As investors in energy production and infrastructure, it’s time to add a new phrase to our repertoire of seemingly obscure industry jargon: ethane rejection. The colorful phrase sounds a tad dramatic, but it’s merely a succinct way of describing a supply/demand imbalance. Just as overproduction caused natural gas prices to finally crater in 2012, the same thing happened in the natural gas liquids (NGL) space.

Last year, as ethane inventories jumped by 54 percent, or 12.3 million barrels, prices eventually dropped 63 percent. Coupled with the lack of sufficient takeaway capacity, the result is that a significant amount of recoverable ethane is simply being left in the natural gas stream because it’s more economic to do so–in other words, ethane rejection.

That brings us to yet another piece of NGL arcana: the frac spread–or fractionation spread. The frac spread is the premium that ethane or other NGLs fetch after subtracting out all costs of production, including the natural gas itself. Unfortunately, the frac spread for ethane has actually turned negative in many producing regions, so it doesn’t make sense for many producers to incur the cost of fractionation and transportation.

Of course, the other component of ethane rejection is the lack of infrastructure necessary to transport and process all the NGLs being produced by liquids-rich shale plays. Although master-limited partnerships (MLP) and other entities are rapidly investing in building out energy industry infrastructure, there’s some debate about whether infrastructure will ultimately be ahead of potential ethane production.

Under normal circumstances, ethane is removed during natural gas processing via fractionation. The petrochemicals industry then converts ethane into ethylene, a widely used compound that’s employed to create numerous industrial necessities from plastic film to detergents. But when ethane is left in the natural gas stream, it actually increases the supply of natural gas since the overall BTUs (British thermal units) haven’t been diverted to ethane as a standalone commodity.

Considering the glut of natural gas that’s already on the market, the good news is that analysts estimate that ethane rejection will result in incremental natural gas production of just 1.4 percent at most. For the sake of context, natural gas inventories were 15.8 percent above the five-year average as of Feb. 22.

So how widespread is ethane rejection? A report issued by wealth manager US Capitol Advisors earlier this year estimated that ethane rejection was running at the equivalent of roughly 28,000 barrels per day (bpd) at the end of 2012. But more recently, industry research firm Bentek Energy estimated that number had risen to 157,000 bpd as of mid-February, not including the region of the US where the Marcellus and Utica Shale formations are situated. Though the firm lacked data for this latter region, they’ve heard anecdotally that producers are rejecting 50 percent to 80 percent of ethane.

The latest earnings reports for ONEOK Partners LP (NYSE: OKS) and Pioneer Southwest Energy Partners LP (NYSE: PSE) both discussed the effect ethane rejection or reduced ethane recovery was having on their respective operations.

In the case of ONEOK, ethane rejection is a major headwind. The MLP’s management reduced its 2013 guidance for distributable cash flow (DCF) to a range of $910 million to $1 billion from a previous range of $1.05 billion to $1.14 billion. So even the upper threshold of their latest guidance merely puts the MLP’s prospective DCF at parity with the $1 billion it generated in 2012.

Management attributed a significant portion of its lowered guidance to “widespread and prolonged” ethane rejection. ONEOK’s NGL segment accounted for $608.2 million in operating income during 2012, or roughly 63 percent of total operating profits. That performance was down 3.2 percent compared to the prior year.

As such, the MLP has also slowed the growth of its payout from a projected $0.02 increase per quarter to just $0.005 per quarter, until industry conditions improve. However, management does not expect prolonged ethane rejection to persist in 2014, though it does allow that there could be intermittent periods where it’s a factor. ONEOK does have hedges in place to offset commodity risk for some of its operations, though no such hedges were in place for its NGL segment at year-end.

Meanwhile, Pioneer Southwest reported that its fourth-quarter production of oil and gas included a loss of about 200 barrels of oil equivalent per day (BOE/D) due to a lack of capacity necessary to recover ethane amid rising production of natural gas. That’s equivalent to 2.6 percent of the 7,668 BOE/D of oil and gas it sold during the fourth quarter.

As for the first quarter of 2013, management forecasts reduced ethane recovery will result in a 200 BOE/D to 300 BOE/D drop in its average production, which is projected to range from 7,400 BOE/D to 7,900 BOE/D. When taking the midpoint of both ranges, that amounts to 3.3 percent of total production for the quarter. However, a new gas processing facility with 200 million cubic feet per day in capacity is slated to come on line in April and eliminate this issue.

There are a number of other MLPs in our coverage universe that focus on NGLs, so it will be interesting to see how the ethane market ultimately corrects itself over the coming year or so. But this also shows why conservative investors are best served by sticking with midstream operators that generate their cash flows from long-term contracts with limited exposure to volatile commodity prices.