Hedging Options Lag Production Growth
By Gregory DL Morris, Special Correspondent
Natural gas liquids production is soaring in North America as a result of the unconventional resource boom in shale gas and tight oil. Whether from a wet gas well in the Marcellus, or associated gas from an oil well in the Eagle Ford, the fractions of ethane, propane, butanes and natural gasoline are pouring onto the market.
To take advantage of this market-changing situation, there is a long and growing list of steam crackers that will use the ethane to make ethylene, as well as propane export terminals and dehydrogenation projects scheduled to be brought into service on the U.S. Gulf Coast and eastern seaboard.
However, the one element that producers, midstream operators and other market participants say is conspicuously absent from the robust growth up and down the NGL value chain is a hedging market. Many independents actively hedge to manage risk in natural gas and crude oil markets, but industry analysts and financial companies agree producers and midstream operators cannot hedge their NGL production as easily nor to the same degree as other commodities. The NGL physical market, they say, has far outstripped the NGL financial market.
The exchanges themselves, including the New York Mercantile Exchange division of CME Group, contend the contracts, tools and markets are available, adding that NGL hedging is a growing business. But many producers say NGL hedging has a long way to go, particularly in regard to long-term options.
“We are 100 percent hedged on our natural gas production through 2017, and 100 percent hedged on our crude oil production through 2016,” says Kolja Rockov, executive vice president and chief financial officer of Houston-based LINN Energy LLC. “We would like to be hedged to the same extent on NGLs, but almost everything out there is short dated–essentially within 12 months. The market is particularly illiquid to Conway, Ks., and because of that we are trying to renegotiate some of our contracts to move a majority of our exposure to Mont Belvieu, Tx., where there is a little more liquidity.”
Conway and Mont Belvieu are the major U.S. NGL market hubs and pricing points, Rockov indicates, adding that surging NGL production in Mid-Continent resource plays glutted storage capacity at the Conway hub earlier this year, depressing the local price of an ethane/propane mix relative to its value in Mont Belvieu. Analysts forecast that the hub-to-hub price disparity will lessen as new midstream capacity comes on line over the next several months.
From LINN Energy’s perspective, Rockov stresses that the problem is not so much that producers are unable to hedge NGLs, but that they are challenged to find ready markets and attractive terms. “We can hedge, but at most it is 18-24 months, and that is heavily backwardated (long-term prices are trading below near-term prices, resulting in a downward-sloping futures curve),” he says. “Typically, hedging is in contango (long-term prices are trading above near-term prices, resulting in an upward-sloping futures curve). (As of November) oil also was backwardated, but that (was) an anomaly. If someone could give us a five-year swap on NGLs for meaningful volumes, we would be happy to discuss it.”
The primary difficulty, Rockov explains, “There are lots of willing sellers, both in the physical and futures markets, but we need willing buyers on the long end of the curve. At present, we are looking at a 20-40 percent discount. You would have to be very bearish to hedge that. Even in the front months, you really can go out only six months before the numbers start to collapse.”
Rockov adds that this is not a recent phenomenon. “We did a look-back analysis of NGL hedging to see where we stood, and using current terms, we would have lost money if we had hedged our NGLs in recent years.”
While producers are eager to have the same flexibility in NGL hedging that they have for crude oil and natural gas, Rockov says the volatility in NGL pricing certainly does not help buyers and sellers get on the same page. “I think everyone needs to reset a bit. NGL prices have been very volatile lately, but looking back over five or 10 years, they were much less volatile. NGLs touched record lows and have started to rebound.”
However, concerns over hedging NGLs or price volatility should not upstage the generally positive outlook for physical demand growing in response to the vast new supplies coming on the market, opines Rodney Waller, senior vice president at Range Resources in Fort Worth.
“In ethane, both the end-use market and Wall Street are eagerly anticipating the new steam crackers due on stream in the Gulf Coast in the 2015-16 time frame,” he relates. “Most people are expecting ethane to recover from the slump in prices this year that was caused by so much supply becoming available.”
Similarly, Waller says he sees new outlets for propane, some of which involve Range directly. “There is a tremendous boom in export facilities for propane,” he says.
According to Range, the Mariner East project is subscribed to transport 65,000 barrels of ethane and propane a day from the MarkWest Energy Partners processing facilities at Houston, Pa., outside Pittsburgh, to the Sunoco Logistics Marcus Hook terminal and dock facilities south of Philadelphia, at the site of a shuttered Sunoco refinery. Pipeline deliveries of propane are expected to start in the second half of 2014, with ethane deliveries beginning in the first half of 2015. In the interim, MarkWest says it is transporting a portion of its propane from the Houston, Pa., complex to Marcus Hook by rail on behalf of Range.
As the anchor shipper under the agreements, Range will have firm transportation of 40,000 bbl/d, evenly split between ethane and propane. Range also will have access to a pro rata share of the 1 million barrels of propane storage at the facility and could use its full capacity commitment for propane deliveries until the ethane facilities are in place, Waller notes.
In addition to Marcus Hook’s truck and rail unloading facilities, Waller says the potential exists for Range to deliver propane to Mid-Atlantic customers, should Sunoco decide to deliver propane through its Northeast pipeline system and expand its terminal operations.
Range had previously signed two agreements to transport or sell ethane from its wet gas production in the Marcellus Shale. First, Range struck a deal with Nova Chemical for ethane from the Houston processing complex through the Mariner West project to Nova’s Sarnia, Ontario, petrochemical facilities, Waller reports. Range then signed a pipeline agreement with Enterprise Products Partners covering a portion of the ethane pipeline capacity on Enterprise’s Appalachia to Texas (ATEX) Pipeline. Ethane volumes from the project are expected to be delivered to petrochemical companies on the Gulf Coast at Enterprise’s Mont Belvieu storage caverns, Waller adds.
Sales of ethane to Nova are expected to begin around the middle of next year, and the ATEX project is expected on line by early 2014, he continues. Volumes to be sold to Nova begin at 5,000 bbl/d and increase to 15,000 bbl/d. Planned ethane sales at Mont Belvieu will be transported by ATEX at an expected initial rate of 10,000 bbl/d, increasing to 20,000 bbl/d, according to Range. Each agreement runs 15 years from its start date.
Adding Incremental Value
With typical ethane extraction, Range estimates the three supply deals–Mariner West, Mariner East and ATEX–will require 800 million cubic feet a day of inlet gross natural gas production by 2016. Currently, the inlet wet gas volume flowing into the processing plants is 350 MMcf/d. At present, Range estimates, it is able to produce 24,000 bbl/d of ethane and 10,000 bbl/d of propane under normal recovery. If the full contractual volumes were being delivered using November prices with a portion of its propane being exported, the company estimates these projects would add $0.35-$0.45 an Mcf of incremental value in its liquids-rich Marcellus area.
Range places its ethane resource potential under its 335,000 liquids-rich acres in Southwest Pennsylvania at roughly 1 billion barrels. The contractual volumes covered under the three arrangements over their 15-year terms total 300 million barrels, or 30 percent of its estimated recoverable ethane resource.
In addition to the projects in which Range is participating, Targa and Enterprise both have announced marine terminal plans targeting the Gulf Coast market.
MarkWest says it is expanding its operations to include new de-ethanization capacity at its Houston, Majorsville, and Harrison complexes. By the end of 2014, MarkWest says it will be able to recover 115,000 bbl/d of purity ethane from the Marcellus and will have total fractionation capacity of 275,000 bbl/d to accommodate the growth in wet gas production.
“The C5 market is fairly robust at present, with prices in line with crude,” Waller observed in November. “That is because there is a strong market for the natural gasoline to be blended into the fuels pool and as a crude diluent. But all the other NGLs are underpriced, so sellers are reluctant to lock in prices. With no effective long-term hedge, you have to take the naked risk. What is missing in the NGL hedge market is parties on the other side willing to do long-term business. The petrochemical guys are willing to hedge, but only out three to six months. Until there is someone on the other side to offset, we will not have a fully functional market.”
While they wait for the market to mature, Waller says producers are creating “dirty hedges” (or “proxy hedges”). “You hedge against crude or natural gasoline, and as those close into near months, you can take them off,” he explains. “But that does not always work. For example, several months ago, propane and ethane diverged from the rest of the barrel. The deterioration in those prices pushed people to put a real floor under them, but not under the best terms.”
Producers say they have only limited options to expand the NGL hedge market, so they are concentrating on growing the physical demand in hopes higher and more varied demand will catalyze the risk-management side of the business. “The project at Marcus Hook is huge,” Waller concludes. “Appalachian producers will have a strong opportunity to develop the export market directly from the East Coast.”
North American Spread
From a deteriorated level of $0.77 a gallon last summer, propane prices had recovered to $0.94 a gallon by early November. But Randy Nickerson, senior vice president and chief commercial officer for MarkWest, notes the same gallon of propane would fetch close to $2.00 in Europe.
“Prices have improved in North America, but we are not capturing much of that spread to Europe. We are shipping by truck into Marcus Hook and moving material out semi-refrigerated on small vessels. We are adding rail capability until Mariner East comes into service. Those markets are there, including Europe and Latin America,” he states.
Nickerson acknowledges that his company has made ample use of proxy hedging out of necessity, rather than preference. “At a very high level, we have a great deal of equity in NGLs, as do a lot of midstream operators. We can hedge those directly or by proxy, but our challenge is to hedge sufficiently,” he comments. “The NGL hedging market has grown, but it is still much less liquid than other hedge markets.”
He emphasizes that the problem is not an inability to hedge, but the fluidity to hedge over the long term and at favorable rates. “When you do try to hedge long on the curve, you take a significant discount,” Nickerson says. “That is the challenge we wrestle with every day. Do we take that position and accept the discount, do we try some proxy hedge, or just sit tight and take the long risk? Conditions vary from week to week, and even day to day. Sometimes we use one approach, and the next week we have to do something different.”
Having observed the effect in-house, Nickerson also considers the cause. “Why does that discount exist? One big problem is that there are so few participants on the buy side. We do not have a worldwide market. And even though there are some large buyers, most of the business is bilateral; it lacks transparency. That inhibits parties who might be inclined to participate,” he says.
Nickerson points out that the major Gulf Coast buyers, particularly of ethane, know more about the overall market than do most small producers or sellers in, say, the Rocky Mountains. “More transparency would benefit the producers. Today’s lack of transparency benefits the buyers,” he contends. “Producers sell on the Conway or Belvieu indexes and do not think much more about it. The steam cracker operators think about it very deeply. When one side thinks deeply and the other does not, it should not be surprising that we have the situation we do.”
The lack of transparency is actually a double whammy, Nickerson goes on. “Not only does the bilateral business exclude the market makers who would be inclined to participate, but it also means they cannot go anywhere else to backstop their positions,” he says.
Nevertheless, Nickerson says he is encouraged by the willingness of some institutions to wade in, if only in conjunction with a physical participant. “Many of the banks in our group have been able to give me quotes for NGL hedges,” he says. “Three years ago, we would have had to go to one of a few big trading houses, and that would have been it.”
Table Already Set
Producers are not the only ones eager to see a more robust hedging market in NGLs. In fact, Bradford Leach, executive director of energy research and product development at CME Group, the parent company of both NYMEX and the Chicago Mercantile Exchange, says the CME Group already has set the table for NGLs hedging. “We built our NGLs complex several years ago,” Leach remarks. “We do not think it is true that the financial products have lagged the physical market.”
Dan Brusstar, senior director of energy research for CME Group, adds, “We have a full suite, and the market is very liquid. The industry hedges as much as it needs to for both cash settlement and physical delivery contracts. We have 30 million barrels of open interest on our own exchange. Propane is very liquid, and ethane is traded within the CME Group natural gas product complex also.”
According to Brusstar, propane is hedged actively. “There is open interest for at least two years out. There is also a fair amount of open interest in ethane,” he says. “In the four or five years since we listed a full suite of contracts, the open interest and activity have been surprising, and not just in the United States, but also in Europe and the Far East.”
Leach notes that liquidity is a subjective term. “Certainly, you are not going to find the volumes in NGLs that you would in natural gas or crude oil and refined products. But in relative terms, there is liquidity within the CME Group NGL product complex, and we definitely want to encourage all potential parties to use those tools,” he states.
Brusstar adds natural gas fundamentals and timing have been no small issues in the NGL hedging market. “There was a glut of dry natural gas production, and prices collapsed. Then the industry brought on substantial volumes of NGLs,” he observes. “Just based on supply and demand, that is the time in any market when producers are going to want to lock in a floor, but the buyers are less likely to agree. In other markets, that might be the point where a financial player steps in as the counterparty, but several banks pulled back a bit after they got hurt in the natural as price collapse. That was especially the case beyond 12 months out.”
The NGL market is active enough in the near 12 months, asserts Mike Corley, president of Mercatus Energy Advisors in Houston. “But things get pretty quiet after that,” he allows. “That is not to say you cannot get anything done over the longer term, but the differentials and prices are not attractive.”
Corley suggests the lack of NGLs infrastructure also is an impediment to more active trading and hedging. “Counterparties are active in natural gas and crude oil, and even some refined products, because the underlying physical markets are well connected. They are less willing to participate in NGL trading or hedging because that infrastructure does not yet exist.”
The other factors he cites include the smaller market size in terms of both volumes and players, and the retail consumer element, at least for propane.
Citing numbers from early November, Corley says the open interest for NYMEX West Texas Intermediate crude oil futures in the front month, December, was 300,000 contracts. “For propane swaps on NYMEX ClearPort, it was 3,000, or 1 percent of WTI. For ethane, it was only 700. At that size, why would counterparties participate when they already are operating in crude oil and natural gas?” he asks. “Over time, those NGL contract volumes will grow; they could even double. But I do not see them expanding five or 10 times.”
LINN Energy’s Rockov points out that with NGL output rising across North America, and with NGLs representing a vital and growing part of the total production stream for many oil and gas companies, the ability to hedge the liquids component will become increasingly important. “NGLs are becoming a larger portion of U.S. production for many producers,” he states. “We believe the market to hedge NGL volumes will continue to evolve.”
Relatively Small Market
Even if the tools are available, market watchers report they are not being taken up to the extent that otherwise might be expected. “The NGL hedging business is not a huge market,” comments Teri Viswanath, director of commodity strategy at BNP Paribas in New York. “With the growth in NGL production, we thought that there would be more hedging, but we have not really seen it.”
Nevertheless, she reiterates, there is a growing need with more producers of NGL and increasing daily production volumes. “Volumes are rising dramatically, but the available hedges are relatively illiquid. They are there, but they are analogous to refined products such as jet fuel,” Viswanath explains. “People have developed mostly dirty hedges pegged to the barrel of crude oil. But that is a problem because the proxies do not stay in their bands.”
Viswanath underscores that the buyers of NGLs are fragmented, and vary greatly in buying power. Huge petrochemical companies that buy ethane feedstocks for steam crackers, obviously have a great deal of leverage, but local propane distributors do not. “Intermediary banks such as us would welcome the opportunity to participate in this market, but the fragmented nature hinders development,” she notes.
Today’s conditions have been exacerbated further by temporal issues, Viswanath continues. “The absence of a winter last year–at least in heating demand terms–was hard on natural gas prices and increased storage, but it was particularly hard on propane demand,” she says.
While some market watchers suggest volatility in NGL pricing drives producers to seek more hedging, Viswanath turns that observation around. “The inability for producers to hedge means more volatility,” she insists. “That said, there is no great near-term solution to NGL hedging. Producers will be exposed to short-term price fluctuations, but the long-term price is expected to rise, so that is OK when you are naturally long. Given the number of ethane crackers and propane terminals, not to mention dehydrogenation plants, the long-term story on NGLs is good.”