Natural gas liquids (NGL) are a group of heavier hydrocarbons such as butane, ethane and propane that occur underground with natural gas (methane) and tend to revert to their liquid phase under normal atmospheric pressure. The price of a mixed barrel of these commodities, some of which can replace naphtha and other oil derivatives in industrial and petrochemical processes, have tended to track movements in the market value of crude oil.

But the traditional relationship between oil and NGL prices has deteriorated significantly over the past 12 months.

Source: Bloomberg

The barrel of mixed NGLs depicted in this graph consists of 36.5 percent ethane, 31.8 percent propane, 11.2 percent normal butane, 6.2 percent iso-butane and 14.3 percent natural gasoline, all of which are delivered to the hub in Mont Belvieu, Texas.

From the beginning of 2006 to mid-2011, a mixed barrel of NGLs usually fetched roughly 60 percent of the price of a barrel of West Texas Intermediate crude oil. However, the price of a mixed barrel of NGLs recently bottomed at about 40 percent of the benchmark oil price for North America.

Some of this recent price weakness stems from rising NGL production. Over the past few years, a trend has emerged among US-based exploration and production outfits. Buffeted by ultra-depressed natural gas prices and a surfeit of supply, operators have scaled back spending in basins that primarily produce this commodity while announcing plans to boost output of higher-value oil and NGLs.

Accordingly, US production of NGLs surged to a record 2.183 million barrels per day in 2011, a 22 percent increase relative to output in 2008. Ethane and propane, which accounted for almost 70 percent of US NGL production in 2011, drove much of this production growth. (Note that the data in this graph only excludes propane produced by refineries and volumes imported from Canada.)

Source: Energy Information Administration

The newfound abundance of ethane and propane has revivified the US petrochemical industry, giving chemical manufacturers a dramatic cost advantage over producers in Asia and the Middle East that rely on naphtha and other oil derivatives for feedstock.

Cracking facilities heat ethane and propane with steam to produce ethylene and propylene, the basic building blocks of three-quarters of all chemicals, plastics and man-made fibers.

Ethylene is a colorless gas used to synthesize polyethylene, polyvinyl chloride and polystyrene, plastics used in everything from food packaging to waterproof garments and synthetic fibers. Meanwhile, propylene is used to make polypropylene, a plastic used in electronics, automobile bumpers and consumer packaging.

Over the past decade, multinational chemical producers such as Dow Chemical (NYSE: DOW) have gradually shifted their production base from the US to Asia (to build a presence in growing demand centers) and the Middle East (to take advantage of lower feedstock costs).

Last year, this trend reversed course. A number of major petrochemical producers announced plans to restart shuttered crackers or construct world-class plants to take advantage of favorable pricing on ethane and propane.

For example, Dow Chemical–the world’s second-largest chemical outfit–announced plans to restart its ethane cracker at its St. Charles complex, upgrade one plant in Louisiana and another in Texas to enable them to accept ethane feedstock and build a new ethylene production plant on the Gulf Coast in 2017. The firm aims to improve its ethane cracking capabilities by 20 percent to 30 percent to take advantage of the superior economics offered by the NGL.

And Royal Dutch Shell (LSE: RDSA, NYSE: RDS: A) in June 2011 announced that it would build a world-scale ethylene plant in Appalachia that would source its feedstock from the Marcellus Shale. Meanwhile, Chevron Phillips Chemical–a joint venture between Chevron Corp (NYSE: CVX) and ConocoPhillips (NYSE: COP)–plans to build a major ethane cracker and ethylene derivatives facility in the Texas Gulf Coast region.

The petrochemical industry accounts for about 54 percent of US NGL demand and substantially all US ethane consumption; developments in this end market have significant implications for the prices of these commodities.

Although cracker restarts and expansions generally have enabled domestic ethane consumption to keep pace with supply growth, the uneven delivery of new midstream and downstream capacity, coupled with the uncertain outlook for the global economy, should ensure that ethane prices remain volatile in coming years.

Whereas a world-scale ethylene production facility with an intake capacity of 90,000 barrels of ethane per day takes about 36 months and $2 billion dollars to build, the gas-processing plants and fractionators that feed these steam crackers cost substantially less and require about 18 months to bring on stream. Accordingly, there will be periods when an uptick in ethane supply won’t immediately be matched by corresponding capacity growth in the petrochemical industry.

NGL prices pulled back substantially in the first half of the year but appear to have arrested their free fall.

Source: Bloomberg

Ethane prices have suffered suffered in part from planned downtime at several steam crackers for routine maintenance at repairs. But an oversupplied propane market in the wake of the no-show winter of 2011-12–the NGL is also used as a heating fuel–has also weighed on ethane prices and will constrain any recovery in the near term. With the spread between propane and propylene prices offering superior profit margins to ethane, some petrochemical plants have adjusted their feedstock intake to take advantage of this opportunity.

A normal winter would alleviate some of this pressure, while planned expansions to Enterprise Products Partners LP (NYSE: EPD) and Targa Resources Partners LP’s (NYSE: NGLS) Gulf Coast export facilities will also reduce glutted inventories when they come online.  

Investors should also be on the lookout for hub-specific discrepancies in NGL prices, as frenzied drilling in liquids-rich plays overwhelms local takeaway capacity. For example, surging NGL production in the Granite Wash and other Mid-Continent plays glutted storage capacity at the delivery hub in Conway, Kan., depressing the local price of an ethane-propane mix relative to the prevailing value in Mont Belvieu, Texas.

However, CEO Terry Spencer told attendees of ONEOK Partners LP’s (NYSE: OKS) conference call to discuss second-quarter results that this price disparity would disappear as new midstream capacity comes online:

Fractionation capacity especially in the Gulf Coast is at a premium as growing unfractionated NGL supplies from the prolific shale developments continue to seek the premium-priced Gulf Coast NGL markets. Accordingly, new pipeline capacity between Conway and Mont Belvieu is being built to accommodate NGL growth from the shales. We continue to believe the NGL price differential between the market hubs will narrow to the cost to build range of $0.8 to $0.10 to gallon over the next couple of years.

In this dynamic and ever-changing pricing environment, investors need to understand the extent to which developments in the NGL market will influence upstream and midstream MLP’s distributable cash flow and payout coverage.

In the Aug. 2 issue of The Energy Strategist, my colleague Elliott Gue analyzed the challenges that plummeting NGL prices presented for Linn Energy LLC (NSDQ: LINE) and other upstream operators. But MLPs engaged in exploration and production weren’t the only publicly traded partnerships to suffer from lower NGL prices: Midstream operators that own natural gas-processing plants also endured their fair share of pain.

In the next installment of The Energy Letter, we’ll take an in-depth look at the 17 publicly traded partnerships with exposure to gas processing and evaluate the extent to which fluctuations in NGL prices will influence their cash flow and distribution growth. Investors seeking to hedge against these risks should consider balancing their exposure to MLPs whose business lines are sensitive to volatility in NGL prices with positions in petrochemical companies that stand to benefit when the prices of these commodities decline.

Around the Portfolios

Eagle Rock Energy Partners LP (NSDQ: EROC) announced the $227.5 million acquisition of two natural gas-processing plants and 2,500 miles of gathering pipelines in the Texas Panhandle as part of BP’s (LSE: BP, NYSE: BP) ongoing effort to divest noncore assets. The deal also includes a 20-year, fixed-fee contract for gathering and processing services that covers BP’s existing wells and a two-year agreement covering any new wells drilled within a 2-mile radius. Throughput on these gathering pipelines averaged 180 million cubic feet per day in the first half of 2012, and volumes should ramp up as drilling activity in the Granite Wash continues to accelerate. Management expects the deal to be immediately accretive to distributable cash flow. Buy Eagle Rock Energy Partners LP up to 12.