I've heard that gathering and processing MLPs have some sensitivity to commodity prices. Can you explain why?
Before hydrocarbons enter either a mainline or trunkline, they need to be gathered and processed. Gathering refers to the process of connecting wells to major pipelines through a series of small-diameter pipelines. Processing is the removal of potential contaminants (including natural gas liquids (NGLs), which may actually be quite valuable) so that the gas meets purity standards for pipeline transmission.
For gathering services, MLPs typically charge upstream companies a set fee for every cubic foot of natural gas or barrel of oil that is gathered. For processing services, MLPs can implement fee-based contracts as well, since they remove direct exposure to commodity prices; however it is possible for an MLP to have a mix of processing contract structures. For example, Azure Midstream Partners (AZUR) noted in its most recent 10-Q that it has keep-whole, percent of liquids (POL), and fee-based contracts. EnLink Midstream Partners (ENLK) also employs a variety of contracts in addition to fee-based, including percent of proceeds (POP) agreements.
With keep-whole contracts, the MLP gets the natural gas from the producer, processes it, then keeps only the extracted NGLs to sell them to third parties at market prices. The MLP profits from the sale of the NGLs; it is not paid by the producer. However, the producer then has to be made whole for the NGLs the MLP took by either delivering or paying for a “thermally equivalent volume of residue gas”. (We like to compare this process to donating plasma. Through the process of plasmapheresis, plasma is separated from a person’s blood, and then the remaining blood material is given back to the donor. If you donate to an organization like the American Red Cross, they will take your plasma to a third party hospital. In order to make you, the donor, “whole”, they give you cookies and juice to keep you from feeling woozy. In this example, you are the producer, the American Red Cross is the MLP, and the hospital is the third party “buyer”. This example breaks down only in that humans do not need plasma removed from our blood for it to continue flowing through our veins and arteries. NGLs, on the other hand, must be removed in order for natural gas to meet pipeline quality standards.) As a result, the MLP is long the price of NGLs and short the price of natural gas. Since NGL prices have historically been closely linked to the price of oil, keep-whole contracts make lots of sense when the crude-to-gas ratio is high.
With POL contracts, the MLP is paid in the form of a percentage of the liquids recovered, and the producer bears all the cost of the natural gas shrink. With POP agreements, the MLP receives a percentage of the proceeds from the sale of natural gas and NGLs. As a result, the MLP is long the price of NGLs, and natural gas as well in the case of POP contracts.
MLPs employ a wide range of derivatives such as options and swaps to hedge the direct commodity exposure that results from non-fee-based processing contracts. However, it is notoriously difficult to get reasonable pricing on NGL hedges beyond 18 months, creating cash flow volatility in so-called lower for longer environments like the one in which we currently find ourselves.
Since the last commodity bust seven years ago, we’ve seen gathering and processing MLPs push for more fee-based contracts, with varying degrees of success. Enterprise Product Partners (EPD) reported in its 2014 10-K that approximately 45% of its portfolio of natural gas processing contracts was entirely fee-based, compared to 35% in the company’s 2012 10-K. ONEOK Partners (OKS) stated in its 2014 10-K that 13% of its contracted volumes were via fee-based arrangements, with the remainder in POP contracts, and noting that the company “continues to seek opportunities to convert our POP contracts to fee-based contracts…”