would have been transported by rail.

Reversal of fortune

The supply-demand conundrum is nothing new to the midstream sector.

A balance hasn’t been reached in the U.S. for more than half a century. Habib said there’s been a “steady mismatch” between the two since the early 1950s. The trend was exacerbated during the energy crisis of the 1970s, when demand rose as domestic production began to dwindle. The U.S. market began relying more heavily on imports. In the 1990s, imported production exceeded domestic production for the first time, said Habib.

Meantime, demand began waning in the late 1990s and early 2000s as domestic production made a comeback. Demand took another plummet when the recession hit. The demand drop helped the U.S. reduce its imports over the past few years, and they’ve since dipped below 50% as domestic production has accelerated. Of course, here at home, production from Canada and plays such the Bakken and Eagle Ford helped create an overabundance of crude.

“This has all had a profound impact on infrastructure development and needs,” said Habib. He said it helped the crude industry evolve from a demand-pull to a supply- push environment. It’s a trend that’s likely to continue for the remainder of the decade.

“Essentially we believe this is going to be sustainable due, in large part, to the fact that fairly positive rates of return can be earned in a lot of these plays even when pricing is in the $60 to $80 range, which would put it at over $20 discount to Brent pricing,” Habib said. “Even at severe discount to international prices, production should continue to develop in these plays as a result of profitability measures. This is a fairly significant reversal from what we saw just a decade ago.”