Energy Hedging 101: The Frac Spread

Afternoon Monkeys,

Sometimes you have to stop worrying, wondering, and doubting. Have faith that things will work out, maybe not how you planned, but just how it’s meant to be. Other times, you have to try and understand the Natural Gas Liquids markets and their respective price relationships to oil so that you can impress people, because, let’s face it: Frac Spreads drive the ladies wild.

A couple weeks back I did a little piece on the crack spread, or, the margin extracted from refining crude oil into distillates and why it’s important to more than just oil refineries. This time, I’m shifting gears a bit, and touching on a ratio that is less commonly known to the layman but is increasingly important to natural gas refiners (midstream firms), or speculative ngas traders: the frac spread, short for fractionation spread, or NGL spread. Dictator of the NGL world.

Listen: before you understand what the frac spread is, it’s important to know who uses it and why. The petroleum and gas industry is segmented into three parts: Upstream, midstream, and downstream. Though it has elements of both upstream and downstream involved, midstream firms are responsible for the gathering, refining, and transportation of natural gas. They gather wet natural gas from wellheads at shale plays (Marcellus shale, Woodford shale, etc), separate the methane, leaving only NGLs (natural gas liquids) behind. These NGLs typically include propane, butane, isobutene, and condensates. Midstream firms then transport and market these heavier liquids (sometimes fee-based, other times POP contracts), from which they derive their profits and operating model.

Listen: The Frac Spread is simply the value gained from the sale of NGLs (C3, IC4, NC4, C5+) less the cost of the natural gas used to fractionate the liquids. It’s a profit margin for a gas processor, whereby your input price (natural gas = COGS) is subtracted from your output (NGLs = revenue). For processors, this is extremely important, because if natural gas prices increase dramatically while NGL prices remain stagnant (as happened post-Katrina), your frac spread will decrease dramatically—sometimes even becoming negative. If midstream firms don’t protect their spread, they’ll inevitably be ruined.

Practical Application

Since the energy markets are about as predictable as John McAfee’s behavior as of late, gas processors and midstream firms use the capital markets to hedge their price risk. They will buy natural gas futures (since they are inherently short), and sell propane futures at a predetermined ratio. It’s important to note that outputs aren’t limited to propane; isobutene, butane, and natural gasoline futures are all part of the equation, but as I’ll discuss later, aren’t very liquid or cost effective for a trader. Using a frac spread, hedgers lock in both their input and output prices and are thus impervious to market movements (both up and downside.)

Trading a Frac Spread

The frac spread is quoted in heating value terms, dollars per mmBtu, to equate propane to natural gas. The natural gas futures contract is composed of 10,000 MMBtu, and is quoted in dollars and cents per mmBtu. Propane futures are quoted in cents per gallon and traded in units of 42,000 gallons (1,000 barrels). One gallon in gaseous form contains approximately 91,500 Btus or 0.0915 mmBtu per gallon. Dividing the price of propane by 0.0915 gives the equivalent price per mmBtu. If propane were trading at 35¢ per gallon, the cost would be $3.825 per mmBtu. As far as I’m aware, the two most popular ratios used to create a balance heating value position are a 3:1 or 5:2 propane to natural gas spread.

At this point, the fractionator has only paid for the value of natural gas consumed, or reduced, in processing. There are many additional costs including processing, transportation, fractionation, and marketing that mustbe paid out of the gross manufacturing margin.

Listen: It’s extremely important to note that in these instances, midstream firms are locking in their sale and purchase prices; they are unable to participate in any upside movement in NGL prices that might take place afterwards. Think of it as an insurance policy. It’s a hedge; not a speculative position.

You might be thinking to yourself, “well, I’m not a gas processing plant or midstream firm, so I don’t care bro. I’m short AAPL because they’re out of innovative ideas, or something. Been trading since I was 15.” That’s fine. If you want to understand the drastic effect an energy firm’s hedging policy has on its bottom line, take a look at MWE’s Q3 earnings report. If not for its frac spread hedging policy (see: additional income from derivatives), its bottom line would have been absolutely clobbered by depressed crude and NGL prices. But, because of futures contracts it had been entering since 2009, it was instead profitable. The same goes for WMX, DCP Midstream, or any midstream component of a fully integrated petroleum company.

Market Correlations

Unlike crack spread options, the frac spread doesn’t have pre-packaged options one can purchase; and because NGL markets are so thin and illiquid, it’s often times difficult to perfectly hedge your exposure further out than just a few months. A true hedge is perfectly negatively correlated to the underlying asset. Thus, rather than hedging exposure on a product-for-product basis (selling propane swaps to lock-in a future sales price), processors often use a proxy hedge, or, using WTI Crude swaps to hedge their NGL exposure.

Traditionally, WTI Crude and NGLs have high market correlations, allowing hedgers to use the cheap and highly liquid crude markets in the stead of thin, expensive liquids markets. That’s why a gas firm will follow crude prices almost as closely as NGL prices; they’re usually very similar.

However, the markets for the past 18 or so months have been unlike any markets we’ve seen before. Lumina Investments knows what I’m talking about. NGL prices and crude prices have become so disjoint that using crude as a proxy hedge is simply no longer effective. As BarCap’s Michael Zenker notes, “some producers will lock in an NGL hedge as a percent of oil production, which results in a proxy hedge that may leave them vulnerable to situations when the prices of oil and liquids do not correlate." This is highly problematic for a hedger, for: if your proxy is no longer correlated, your hedge is no longer effective, and your exposure is as if you had never hedged at all. This is referred to as basis risk.

Thus, the crude/NGL proxy hedge is losing its effectiveness as of late, and energy firms are being forced to move into product-for-product hedges, whose markets are less liquid and more costly.

Highlights:

•The Frac Spread is the value of natural gas liquids extracted from raw natural gas. It’s a profit margin.

•The predominant NGLs are propane (C3), isobutene (IC4), butane (NC4), and natural gasoline (C5+). The term “C3+” refers to all four hydrocarbons.
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Gas processors and midstream firms pay close attention to this spread, since they are the ones doing the processing and subsequent marketing of the product.

•Your frac spread can be tailored to fit your product mix.

•Since the NGL futures markets are illiquid, hedgers often use WTI futures instead, since they are traditionally highly correlated. However, this proxy is increasingly ineffective as price patterns are becoming disjointed, exposing the hedger to basis risk.

•Mont Belvieu in Texas is the leading US gas hub, and its area frac spreads reached all time highs in early 2011 after dipping into negative territory post-Katrina.

Listen: If anything, the frac spread is a great indicator of the direction the gas markets are headed, and thus, where the stock of a midstream firm is headed. If you were to plot the midstream industry’s index (if there was such a thing) price pattern next to the same time period’s frac spread, it’s a solid bet they’d move in close harmony. Chesapeake might be a notable exception to this observation, since their “hedging” strategy has been known to be speculative and not-so-effective (at best). It’s a subject that could be spoken on for hours, but if you have any questions, feel free to PM me or post and I’ll do my best to respond. Hope this helped. Happy hedging everybody.