Should Low NGL Prices Concern Investors?

By Matthew DiLallo - August 5, 2012 | Tickers: CHK, DVN, EPD, LINE, OXY | 0 Comments

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I was reading through the earnings release of Linn Energy (NASDAQ: LINE) the other day and I read something that made me do a double take.  CEO Mark Ellis was quoted as saying, “Our second-quarter distribution coverage ratio was negatively impacted by historically low NGL prices, which were 38 percent lower than first-quarter 2012 prices."  Wait a minute, I thought NGL’s were becoming the saving grace for the domestic oil and gas industry since production of dry gas is starting to become downright uneconomical.  If NGL prices lose their luster, where does that leave the industry?

According to an article on the Wall Street Journal, “For Energy Producers, Natural Gas May Not Be the Only Source of a Glut,” the industry’s shift toward producing more NGL’s from rich or wet gas is “creating a new supply glut problem…and threatening to crimp profits.”  As we saw in Linn’s report, it’s not a threat anymore, it is happening, but to what extent?

The article further went on to state that last year saw record NGL production of about 2.18 million barrels per day and revenue was $42 billion for the industry, just shy of the $48 billion that dry gas brought in.  Pricing this year has seen a dramatic falloff and they give examples of two of the more prominent components of NGL’s Ethane (falling from 89 cents a gallon to 28.4 cents a gallon) and Propane (from $1.47 a gallon to $0.79 a gallon).  That's pretty dramatic and could be a big problem.

With companies like Devon Energy (NYSE: DVN) and Chesapeake Energy (NYSE: CHK) betting big on NGL’s, are they about the find out that their knight in shining armor was all a façade?  Take Devon for example, they’ve grown their liquids production for six straight quarters and have been lauded as a leader in NGL production.  Or what about Chesapeake, already reeling from ill-timed bets on natural gas before the financial crisis, they grew their liquids production by 69% year over year and are planning on growing production to 42 million barrels in 2012 and 57 million barrels next year.  In the WSJ article Chesapeake is mentioned as not being concerned about low NGL prices as they expect demand to eventually grow with supply. 

Would these companies be forced to cut production if prices continue to decline?  According to Occidental Petroleum (NYSE: OXY) the answer is yes, as their CEO is quoted as saying, "If the current low NGL prices continue, cutbacks in liquids-rich wells or gas-rich wells may be necessary."  It will be interesting to see what he and his peers end up doing while they do wait for demand to pick up. 

The question as to whether low NGL prices should concern investors is a critical one to answer.  Why did they fall so dramatically in the last quarter, and is that a sign of things to come?  I think a statement provided by Enterprise Products Partners (NYSE: EPD) in their earnings release should shed some light on this critical issue. 

CEO Michael Creel is quoted as saying, “"Increases in gross operating margin associated with these higher volumes, our marketing activities and improved hedging results in our natural gas processing business more than offset the effects of lower NGL and natural gas prices that resulted in a decrease in our equity NGL production and reduced drilling activity in certain regions. During the second quarter of 2012, the U.S. petrochemical industry had an extended period of planned and unplanned plant turnarounds, which led to lower demand and prices for ethane. Most of these maintenance activities were completed in early July. We estimate that demand for ethane is currently running in excess of one million barrels per day, and we have seen ethane prices strengthen accordingly,"  If that’s true then it would seem that this quarter will be an outlier.

Still, a real pickup in demand is a few years away from really picking up so we could see a lot of volatility in NGL prices.  Long term however, the outlook has never been better and companies like Enterprise are leading the charge as they’re spending billions to take advantage of the commodity.  Not only is Enterprise helping to rescue this stranded commodity from the Marcellus but they’re also building one of the world’s largest propane dehydrogenation units to consume some of this oversupplied feedstock.  The problem is that the plant will not come online until late 2015.  There are several other projects in development or discussion from major petrochemical companies but those facilities can take five years to build. So demand will eventually be there but what do producers do in the interim?

In the short term we could begin to see a pullback in NGL production if the price declines witnessed by Linn and Enterprise are due to more than just downtime at the petrochemical plants.  Over the longer term there is much less reason to be concerned as announced projects come online.  Investors should watch this closely and be especially mindful of highly leveraged companies like Chesapeake as they would feel the pinch first.  Personally, I like Linn for its solid hedging program and Enterprise for its less sensitivity to commodity price volatility, but as we saw this quarter, even they were affected by the price swing.

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