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Trader's Corner

This week’s Trader’s Corner looks at a slowdown in U.S. natural gas production growth and contemplates its potential impacts for propane production.

As we all know by now, the breakthrough in technology that allowed the development of natural gas from shale plays in the U.S. dramatically changed the propane supply picture.

Propane supplies increased by 41 million barrels last year alone, but exports and increased petrochemical consumption took all of those supplies and then some. The amount available for the U.S. domestic retail market actually was lower than the previous year.

As they currently sit, U.S. propane inventories will need to build about 41 million barrels to reach their average point by next winter. That would be the largest build over the last five years. With the price of U.S. propane well below 50 percent of West Texas Intermediate (WTI) crude, it fits into all export destinations. Unless the government steps in, free markets will see to it that U.S. propane exports will remain high. Export capacity is expanding.

There is no reason to think petrochemicals are going to back off at these prices either. They are expanding capacity and the economy is slowly improving.

As we go into this summer, we hear tank levels are low at many propane retailer and customer locations. There will probably be resistance to fill tanks because so many consumers shelled out big bucks for propane this winter. We suspect many will try to skate by this summer, which could put pressure on inventory early next winter.

But all of these potential demand-side issues can easily be resolved by another banner year in propane production growth. The question is: Will we see another banner year in propane production? Certainly propane is being traded that way. Otherwise, there is no reason at today’s inventory levels for propane to trade at 45 percent of WTI crude.

There are some trends that concern us about assumptions on propane supply growth. As we look at the following charts, remember natural gas production is the driver of new propane supply. There is a lot of new U.S. crude production, but it really doesn’t change propane supplies. We are still refining about the same amount of crude, which yields about the same amount of propane. New U.S. crude production simply backs off crude imports; it does not cause an increase in refinery output.

In order to increase natural gas production, we must drill for it. The chart above shows fewer rigs are drilling for natural gas in the U.S. In January, there were only 362 natural gas rigs active compared to 1,585 in September 2008. We read comments from one natural gas expert concerning rebuilding natural gas inventory this summer. He said the lower rig count is not a worry. He points out improvements in drilling processes for shale gas mean fewer drilling rigs are needed. Just the same, a drop of around 1,200 rigs is a lot to overcome.

The chart above plots the difference in natural gas production between years. Natural gas production continues to grow, but the rate of growth is slowing. The question is what impact this slowing production is having on propane supplies. The following chart is going to surprise you.

Over the last few years, when growth in natural gas production was slowing, the rate of growth in propane production was increasing. Such a rapid rise in propane production during years that natural gas production was declining seems strange, doesn’t it?

We developed a theory when looking at this data and comparing the charts, and we will share it with you. But it is just a theory.

We went back to 2009 and noted how the increases in natural gas and propane production looked logically proportional. Then in 2011 there was the massive growth in natural gas production, but growth in propane production actually slowed.

Our theory is there was enough spare U.S. fractionation capacity in 2009 and 2010 to handle the growth in natural gas production in those years. But in 2011, available capacity was used up and new capacity was not yet ready. That means a lot of natural gas liquids were being stored as Y-grade, which is all of the products mixed together before fractionation.

Our theory continues that in 2012 and 2013 new fractionation capability allowed accumulated Y-grade to be fractionated. Processing the accumulated Y-grade resulted in a disproportionate growth in natural gas liquids production compared to the growth in natural gas production.

At some point, the backlog of Y-grade gets processed and the growth in propane supplies depends on the growth in natural gas production. In other words, we begin to see more proportionate increases in production growth/decline between natural gas and propane.

If the theory is correct, when will the reconnect occur? Is there still plenty of accumulated Y-grade to keep growth in propane production disproportionately high this summer? Propane is trading now as if that’s what the market expects. Since processors are sellers and they are aggressively selling, it would appear they believe there is plenty of natural gas liquids to process this summer and enough propane will be made to meet all of the demand-side pressures. They should know, after all, how much Y-grade is available.

Nevertheless, the data gives us cause for concern and adequate reason to be a little weary of the current bearishness in propane prices. If our theory is correct, we know the growth in propane production will eventually be proportional to the growth in natural gas production. Since we already see the dramatic slowdown in natural gas production growth, we have to assume a corresponding drop in propane production growth will occur at some point.

Natural gas production could increase this summer. The price has improved, the possibility of more liquefied natural gas (LNG) exports is possible and there is the need to replenish low natural gas inventory. That would help maintain the growth in propane supplies. Still, we haven’t seen a dramatic increase in natural gas drilling rig count through January, so we have to believe the growth in production of 2011 and 2012 is unlikely at this point.

We don’t need to go to sleep on this theory. Vigilance is the watchword in terms of monitoring natural gas production and corresponding propane production. If we see the growth in propane production increase another 41 million barrels this year, then we have no worries about propane supply and the current price is justified. But, if the growth drops off, it has to raise concerns about upward pressure on prices.

Call Cost Management Solutions today at 888-441-3338 for more information about how Client Services can enhance your business, or drop us an email at
Propane prices continued to fall as sellers remained aggressive with their March barrels.

Worries about crude demand because of weak economic data from China kept crude in check despite escalating tensions between Russia and the West over Ukraine.

Monday: Propane prices fell to start the new week as sellers remained aggressive with the end of winter near despite low inventory levels. Crude fell on reports of weak economic data from China.

Tuesday: Propane rallied ahead of weekly inventory data as traders guarded against a surprise in inventory changes. Concerns about crude demand destruction in top consumers the U.S. and China sent crude lower.

Wednesday: The U.S. Energy Information Administration (EIA) reported a million-barrel drop in U.S. propane inventory. Most of the drop occurred in the Midwest, pushing Conway prices higher, but Mont Belvieu propane gave up most of its pre-EIA gains. Crude tumbled following a 6-million-barrel build in U.S. inventory.

Thursday: Surprisingly Conway propane prices fell 4 1/2 cents despite low inventories. The market perception continued to be that inventories will replenish this summer and reach a good level to start next year. Crude got its first gain of the week, likely benefiting from a big selloff in equities markets.

Friday: Propane continued to struggle to find a pricing floor as sellers remained aggressive as winter demand begins to wind down. Crude posted a gain as the threats to supply from the Ukrainian situation dominated market activity.

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