Processing Second-Quarter Results
With the majority of energy-focused master limited partnerships (MLP) having reported quarterly results, we have an opportunity to reflect one of the key trends that emerged from the deluge of financial data: the extent to which the dramatic decline in the price of natural gas liquids (see Growing Pains: Expect NGL Prices to Remain Volatile) reduced firms’ distributable cash flow (DCF) and payout coverage.
Gas-processing facilities, many of which are owned and operated by MLPs, remove the natural gas liquids (NGL) from wellhead gas stream through condensation or absorption. This procedure ensures that the natural gas conforms to the pipeline network and end markets’ standards for pressure, specific gravity, thermal value, purity and dew point temperature levels.
While the natural gas exits the processing plant and flows into the intrastate and interstate pipeline network, the resultant mix of NGLs undergoes fractionation, a process that separates the stream into discrete components based on their unique boiling points.
Over the past several years, limited fractionation infrastructure and rising NGL production from shale oil and gas plays have enabled Enterprise Products Partners LP (NYSE: EPD) and other MLPs to secure lucrative agreements that guarantee a minimum fee regardless of whether the customer uses its allotted capacity.
The natural gas-processing business, on the other hand, usually entails more exposure to fluctuations in commodity prices, though operators gird themselves against the market’s vagaries through hedging strategies and their contract mix.
Demand for processing tends to hinge on the frac spread, or the price of natural gas relative to the value of NGLs. When NGL prices are high relative to the price of natural gas, demand for processing increases. That’s because producers want to remove every possible barrel of NGLs from the raw gas stream to take advantage of higher liquids prices.
Processors are compensated for their services in a number of different ways, including simple fees based on the volume of gas processed and percent-of-proceeds (POP) arrangements, where they receive the value of a portion of the gas and NGLs sold. The latter contract would bolster the processor’s margins when NGL prices are elevated. In keep-whole arrangements, the processor takes possession of the extracted NGLs and reimburses the producer for this energy content lost, usually via a cash payment that’s based on the market value of natural gas.
Although contract mix and hedging are essential to ensuring that processing assets generate consistent levels of cash flow, MLPs that own gas plants can opt to leave ethane–the lightest, most abundant NGL–in the vapor stream without running afoul of pipeline requirements. Ethane rejection tends to occur when the margins from processing the NGL turn negative or when fractionation capacity isn’t available further down the value chain.
After energy prices cratered in late 2008 and early 2009, MLPs that own processing infrastructure moved to shift their contract mix toward fee-based agreements–a trend that producers encouraged when NGL prices remained elevated.
Despite these efforts to reduce exposure to NGL prices, nine of the 17 MLPs that participate in this segment of the midstream market failed to generate enough cash flow to cover their quarterly distributions.
Source: Company Reports, Bloomberg
Enterprise Products Partners and Plains All American Pipeline LP (NYSE: PAA), the two MLPs that bucked the trend and managed to grow their distribution coverage ratios in the second quarter, operate a wide range of midstream assets and benefited from new projects coming onstream.
To better understand the outlook for NGL prices and the gas-processing industry, we’ll review management’s comments on business conditions in this market segment and their plans to shore up distribution coverage ratios.
Atlas Pipeline Partners LP (NYSE: APL): Management attributed the MLP’s challenging second quarter to the outage of fractionation capacity in Mont Belvieu, limited liquids takeaway capacity and a 36 percent weighted-average decline in NGL prices. About 60 percent of the firm’s gas-processing capacity operates under POP contracts, while keep-whole deals account for roughly 25 percent and fee-based arrangements make up the remainder. Management noted that the firm continues to hedge its exposure to commodity prices and, excluding ethane, has hedged about 78 percent of its liquids exposure in the back half of 2012 and 75 percent in 2013. The firm’s WestOk plant began rejecting ethane during the quarter because of depressed prices at the hub in Conway, Kan., which faced a supply overhang from robust production in the Granite Wash. Management will continue this policy until processing margins for this NGL improve.
Copano Energy LLC (NSDQ: CPNO): Like Atlas Pipeline Partners, Copano Energy also began rejecting ethane at some of its gas-processing units in Oklahoma. In a conference call to discuss second-quarter results, management warned, “While we believe NGL prices may improve slightly during the second half of the year, we do not expect prices will return to the levels we saw at the beginning of 2012.” Despite weaker margins on POP contracts in Oklahoma, the firm’s results were shored up by ongoing efforts to reduce its exposure to fee-based contracts as it expands its asset base serving the Eagle Ford Shale.
Crestwood Midstream Partners LP (NYSE: CMLP): The MLP’s second-quarter processing volumes declined 10 percent from year-ago levels, largely because of reduced drilling activity in the Barnett Shale and the Fayetteville Shale, both of which primarily produce natural gas. Operational revenue from Crestwood Midstream Partners’ Granite Wash system declined by about 50 percent because of lower margins on POP processing contracts. Rather than dwelling on the challenges, management highlighted the company’s purchase of Devon Energy’s (NYSE: DVN) gathering and processing assets in the liquids window of the Barnett Shale. Management expects the deal to “add substantially” to the MLP’s distributable cash flow
DCP Midstream Partners LP (NYSE: DPM): DCP Midstream Partners increased its second-quarter distribution by 1.5 percent sequentially, a signal of management’s confidence in the MLP’s growth prospects. The firm also maintained its full-year guidance for distributable cash flow, noting that recent drop-down transactions from its general partner should offset a difficult first half for propane distribution and the decline in NGL prices. Much of the shortfall in second-quarter cash flow stemmed from a$14 million writedown on the firm’s propane inventories. DCP Midstream Partners has hedged about 70 percent of its exposure to commodity prices.
Eagle Rock Energy Partners LP (NSDQ: EROC): The slide in commodity prices and a 38 percent drop in the frac spread prompted the MLP to maintain, rather than raise, its second-quarter distribution. During a conference call to discuss second-quarter results, management also indicated that its expects the gulf between NGL prices at Conway and Mont Belvieu to narrow by mid- to late 2013 and reassured investors that “the end is in sight” for these wide differentials. Capacity constraints at Eagle Rock Energy Partners’ Woodall processing facility and the design of the firm’s other gas plants prevented the MLP from rejecting ethane. Fortunately, price floors ensured that Eagle Rock Energy Partners’ keep-whole contracts didn’t generate negative cash flow. Although the management team believes NGL prices have bottomed, the MLP has opted to focus on maintaining its current distribution until the outlook for commodity prices becomes more stable. Eagle Rock Energy Partners has hedged about 80 percent of its exposure to ethane and natural-gas prices for in 2012 and 70 percent in 2013.
Enbridge Energy Partners LP (NYSE: EEP): The MLP raised its second-quarter distribution by 2.1 percent sequentially, reflecting management’s confidence in the firm’s slate of growth projects and its outlook for future cash flows. Nevertheless, in a conference call to discuss second-quarter results, Enbridge Energy Partners’ management team acknowledged that depressed NGL prices could mean that the MLP’s cash flow will fall short of its distribution in coming quarters. The firm also emphasized the difficulty hedging against price weakness at the Conway hub, aside from shifting volumes to Mont Belvieu. Management also lowered the estimated earnings before interest, taxes, depreciation and amortization (EBITDA) for its Ajax gas-processing system that will serve the Granite Wash and is slated to come onstream in the first quarter of 2013.
Enterprise Products Partners LP (NYSE: EPD): The blue-chip MLP posted impressive second-quarter results, as new assets boosted overall throughput on the firm’s midstream infrastructure and offset exposure to weak NGL prices. Management noted that equity NGL volumes declined 20 percent from a year ago, while fee-based processing throughput increased 15 percent. Enterprise Products Partners attributed weak ethane prices to planned and unplanned plant outages in the petrochemical industry, the majority of which were completed in early July. The MLP’s gas-processing facilities in the Rockies rejected ethane during the quarter, as the firm was able to purchase favorably priced ethane volumes at the Conway hub and transport the NGL to Mont Belvieu. Enterprise Products Partners’ strong quarter demonstrates the appeal of a diversified asset base in a volatile environment.
MarkWest Energy Partners LP (NYSE: MWE): Management sought to assuage concerns about weak NGL prices, noting that the petrochemical industry plans to construct up to five world-scale ethane crackers over the next four years and that 175,000 barrels per day of additional propane export capacity will come onstream in 2013. If MarkWest Energy Partners achieves the low end of its full-year guidance for distributable cash flow, the MLP will cover its distribution by an estimated 1.13 times. This forecast assumes that the number of outstanding common units remains stable and that NGL prices remain depressed. Management also indicated that the firm was weighing the possibility of adding product-specific NGL hedges to replace some oil hedges.
ONEOK Partners LP (NYSE: OKS): ONEOK Partners indicated that if commodity prices continue to flounder, the firm’s distribution coverage ratio would drop to 1.05 times in the worst-case scenario. Management spent considerable time updating its outlook for NGL prices during a conference call to discuss the MLP’s second-quarter results. With idled steam crackers back online and ethane consumption likely to exceed 1 million barrels per day, ONEOK Partners expects US ethane inventories to return to seasonal norms as soon as the end of 2012. Management likewise projects that additional export capacity slated to come online in 2013 will alleviate the supply overhang plaguing the propane market. Over the next few years, the firm expects new fractionation capacity and NGL pipelines to reduce the ethane price differential between Conway and Mont Belvieu to narrow to between, $0.08 and $0.10 per barrel. However, Terry Spencer, president of ONEOK Partners, also warned that the price of lighter NGLs would remain volatile: “As NGL growth continues at a rapid pace, we believe that over the next couple of years, there will be some periodic oversupplies of ethane as new NGL production and infrastructure brings additional NGLs to market.”
Penn Virginia Resource Partners LP (NYSE: PVR): Penn Virginia Resource Partners’ midstream operations in the Mid-Continent region, which posted a 27.4 percent decline in adjusted earnings EBITDA during the second quarter, also faced their fair share of headwinds. Although throughput on the MLP’s gathering and processing system surged to 453 million cubic feet per day from 422 million cubic feet per day a year ago, this increase in volumes failed to offset the massive decline in NGL prices at the hub in Conway, Kan. Penn Virginia Resource Partners also has some exposure to NGL prices in this region, as keep-whole agreements account for about 15 percent to 20 percent of throughput in a given quarter. Meanwhile, percent-of-proceeds contracts account for about 60 percent of processed volumes. With volumes and pricing Penn Virginia Resource Partners’ coal segment likely to remain under pressure in 2013, management has pinned its hopes on the firm’s eastern midstream segment, which accounted for 31 percent of total adjusted EBITDA in the second quarter. Management has noted that the expansion of existing infrastructure in the Marcellus Shale and the integration of assets acquired from Chief E&D holdings will increase the percentage of fee-based contracts to 80 percent of nameplate capacity.
Plains All American Pipeline LP (NYSE: PAA): Like Enterprise Products Partners, this blue-chip MLP enjoyed a strong second quarter, fueled by a diversified asset base and a number of growth projects. Management expects the logistics division to post sequentially lower adjusted profit in the third quarter because of the decline in NGL prices and its implications for margins. At the same time, management emphasized that these headwinds would likely dissipate in the first quarter of 2013.
Regency Energy Partners LP (NYSE: RGP): Management attributed about $2 million of $7 million in lost margin to lower NGL prices–capacity outages accounted for the other $5 million.
Targa Resources Partners LP (NYSE: NGLS): Management’s current full-year guidance calls for the MLP to generate more than enough cash flow to cover its distribution. This forecast is based on a conservative set of commodity price assumptions: $80 per barrel of oil, $2.50 per million British thermal units of natural gas and $0.75 per gallon of NGLs, which includes $0.30 per gallon of ethane and $0.80 per gallon of propane. Both ethane and propane prices have rebounded beyond these thresholds, but management has emphasized that the firm would still be able to grow its distribution in this environment.
Western Gas Partners LP (NYSE: WES): The drop in NGL prices had scant effect on Western Gas Partners’ second-quarter operating results, thanks to the MLP’s focus on signing fee-based contracts. That being said, its processing operations suffered from downtime at third-party fractionation and petrochemical facilities, which forced some of its gas plants to reject ethane.
Williams Partners LP (NYSE: WPZ): Management acknowledged that its NGL price assumptions weren’t conservative enough and stated that although the supply-demand balance for ethane and propane continues to improve, an influx of new supplies in 2013 and 2014 could lead to short-term downside. Williams Partners LP plans to grow its fee-based business by 89 percent between 2011 and 2014, which should help to alleviate its exposure to fluctuations in NGL prices.
Around the Portfolios
Magellan Midstream Partners LP (NYSE: MMP) announced a two-for-one split of its common unit. Unitholders of record by Sept. 28, 2012, will receive an additional limited partner unit for each unit they already hold on Oct. 8, 2012. Once this split takes place, we will adjust our buy target accordingly. Until then, Magellan Midstream Partners rates a buy if the stock dips to less than $60.
Both Magellan Midstream Partners and Enterprise Products Partners LP (NYSE: EPD) announced that their assets in the Gulf Coast were unscathed by Hurricane Isaac. Buy Enterprise Products Partners LP when the unit price slips to less than $50.