Natural-Gas Liquids: The Implications of the Next Energy Tsunami

Natural-Gas Liquids: The Implications of the Next Energy Tsunami

          
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Natural-Gas Liquids: The Implications of the Next Energy Tsunami

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  • In This Article
    • Recent BCG analysis examined the implications of the surging supply of natural gas and natural-gas liquids on the NGL market and the broader value chain.

    • In the near term, natural-gas producers are likely to cut back upstream activities. In the longer term, demand creation in the form of new steam crackers should kick in to absorb excess supply.

    • The upheaval in the U.S. NGL market will have repercussions along the entire value chain and will require industry participants to rethink key strategic levers such as investment allocation, portfolio and contract balance, and feedstock flexibility.  

     

    The rapid and unprecedented boom in U.S. unconventional-natural-gas supplies is creating an equally fast and unprecedented boom in their byproducts: natural-gas liquids (NGLs). Just as the natural-gas bonanza is transforming the economy, so, too, will the coming glut in key NGLs, such as propane and ethane. The implications for the NGL market and its broader value chain can only be understood by grasping the unique interplay between the natural-gas and NGL markets.

    What makes the NGL dynamic different from that of oil or gas is that these hydrocarbons are produced as a byproduct, not a primary product. This means that favorable economics for the primary product can create a perverse dynamic in which supply of the byproduct can continue to grow despite the fact that it exceeds consumption. In these situations, byproducts ultimately find a home but in lower-value applications and markets. In this case, the natural-gas tsunami has set off a self-reinforcing downward spiral in NGL prices as its supply has quickly outpaced new demand creation. As a result, NGLs are in the uncomfortable position of riding the tail of the growing natural-gas-production tiger.

    The fundamental economic drivers of the story are familiar. New fracking technology has created a surge in shale gas production in the U.S., which has put tremendous pressure on natural-gas and NGL prices. Natural-gas prices have declined from about $5.8 per million metric British thermal units (MMBTU) in January 2010 to $2.9 per MMBTU in July 2012. Prices of the West Texas Intermediate marker crude, on the other hand, have trended upward from $78 per barrel to above $100 per barrel, before declining to $89 per barrel during the same period.

    The divergence in oil and gas prices has driven rigs to be redeployed toward the drilling of oil and liquids and away from gas. The oil rig count has more than tripled, while the gas rig count has declined an estimated 40 percent. The added value of natural-gas byproducts has helped to sustain the viability of natural-gas production—particularly for wet, NGL-rich gas plays. Thus, while rig count declined in dry-gas fields such as Haynesville and Fayetteville, it continued to grow in liquids-rich plays like Marcellus and Eagle Ford and in oil plays such as Mississippian and Bakken, where gas is a byproduct.

    Since the middle of the last decade, when the unconventional-natural-gas revolution took off, the industry has seen steadily increasing natural-gas and NGL production—and this trend is forecasted to continue. For example, additional midstream capacities of 9.1 billion cubic feet per day processing (about a 10 percent increase in total volume) and 1,122 thousand barrels per day fractionation (about a 40 percent increase in total volume) are expected to be added from 2012 through 2014. This significant new capacity will outpace demand creation—which involves longer-term investments such as the building of chemical plants—and will amplify the current mismatch in NGL supply and demand.

    The industry’s gravitation toward wet-gas plays has accelerated the surge in NGL production, which is exerting significant downward pressure on prices. Over the past two years, both ethane and propane prices have declined to much lower levels compared with natural gas. (See Exhibit 1.) Propane has declined from 6.7 times natural-gas BTU value to 3.5 times, while ethane has crashed toward natural-gas parity—declining from 3.6 times to 1.5 times.

    exhibit

    The new NGL pricing dynamics have important ramifications for the economic viability of extraction. The recent sharp decline in ethane prices, for example, has encouraged producers in some regions to reject this hydrocarbon into the gas stream rather than recover it and transport it for fractionation. While ethane extraction economics remain positive for regions closer to the Gulf Coast, ethane rejection is already occurring in the midcontinent and Rockies regions. The scale is meaningful: about 125 thousand barrels per day, or about 10 percent of total ethane production, is being rejected.

    Where Does the NGL Market Go from Here?

    There are two scenarios that could break the vicious cycle of low NGL prices. The first, and likely to be the more immediate, is for producers to cut back on upstream activities. At current natural-gas and NGL prices, liquids-rich plays are still profitable (such as Marcellus), whereas dry plays are not economical and thus at risk of shut-ins (such as Haynesville). (See Exhibit 2.) Production shut-ins in wetter regions become more probable with further NGL price erosion.

    exhibit

    The second and more probable scenario in the medium to longer term is for demand creation to kick in. The present imbalance in the ethane and propane markets will be corrected as existing steam crackers expand, new greenfield steam crackers come online, or exports grow. Ethane prices have traditionally been set in relation to the price of light naphtha, a byproduct of oil, which is also used in gasoline production. But today, supply outstrips consumption, and there is little naphtha-cracking capacity available that can be converted for ethane feed. In response to the industry’s new pricing dynamics, there will be more significant ethane-cracking capacity in the period from 2013 through 2017 as expansion projects are completed and newly built crackers commence operation. Under the demand-creation scenario, the ethane surplus is likely to be eliminated by 2016 or 2017, and prices should return to historical levels.

    Propane has fewer attractive alternative uses than ethane, and its supply is expected to remain abundant long through 2020. The price of propane has traditionally been set by light-naphtha arbitrage in steam crackers. Today, with supply exceeding consumption in steam crackers, the marginal use of propane has shifted to export netback or below because of the current constraints on propane exports. Over the medium term, investments in propane dehydrogenation for on-purpose propylene production will consume some propane. However, exports should continue to grow as supply increases and terminal capacity is built out. Over time, prices should converge toward export netback from light-naphtha substitution in Europe.

    What Are the Broader Market Implications?

    The dramatic glut in natural gas is creating an upheaval in the U.S. NGL market. This will have repercussions along the entire value chain and will require industry participants to rethink key strategic levers such as investment allocation, portfolio and contract balance, and feedstock flexibility. As with all fundamental industry disruptions, changing NGL-market dynamics will create distinct winners and losers.

    Exploration and Production Companies. These organizations will accelerate their pursuit of liquids-rich or oil-rich plays to ensure positive economics. The sector is positioned for extended cyclical-drilling behavior and price fluctuations. Sustained low prices below $2 per MMBTU will lead to well shut-ins or drilling curtailment in drier plays, thus helping support prices. Any significant price recovery at more than $4 per MMBTU to $5 per MMBTU could quickly bring production back online as a result of the higher price elasticity of shale supply. But without new demand, prices will continue to be under pressure to fall.

    The Midstream Landscape. Midstream economics are changing, and companies with flexible off-take options will be at a competitive advantage. The industry should expect to see continued infrastructure (such as gathering and processing) build-out in liquids-rich plays. Midstream economics will be subject to increased NGL price volatilities, which will necessitate balanced contract types (such as a shift toward fee-based arrangements) and product exposures. Owners of key NGL midstream assets will continue to profit as increased supply creates infrastructure bottlenecks.

    The Petrochemical Industry. This industry is likely to be one of the clear winners of an NGL glut. The high oil-to-gas ratio and growing NGL supply will position the U.S. as a relatively low-cost producer of petrochemicals for some time. Crackers that have less flexibility to use ethane will be disadvantaged. Over time, petrochemical operators can be expected to focus on achieving greater feedstock flexibility to shift plants from 100 percent ethane feedstock to an ethane-propane mix as the economics dictate.

    Utilities and Independent Power Producers. As gas becomes the low-cost fuel, the companies that are more reliant on natural gas should be another clear and early set of winners. Growing gas generation will call for greater coordination of power- and gas-facility planning as new plants and pipelines are sited. Coal stockpile and supply management will continue to be a key utility strategy because of dynamic coal-gas switching. Low-cost gas-fired generation will likely present near-term expansion opportunities for transmission and distribution companies as well as for retail companies, but it may displace higher-cost renewable-energy options.

    Propane (Liquefied Petroleum Gas) Suppliers. These companies will probably be the beneficiaries of improved retail margins in the near term as a result of decreased wholesale propane prices. Over time, the narrowing gap between propane and natural-gas prices should encourage propane usage, or at least slow natural-gas penetration in the home-heating market. Propane will also be more competitive against other alternatives (such as electric heat pumps) in rural areas where natural gas is not accessible.


    Following right behind the unconventional natural-gas tsunami, the flood of new NGL supplies will have equally disruptive ripple effects along the value chain. The sheer scale of natural-gas and NGL resources coming to the market suggests that the industry will continue to go through a dramatic transformation as prices remain depressed. The timing and exact profile of new demand creation remains a key wild card. The unique position of the NGL industry at the tail of the unconventional-natural-gas tiger makes its dynamics more complicated but no less important to follow. These are indeed early and interesting times in the industry’s new chapter.

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    • Lead Knowledge Analyst
    • Houston

     

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