The US Midstream Sector

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					THE U.S. MIDSTREAM SECTOR “MEETING THE CHALLENGES in TURBULENT TIMES”

Peter Fasullo Principal En*Vantage, Inc. Houston, Texas www.envantageinc.com

ABSTRACT
To gain a perspective of where the Midstream Sector might be headed, this paper reviews its history and past challenges, examines its current makeup and discusses the abilities of midstream players to handle the challenges that lie ahead. It also ponders whether the Midstream Sector needs realignment to make it more capable to extract opportunities and serve customers in these turbulent times.

The US Midstream Sector “Meeting the Challenges in Turbulent Times” Peter Fasullo, En*Vantage, Inc.
March 11, 2003

I. Introduction:
History has shown that the Midstream Sector has always faced challenges as illustrated by the themes of past annual GPA conventions. Twenty years ago the theme was “Challenging New Horizons”, ten years ago it was “Succeeding in a World of Challenges” and three years ago the theme was “Creating Value in a Changing World.” The fact that this is the 82nd Annual GPA Conference is a testament to the Midstream Sector’s longevity and ability to face major challenges while effectively serving the needs of its customers. However, at any particular time, the effectiveness of the Midstream Sector to deal with challenges depends on how well companies with midstream operations accept certain realities and proactively deal with the issues at hand. Currently, the business climate for the Midstream Sector is filled with a number of uncertainties. The Enron after shocks, a sluggish economy, geopolitical events and a high priced natural gas environment are just some of the macro-issues now testing the Midstream Sector. The actions taken by midstream businesses in reaction to these and other issues will determine the future course for the Sector. To gain a perspective of where the Midstream Sector might be headed, we will review its history and past challenges, examine its current makeup and discuss the abilities of midstream players to handle the challenges that lie ahead. We will also ponder whether the Midstream Sector needs realignment to make it more capable to extract opportunities and serve customers in these turbulent times.

II. Definition of Midstream:
Before addressing the paper’s main topics, the term Midstream needs defining since it can be broadly used to describe a certain segment of the energy sector. The Midstream Sector is a collection of assets and services that help link the supply side of the value chain with the demand side for any type of energy commodity. In other words, the Midstream Sector acts as bridge between energy producers and energy end users and it is only as strong as its ability to link one side of the value chain with the other side.

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The Midstream Sector can include, but not be limited to, the following functions:        Gas Gathering, Treating and Processing Natural Gas Pipelines (Primarily Intrastate) Product Pipelines (Mainlines and Distribution or Purity Lines) Fractionation Natural Gas and Product Storage Product Terminals Import/Export Facilities

For purposes of this paper the term Midstream Sector will primarily refer to those midstream functions that are involved in the production, handling and distribution of NGLs. The Midstream NGL value chain is interwoven between the E&P sector on the upstream side and the petrochemical, refining and retail fuel markets on the downstream side (Chart 1). To make things more interesting, the refining industry is a consumer as well as a producer of LPGs. Even the power generation sector has an indirect impact on NGLs, as it is now a major consumer and price determinant of natural gas.

Chart 1 Because the Midstream Sector is where the E&P, gas pipeline, petrochemical and refining industries meet, the Sector is subject to various challenges outside of its control. Market events that can affect crude oil, natural gas, petrochemicals and refined products can profoundly influence the performance and profitability of a Midstream business. Also, the Midstream Sector has no distinct (ownership) borders or boundaries. Today, major oil companies, independent oil & gas producers, independent gatherers & processors, intrastate pipeline companies, energy merchants, petrochemical producers and master limited partnerships (MLPs) have operating or ownership positions along one

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or more segments of the Midstream value chain. Later in this paper we will discuss the significance of this point as it pertains to the Sector’s ability to handle the challenges ahead.

III. History of the Midstream Sector:
Pre - 1980’s Unlike today, the ownership structure of the Midstream Sector was much simpler in its early history:  Majors such as Amoco, Chevron, Conoco, Exxon, Mobil, Phillips, Shell and Texaco built midstream facilities to bring their equity production to market and to supply their refineries and petrochemical plants.  Interstate Pipelines such as Columbia Gas, Northern Natural, Tennessee Gas, Texas Eastern and Transco expanded into gas gathering and processing to grow their rate base and secure natural gas supplies.  Even “Old Line” Petrochemical Companies, such as Dow and Union Carbide, built NGL gathering lines, gas pipelines, and fractionation and storage facilities to secure their fuel and feedstock supplies. During this time, the energy markets were heavily regulated. Natural gas was considered a premium fuel and the long-term availability of natural gas and NGLs was uncertain. The critical challenge for these players was securing and controlling hydrocarbon supplies for their downstream facilities and customers. Owning and operating midstream assets served this purpose and there was an unwillingness to rationalize capacity or sell marginal midstream assets. As such, midstream assets had more of a utility function and did not necessarily operate as a profit center. Seldom did these assets serve third parties for fear of being federally regulated. The 1980’s By the 1980’s, independent midstream players serving third parties began to make their presence known. Independent gatherers & processors, intrastate pipelines and NGL logistics companies were expanding, aided by price deregulation and a greater confidence of crude oil and natural gas availability.  Examples of such players were Enterprise, Houston Pipeline, Koch Hydrocarbons, MAPCO, Mitchell, Tejas, Transok and Valero.  Their assets were oriented to major producing basins and/or were located in major market centers, so they had a strong regional presence.  They were mostly dependent on the wholesale markets.  They operated for profit, serving customers like oil & gas producers, electric utilities, LDCs, refiners and petrochemical companies. Although independent midstream companies were growing during this period, a number of issues highlighted the vulnerabilities and excesses of the Sector:

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   

“Take or pay” contracts strained the relationship between producers and gas pipeline companies. Price deregulation brought on margin volatility and competition from alternative fuels and petrochemical feedstocks. The gas “bubble” developed, as gas went from supply constrained to demand limited. Gas drilling plummeted, NGL production stagnated, and gasoline lead phase down and vapor pressure controls diminished the marketability of natural gasoline and normal butane as motor gasoline blendstocks.

Early to Mid 1990’s The excesses of the 1980’s, gave rise to rationalization and consolidation in the Midstream Sector in the early 1990’s.  Lacking the desire to seek third party customers, some Majors and E&P companies sold their midstream assets as their equity production declined and their focus shifted to bigger offshore or international plays.  Consolidation also occurred within the Midstream Sector as independent players began to merge with or acquire other players to create greater economies of scale and scope. The early 90’s also ushered in the environmental movement. Natural gas was recognized as a reliable, clean fuel that would play a key role in the nation’s clean air crusade. Price deregulation and the repeal of the Fuel Use Act in 1987 that restricted gas usage in new power generation facilities started to yield dividends as gas demand began to rise. The Clean Air Act enacted in 1990 had benefits for NGLs as well. MTBE was the preferred oxygenate for reformulated gasoline, creating a new end use for normal and iso-butane. Mid 1990’s to 2001 By the mid-1990’s, the Midstream Sector was viewed as a model for extracting opportunities and serving customers in a relatively unregulated environment. Not only did midstream entities strategic link supplies and markets, but they also provided a platform for marketing and trading. Additionally, the Midstream Sector could potentially offer returns exceeding the regulated cost-based returns of the utilities and interstate pipelines. The attractiveness of the Midstream Sector combined with a growing economy and the advent of power deregulation gave rise to a “feeding frenzy” for midstream companies and assets in the mid to late 1990’s.  Excluding the M&A activity that occurred between the Majors and the large diversified energy companies, transactions for independent midstream entities, from 1994 to 2000, totaled over $15 billion.  Electric utilities, diversified energy companies and energy marketers were the primary acquirers of midstream companies and assets.  Shell was the only Major that acquired a midstream entity while other Majors either sat tight or sold their midstream functions to third party marketers in return for a dedicated marketing alliance.

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During this time, cash flows (EBITDA) for many Sector participants were peaking and multiples paid for midstream businesses averaged 10 times the previous 12 months’ EBITDA, with a range of 8 to 13 times. This implied a return on investment in the single digits, unless the acquirer could generate significant synergies or grow the midstream business at double-digit rates. Some acquirers, fairly new to the Midstream Sector, failed to recognize the risks or take the necessary steps to succeed in a deregulated market. In many instances, adequate synergies were not generated to support the high multiples paid, which made the acquisition particularly sensitive to normal economic downturns or market shocks. Upstream & downstream drivers were often taken for granted with the belief that the midstream entity could be put on autopilot. By 2000, we witnessed another wave of transactions as some recent acquirers decided they could not handle the challenges of the Midstream Sector. PG&E, TransCanada, LG&E and PacifiCorp exited their midstream businesses at a significant discount from their original purchase prices, and at reduced multiples of 6 to 8 times EBITDA. For other diversified energy companies like Duke, Dynegy, El Paso and Williams, their midstream acquisitions and joint ventures provided them geographically focused assets giving them greater access to hydrocarbon resources and markets. These companies were labeled the “energy super stores” or what is as commonly referred to today as the “energy merchants”, entities marketing and trading a host of energy commodities. MLPs greatly expanded their presence in the Midstream Sector during the past several years. MLPs are publicly traded entities managed just like C-corporations, however there are distinctions:  MLPs distribute a higher amount of cash flow to their shareholders because net income is taxed only at the shareholder level, thus avoiding the double taxation of dividends common to C-corporations.  MLP units are valued based on their expected distributions, currently yielding 6% to 8% with expected annual growth of about 5% to 10%. The sanctity of the distribution is a very important factor to investors. Consequently, the most successful MLPs have been those focusing on that portion of the value chain with predictable, consistent cash flow profiles. Natural gas & NGL pipelines, fractionation and storage facilities typify the asset profile of Midstream MLPs. Many of the large, diversified natural gas companies and energy merchants have formed MLPs and are their general partners.

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IV. Current Structure of the Midstream Sector
Today, a diverse group of companies compose the Midstream Sector. Majors, energy merchants, independent midstream players and a petrochemical company occupy the top positions along the NGL value chain (Chart 2).

Chart 2

Top Players Along the NGL Value Chain
(Ranked according to operating position)
GAS PROCESSING 1. DEFS 2. BP 3. El Paso & L.P. 4. Williams 5. ExxonMobil 6. Enterprise 7. ONEOK 8. ConocoPhillips 9. Devon 10. Dynegy RAW MIX PIPELINES Enterprise TEPPCO Koch ChevronTexaco Dynegy BP El Paso L.P. ExxonMobil Koch ConocoPhillips FRACTIONATION Koch Enterprise ConocoPhillips Dynegy El Paso L.P. ExxonMobil BP ONEOK DEFS Williams SALT DOME STORAGE Enterprise TEPPCO Dow Dynegy Williams ConocoPhillips BP ExxonMobil El Paso L. P. ONEOK TERMINALS TERMINALS IMPORT EXPORT Dow Enterprise Dynegy Trammo Enterprise Dynegy ChvTexaco PRODUCT DISTRIBUTION Enterprise Dow ConocoPhillips TEPPCO Koch KinderMorgan ChevronTexaco Dynegy El Paso L.P. ExxonMobil

These players and many other smaller midstream companies make up the Sector, as we know it today. Some are more integrated than others across the entire energy value chain and many players have different strategic and financial objectives for being in the midstream business. However, the Midstream Sector continues to transform. The aftershocks of Enron have exposed the financial vulnerabilities of some energy merchants operating in the Midstream Sector. Like the fishing boat, Andrea Gail, in “The Perfect Storm” these players are trying to survive wave after wave of trials and tribulations and are fighting for their financial survival: putting projects on hold, and selling assets (many of them midstream) either to their MLP affiliates or to third parties. Other players and outside investors are taking advantage of this situation by acquiring these midstream assets, while a few industry participants are in limbo trying to decide if their midstream holdings are core to their long-term future.

V. Current Realities and Issues
In the midst of all this turbulence, companies operating in the Midstream Sector must respond to a number of challenges posed by certain realities and issues listed below in no particular order of importance:

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  

Price and margin volatility U.S. petrochemical industry’s health Poor market liquidity for NGLs

  

High priced gas environment A maturing gas resource base Tight credit

The realities and issues listed above are not entirely mutually exclusive. They often have a cause and effect relationship on each other, such that each issue cannot be examined in isolation of the others. Additionally, these issues will not affect all Midstream participants equally. A company’s ability to effectively deal with challenges depends on: its size, corporate structure & financial strength; its strategic focus; the type & location of its midstream asset; its integration along the value chain; and its commercial arrangements with its customers. The critical areas where these issues have the most impact are as follows: Processing Margins (“Frac Spread”) Price and margin volatility has been a long-standing issue confronting US gas processors since the early days of energy price deregulation. NGL price volatility exists simply because NGL market values are set by or in competition with the value of petroleum derived products used in the production of petrochemicals and motor gasoline. Consequently, the same global market forces and geopolitical events that drive crude oil prices can greatly influence NGL prices. Chart 3
Historical Processing Margins
Mont Belvieu Price versus Henry Hub
34 32 30 28 26 24 Mexico's Cactus Plant Explosion Economic Recession Gulf War OPEC Discipline

cents per gallon

22 20 18 16 14 12 10 8 6 4 2 0
g Au

Average Margin 13.2
Average Variable Cost Breakeven Range Econmomic Recession Crude Collapse Gas Price Spike Winter'95/96 Major Gas Price Spike Winter '00/01

Asian Crisis

While NGL market values are determined by petroleum product prices, the price floor for NGLs is set by natural gas prices, which are more influenced by North American market

02 gAu 02 bFe 1 0 gAu 01 bFe 0 0 gAu 00 bFe 9 9 gAu 99 bFe 8 9 gAu 98 bFe 7 9 gAu 97 bFe 6 9 gAu 96 bFe 5 9 gAu 95 bFe 4 9 gAu 94 bFe 3 9 gAu 93 bFe 2 9 gAu 92 bFe 1 9 gAu 91 bFe 0 -9

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fundamentals. At many times, the market cycles for natural gas, crude oil and petrochemicals move in different directions, either because of weather, economic cycles, industry events or geopolitical crises. When these happenings occur, the “Frac Spread”, the margin between NGL and natural gas prices, can change dramatically and frequently as illustrated by Chart 3. Over the past 5 years, the “Frac Spread” has averaged around 11 cents per gallon, below the level required to justify a return on investment for a new cryogenic plant processing the average U.S. gas quality of 2 gpm gas. Natural Gas Concerns are mounting that a fundamental shift is occurring in the North American gas market toward consistently higher prices. Price spikes are becoming more frequent. Since 2000, Gulf Coast prices have averaged nearly $4.00/MMBtu, much higher than the $2.00/MMBtu average level of the 1990’s. Absolute prices are higher, but more importantly natural gas is becoming more valuable relative to crude oil (Chart 4). The gas to crude price ratio averaged 77% over the 1999 to 2002 period compared to 70% over the 1995 to 1998 period and 51% over the 1991 to 1994 period. Even if crude prices return to the $25 to $30/ barrel level, gas prices in the $3.50 to $4.00/MMBtu range may be the norm with more upside pressure than downside. The days of sub $3.00 gas are less likely to occur, unless crude prices drop below $22/barrel on a sustained basis.
Natural Gas/Crude Oil Price Ratio
(On a BTU Basis; Henry Hub to WTI)
210.0% 190.0% 170.0% 150.0% 130.0% 110.0% 90.0% 70.0% 50.0% 30.0% 10.0%

Winter ‘00/’01

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Chart 4

Several supply/demand fundamentals are responsible for elevating the value of gas relative to other energy commodities. On the supply side, concerns are that natural gas production for 2002 declined anywhere between 2% to 6% from 2001 production levels. Although drilling in Canada is at near record levels, there is continued apprehension concerning U.S. gas production based on

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Jan-02

the lack of any upturn in drilling activity domestically, despite the recent rise in gas prices above $5.00/MMBtu (Chart 5).

Historically, there has been at least a 6 to 9 month lag between the time gas prices rise and when the rig count starts to increase.
U.S. Gas Operating Rig Versus Gas Prices
1,200 1,100 1,000
# of Gas Rigs
Gas Rig Count Gas Prices

$9.00
Avg Daily Henry Price

$8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00

900 800 700 600 500 400
Ja n Ap -98 r Ju -98 O l-9 c 8 Ja t-98 n Ap -99 r Ju -99 O l-9 c 9 Ja t-99 n Ap -00 r Ju -00 O l-0 c 0 Ja t-00 n Ap -01 r Ju -01 O l-0 c 1 Ja t-01 n Ap -02 r Ju -02 O l-0 c 2 Ja t-02 n03

Chart 5 A number of industry pundits claim that the disconnect between high gas prices and drilling activity is indicative of a structural change in the E&P industry. As a result, the frenzied pace of opportunistic drilling that was spawned by the 2000/2001 price spike is unlikely to be repeated. The structural change that could be underway is as follows:  Lower 48 producing basins are maturing and offer lower rates of returns than in the past with exception of the deep water Gulf of Mexico and coal bed methane in the Rockies.  Industry consolidations, particularly among the Majors, have created superlarge companies that must pursue prospects that yield longer-term higher rates of returns to support their cost structures. Accordingly many large E&P companies are focusing on less mature international prospects, unconventional gas plays and deep water Gulf.  Many other U.S. producers are limited by leveraged balance sheets. Because of tight capital, many medium to small players are husbanding their cash or developing what holdings they already have which are generally older, and therefore smaller, reservoirs. While the U.S. is still rich in reserves, it may take a sustained, high priced gas environment to spur an increase in drilling. Without the Majors’ strong participation and a slower response by independent producers, the rate of increase in drilling, seen after

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previous price spikes, may be slower and will probably exacerbate the supply tightness we are currently experiencing. On the demand side, electric power generation is about to overtake the industrial market as the primary consumer of natural gas in the U.S. (Chart 6).

Natural Gas Consumption: Electric Generation versus Industrial
8.00

Gas Consumption (TCF/Year)

7.00
Industrial

6.00 5.00
Repeal of the

Electric Generation

4.00 3.00

Fuel Use Act

Source: EIA

2.00 1986 1988 1990 1992 1994 1996 1998 2000

Chart 6 The repeal of the Fuel Use act in 1987, environmental regulations and a growing appetite for electricity created a very favorable environment for independent power producers and non-regulated utility affiliates to build gas-based power generation. These new power plants, still coming online, are more fuel efficient and are displacing older, less efficient utility boilers that had some fuel switching capabilities. Consequently, the newer power plants can tolerate higher relative values for natural gas than the older less efficient generators. As natural gas consumption for electric power continues to grow, the economics of power generation will increasingly set the marginal price for natural gas. This situation threatens U.S. manufacturers, steel, paper and petrochemical producers as well as gas processors, all who either use gas as a fuel or feedstock or both. The price competitiveness of the U.S. Industrial Sector versus other industrial companies in World areas with cheaper fuel costs could be severely jeopardized. The implications for the U.S. Petrochemical Industry and its impact on the Midstream Sector will be covered in the following discussions. The US Petrochemical Industry The Midstream Sector is growing increasingly dependent on the US Petrochemical Industry as a market for NGLs (Chart 7). Chart 7

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US Market Share Demand for NGLs 1974 1984 1994 Petrochemicals 32% 36% 52% Refining 32% 25% 20% Fuel & Other 36% 39% 28%

2002 56% 15% 29%

The U.S. Petrochemical Industry presently accounts for approximately 56% of the nation’s total NGL demand of around 2.8 million barrels per day (MM BPD) compared to only 32% of the 2.2 MM BPD of NGLs consumed nearly 30 years ago. Its dominant NGL market share is due to the following reasons:  US ethylene capacity based primarily on ethane & propane cracking doubled over the last 20 years.  Refinery demand for normal butane and natural gasoline declined due to lead phase-down and vapor pressure controls.  Fuel and other uses for NGLs had very moderate growth. From the perspective of U.S. ethylene producers, ethane and propane now constitute 65% of their total feedstock supply versus 50% two decades ago. The reliability of natural gas and NGLs supplies along with the fact that it is cheaper to build ethylene plants based on light NGLs were mainly responsible for this feedstock shift. The Midstream Sector’s relationship with the Petrochemical Industry goes well beyond market share. Recalling that the “old line” petrochemical companies were some of the first entrants into the Midstream Sector, the physical ties between the two industries are very strong as illustrated by the following facts:  Approximately 92% of the US Ethylene capacity is located along the Texas/Louisiana Gulf Coast.  Over 75% of that capacity has direct access to Mont Belvieu.  Over 90% of total US ethylene capacity is connected to at least some part of the US NGL transportation system.  Almost every ethylene plant has access to underground NGL storage. Obviously, the U.S. Petrochemical Industry’s health is extremely important to the NGL value chain. A sluggish economy has reduced average operating rates of U.S. ethylene plants to the low 80% levels. The relatively high prices of natural gas and NGLs are also causing severe and perhaps long-term competitive damage to the U.S. Petrochemical Industry according to the consulting firm CMAI. The economic slowdown and higher feedstock & fuel costs are already having an impact as witnessed by Dow Chemical’s recent announcement that they would shut down their Seadrift and Texas City ethylene plants this year to reduce expenses. These are primarily ethane crackers consuming a total of 40 MBPD of ethane, approximately 6% of the ethane produced by U.S. gas processors. Petrochemical companies with flexible feedstock plants are also re-evaluating their longterm feedstock slates and may be looking to reduce ethane cracking and import more 11

economical condensates and naphtha feedstocks. The nation’s ethylene producers have considerable flexibility to swing NGL consumption and affect NGL supply/demand balances as shown on Chart 8.

Chart 8 Feedstock Flexibility of US Ethylene Industry
Feedstock Ethane Propane N-Butane Nat’l Gaso/ Naphtha’s/ Condensates Gas Oils Base Demand 525* 200 0 (MBPD) Max. Demand 875* 450 150 Swing Volumes 350 250 150 Swing Vol. As % of US Supply 44.5% 18.6% 46.5%

350

675

275

NA

80 230 150 * Includes Dow’s Seadrift & Texas City Plants

NA

The major concern is that over time ethane-based ethylene plants in the Middle East and elsewhere, which have access to cheaper ethane and natural gas supplies, will pressure the U. S. ethylene industry to minimize ethane cracking. If this were to happen, potentially 40% of the ethane produced by gas processors could be displaced, which would significantly change ethane’s role as a clearing market for surplus BTUs. On the positive side, cracking of propane, butane and natural gasoline should increase. These NGLs will remain price competitive, as their values are determined more by crude oil than by local natural gas prices and they also produce more valuable co-products.

VI. Challenges & Implications
The issues just described pose a number of challenges for all Midstream participants and for the viability of the entire Sector to be a growing industry providing services to upstream and downstream customers. Managing Price & Margin Volatility Companies with processing operations face considerable challenges in managing economic risks and achieving acceptable rates of return while still serving the producer. It is virtually impossible to lock-in processing margins for any length of time due to the poor market liquidity for NGLs. Long dated or futures markets for NGLs are nonexistent. So, those gas processors that have “keep whole” provisions in their processing contracts are most susceptible to price and margin volatility.

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Today, many of these gas processors are attempting to change this contractual structure by offering producers more of a fee-based processing arrangement that enables the processor to continue processing a producer’s gas during times of very poor margins. The benefits are twofold: (1) the producer is assured that his gas will be processed to meet pipeline quality specifications during times when processing is uneconomical; and, (2) the processor can smooth out his earnings stream even though he caps his upside during very good times. This second benefit would be particularly important to those midstream companies that would like to place or transfer their processing business into an MLP. However, the jury is still out as to whether gas processors will be entirely successful in this endeavor. Competition from other processors may be the major obstacle, particularly along the Gulf Coast where “keep whole” agreements are more common. This is in contrast to more isolated areas like the Rockies, where processors have less competition and more leverage to strike processing arrangements that lessen the risk of price and margin volatility. The challenge for some processors is to find the right balance with producers that will not overly penalize either party when markets swing out of balance. There is always the risk that some producers, who have enough critical mass, might process their own gas or seek out competing processors, who are willing to withstand the volatility of a “keep whole” agreement. Achieving Greater Efficiencies Midstream Sector participants will be challenged to adjust their operations in the event ethane cracking is significantly reduced as competition from international ethylene producers intensify. Processors may need to upgrade their ability to reject or reinject ethane into the gas stream to optimize BTU deliveries against pipeline specifications. Additionally, the Midstream Sector must continue to rationalize underused capacity, particularly with regards to gas processing. M&A activity has concentrated 72% of US NGLs produced from gas processing in the hands of the top 10 operating companies versus 52% ten years ago (Chart 9). Another 157 smaller processing companies account for the remaining 28%. Although gas processors may not have 100% ownership of their processing facilities, in many cases, the plant operator is the business manager for the facility and is often the buyer of the plant’s output when gas producers do not take title of their liquids. Chart 9 Top 10 US Gas Processors
(In terms of NGL Production in MBPD)

1992
1. 2. 3. 4. 5. 6. 7. 8. 9. 10.   GPM (Phillips) ------Exxon -----------------Amoco ----------------Texaco ---------------Dynegy ---------------UPR -------------------Valero -----------------Conoco ---------------Arco -------------------Shell -------------------Total Production-----Market Share--------157 118 94 85 82 79 64 64 61 59 863 52% 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.   DEFS-----------------BP --------------------El Paso --------------Williams --------------ExxonMobil ---------Enterprise ------------ONEOK ---------------ConocoPhillips-------Devon -----------------Dynegy ----------------Total Production-----Market Share---------

2001
396 199 158 121 120 75 74 66 62 59 1330 72%
Source: Gas Processors Report

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Despite past consolidations among gas processors, the average utilization rate for U.S. gas processing plants has fluctuated between 66% and 72% for the past 10 years (Chart 10). The low utilization rate is even more concerning given that the number of plants in the U.S. has dropped from 735 to 570 during this period according to Oil & Gas Journal.
U.S. Plants: Number & Utilization
( As of Jan 1 of each year)
750 Number of plants Utilization rates % 74

72 700 70

# of Plants

650

68

600

66

64 550 62

500 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

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Chart 10 Excess processing capacity continues to be a systemic problem because processing plants are generally captive to a specific production area for their source of gas. Facilities are usually sized for the maximum production that can be reasonably expected. A processing plant’s useful life can be 30 plus years, so production declines can eventually lower the plant’s utilization rate during its lifetime. Even though plants are skid mounted, moving them to another production region is generally uneconomical because 50% of the cost of a facility is site work, which usually offsets material cost savings. As major gas producing basins mature, it will place further pressure on gas processors to rationalize excess plant capacity, lower operating costs and put greater focus on the growing gas basins that need processing services. Midstream players, which have NGL pipelines, fractionation and storage facilities, will also have to pay close attention to the dynamics occurring upstream and downstream to be able to either rationalize excesses or adequately plan to bring additional production to market.

VII. The Future of the Midstream Sector
Although there are serious issues facing the Midstream Sector, opportunities along the NGL value chain will continue to exist simply because:  Natural gas is and will continue to be the clean fuel of choice.  North American gas reserves are such that producers can find and supply needed natural gas if the economics are right, with Canadian and LNG imports increasingly bridging supply & demand gaps in the future.

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Uitlization Rates %

 

Historically, 80% of all natural gas produced has been processed or conditioned to meet pipeline quality specifications. There is no reason to believe this ratio will significantly decline. So processing will continue to be a must have business. The U.S. Petrochemical and Refining Industries will remain the largest in the world due to the nation’s market size and substantial logistic network. Although, ethane cracking could be minimized in a high priced natural gas environment, the majority of the U.S. petrochemical feedstock supply will continue to come from NGLs.

However, the issues previously discussed will pressure companies with midstream businesses to become more efficient, more focused and more nimble to generate adequate returns on investment. Rationalization needs to occur in some segments, margin risks need to be mitigated, and linkages to upstream and downstream drivers need to be maintained and strengthened. The challenge for any company operating in the Midstream Sector is to determine the proper business model to handle the issues and extract the opportunities while still being able to generate adequate returns. Are the risks so great that the Sector needs to revert back to its earlier days when integrated Majors controlled most of the functions along the NGL value chain, or can there be profitable independent midstream players that provide value added services to upstream and downstream customers? Opportunities will always exist for smaller, niche players to fill the gaps created by the exit of larger players in a particular region. But a strong case can be made that the Midstream Sector needs and can support a small number of large, fairly integrated and properly capitalized midstream companies. Revisiting the top NGL players and their current situations provides a good indication of the future direction of the Midstream Sector. Duke Energy Field Services (DEFS), a joint venture between Duke Energy (70%) and ConocoPhillips (30%), is heavily concentrated in gas gathering & processing and is the nation’s largest operator of gas processing capacity.  Their core operations are in the Rockies, Mid Continent, Louisiana, Oklahoma and Texas, and they offer value-added services such as gathering & processing, transportation, storage, fractionation and marketing to third party customers.  DEFS is also the general partner of TEPPCO Partners. TEPPCO is an MLP that transports & distributes NGLs and refined products and has been very active in acquiring NGL pipelines and gas gathering systems, recently.  Through a series of partnerships, the DEFS/TEPPCO combination provides enough critical mass to minimize risks and to effectively service customers. Enterprise Products Partners, L.P., an MLP, is entirely focused on the Midstream Sector and it is the most integrated, operationally connected midstream player in North America.

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

 

It has been very successful expanding all along the NGL value chain, having franchise pipelines, fractionators, storage facilities and an import/export terminals to link major NGL production centers along the Louisiana Gulf Coast and the Rockies with the major market centers at Mont Belvieu, Conway and along the Mississippi River. Its alliance with Shell provides it a great anchor to process deep water Gulf of Mexico natural gas as Enterprise is currently the 6th largest processor in the U.S. with all its processing capacity in Louisiana. Unlike other Midstream MLPs, Enterprise has successfully taken on the commodity risk of processing because their distribution is based on the cash flow generated by their fee-based NGL assets rather than on their processing operations.

The energy merchants such as the Williams Companies, El Paso Corporation and Dynegy continue to hold significant positions along the NGL value chain. However most of their energies are currently devoted to repairing their balance sheets. With extremely tight credit, their growth in this Sector is questionable at this time.  El Paso is attempting to transfer all of its Midstream assets to its MLP, with its South Texas processing plants remaining in the Corporation until contracts can be converted to more of a fixed fee basis.  Even though Williams has an MLP, Williams NGL assets remain in the Corporation. In 2002, Williams sold virtually all of its ownership interest in the MAPCO/Seminole NGL pipeline system to Enterprise to strengthen its balance sheet. The company is currently has its Canadian processing plants and Louisiana ethylene plant with its associated midstream assets up for sale.  Dynegy Midstream has been reducing its NGL presence over the last several years by selling non-core processing plants. With the energy merchants in a retrenching mode, that leaves the integrated Majors such as BP, ExxonMobil, ConocoPhillips and ChevronTexaco still holding dominant asset positions in the Midstream Sector. Unlike their predecessors, Majors today are much more sensitive to returns on investment and are focusing most of their attention to offshore and international E&P plays that generate higher returns. Controlling hydrocarbon supplies from the well-head to the burner-tip is not the critical issue it once was 30 to 40 years ago. As a result, most Majors should continue to rationalize their marginal midstream assets and outsource midstream responsibilities to those players who are focused on growing the business. However, some Sector participants are still deciding what course of action to take with their midstream assets, some of which were acquired from recent M&A activities. In their current state, some of these assets are under performing either from a lack of capital, vision or the right connectivity. Our analysis shows that many of these midstream assets could easily “fit and groove” with each other or with other midstream businesses to create sufficient critical mass and synergies to significantly improve their earnings potential.

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As previously mentioned the players that have been focused on growing either organically and/or by acquisitions within the Sector are the MLPs. Their ability to raise capital has given them an edge to opportunistically take advantage of the recent turmoil. Whether the MLPs have the most effective financial structure to continue to expand in this Sector along the entire value chain is a topic for another paper. The most important point is that Sector participants must have the vision, desire and the right approach to profitably grow a midstream business. Although the Midstream Sector does not have infinite opportunities, there is a need for a few, strong players that have:  Low cost operations  Strong linkages to one or more producing region.  Efficient transport, storage & distribution systems to link to major market centers and customers.  The ability to manage business risk through integration.  Selective acquisitions that are synergistic and accretive to earnings.  The ability to leverage through incrementality.  The flexibility to adjust operations. In time, solutions will be found to deal with the challenges and alliances between Midstream participants and their customers may be part of the solution:  The commodity risks associated with gas processing will get resolved contractually, simply because the service is needed and most producers will want to focus their resources on finding and producing crude oil and natural gas rather than have the processing function default to them.  A high priced gas environment will eventually induce new supplies from Canada and possibly the McKenzie Delta, and LNG will become more of a prominent supply source where the Midstream Sector can play a critical role in conditioning and transporting the gas to market.  The U.S. Petrochemical Industry will make the proper adjustments to its feedstock slate to remain competitive with foreign petrochemical producers and NGLs will continue to be the feedstocks of choice.

VIII. Conclusion
Whenever an industry undergoes major challenges due to economic downturns, geopolitical events, regulatory mandates or fundamental market shifts, a period of restructuring usually follows. Inefficiencies are wrung out of the system and stronger, more efficient players displace weaker, less efficient ones. What is threat to some is an opportunity for others. Currently, the Midstream Sector is at another inflection point in its history. The convergence of a number of different issues requires the Sector to become more efficient. Another round of rationalization and consolidation is needed, challenging companies with midstream business to decide whether they have the vision and desire to face the issues and capture the opportunities. Those companies that can effectively network the right midstream assets together can be successful in this Sector. 17


				
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