Risk Management

The rising amount of natural gas production from unconventional shale formations has demonstrated the need for additional midstream infrastructure and given midstream companies additional opportunities to market the resultant gas and liquids. But, with that additional opportunity for marketing the product comes the danger of unfavorable fluctuations in commodity prices. To cope with the risk, midstream companies are cautious about how they structure their contracts with producers—and some are moving away from marketing the product altogether.

Protecting cash flows is an essential component of guaranteeing unit holders a secure distribution each quarter. Many midstream master limited partnerships (MLPs) are reluctant to market natural gas and its liquids if they feel the additional risk from marketing natural gas puts that distribution in jeopardy.

"Those that do market natural gas and liquids do so cautiously, trading around their own assets, behind carefully structured contracts and within the context of an active risk management program," says Keith Barnett, executive vice president of Houston-based Spring Rock Productions LLC. Spring Rock provides natural gas and crude oil production forecasts in North America.

For interstate pipelines, federal law and Federal Energy Regulatory Commission guidelines are pretty clear about how the pipeline companies are allowed to operate, he says. They charge their shippers a fee for moving molecules from point A to point B. Generally, they do not own the molecules that move through their lines and when they do, they are not allowed to discriminate in tariffs or shipping preferences against people who run competing businesses.

Pipeline companies that own interstate lines are responsible for maintenance of the pipelines and administration of fees. Because of this simple toll structure, interstate pipelines do not bear any risk from commodity price fluctuations.

"For the operator of an interstate pipeline, there is very little, if any, commodity exposure. They are essentially a toll road," he says.

The rules regulating intrastate pipelines are a little more flexible and allow alternative business models. Many integrated midstream companies have also set up marketing companies to offer clients secure supplies of natural gas, natural gas liquids (NGLs), crude or other commodities they may need. But taking on marketing activities usually means buying and selling the commodities on their own account, a risk that investors in midstream companies generally dislike.

Most intrastate midstream companies participate in the full value stream of natural gas—gathering, treating, processing, transporting and marketing the gas and liquid streams. Buying and selling the underlying commodities introduces a different level of risk for these companies which must be properly managed and communicated to attract investors to the business, Barnett says.

The first step to managing the risk of commodity fluctuations is to establish clear contracts with producers. Some companies manage risk better than others and the market tends to reward those who do it best. The agreements with producers can be month-to-month, a specified period of time or can last the entire life of the field. Negotiations typically occur prior to moving any product and can be influenced by a wide range of factors.

The relative size of the producer and midstream company, the value of the liquids relative to gas, the quantity of liquids from the play and the distance to a competing pipeline all weigh on negotiations. In general, however, the agreements between producers and midstream companies fall under three general types: fee-based, fixed margin and keep-whole. Midstream companies structure their gas contracts with producers in such a way to carefully manage the risk from commodities but still give them some upside for favorable movements in commodity prices, Barnett says.

“For the operator of an interstate pipeline, there is very little, if any, commodity exposure. They are essentially a toll road.” — Keith Barnett, executive vice president, Spring Rock Production LLC

Fee-based arrangements

Under these arrangements, producers generally pay the pipeline companies a fixed cash fee for gathering and processing natural gas and liquids from the wellhead. This fee is directly related to the volume of natural gas that flows through the pipeline systems and generally does not decline with fluctuations in commodity prices.

A sustained decline in commodity prices, however, could force producers to pull back their volumes and result in a decrease in fees for pipeline companies. The producer keeps the value of both the natural gas and the liquids under the arrangements and incurs the risk from commodity price fluctuations. The midstream company, in this scenario, is essentially a toll road, charging others for molecules which pass through its pipeline. Its primary responsibility is to maintain the integrity of the line and to treat all shippers equally.

Under this arrangement, the benefit to pipeline companies is the stable flow of fee-based income which is generally insulated from commodity price risk. The disadvantage is that the benefit of any increase in commodity price goes to the producer, not the pipeline company.

"This is the most common arrangement for interstate pipelines or for intrastate pipelines when the producer is large and has a great deal of negotiating power over the midstream company," Barnett says.

Another type of agreement is a fixed-margin contract. The term "percent of proceeds" has traditionally been used just for natural gas liquids, but it can apply to the full product stream from wells. Under this arrangement, the midstream company will buy the crude, natural gas or liquids from the producer at a discount to an indexed price. It will take the commodity, clean it up to pipeline specifications, pull out any liquids, and market everything with separate contracts with end users.

The product is sold at an indexed price into the market. For traditional NGLs, the producer receives the residual volume of gas at the tailgate of the plant plus a portion of the sales proceeds of the value of the liquids. Depending upon the liquid content of the gas, the tailgate volumes can be 10% to 25% less than the inlet volumes.

As another example, the midstream company might buy natural gas and its associated liquids at 94% of an indexed price and then contract to sell it at an indexed price. The arrangement in this hypothetical example has a margin of 6% of the indexed price. As long as the processing, transportation and storage costs do not exceed this 6%, the midstream company has a built-in profit.

In general, the profits for the midstream company under this type of contract rise and fall with commodity price indexes. The fixed margin is attractive to the midstream companies, but some large producers may want a share in the margin as well.

"These larger producers frequently have the influence to negotiate a portion of the margin," Barnett says.

Keep-whole arrangements

Under a keep-whole contract, the midstream company will gather and process natural gas from a producer to extract the liquids. The processor returns the same volume, in British thermal units (Btu), of gas taken at the inlet of the plant to the producer at the tailgate of the plant. The arrangement "keeps them whole."

The midstream company generally keeps the processed liquids and sells them from its own account. Its margin is a function of the difference between the value of the liquids and the value of the natural gas used to make up the shrinkage caused by extracting the NGLs.

Profits are subject to commodity risk as well as the difference between natural gas and liquids prices. NGLs have a stronger price correlation to crude oil than to natural gas, so these arrangements can provide large margins in a favorable commodity-price environment, but can also be subject to losses if the cost of natural gas exceeds the value of its thermal equivalent in liquids.

To protect themselves from potential losses, some midstream companies who use keep-whole arrangements will negotiate a discount to natural gas indexed prices or may charge fixed cash fees for ancillary services, such as gathering, treating and compression. Another clause that is commonly added to protect the midstream company is the ability to bypass processing if the value of the liquids is low relative to the natural gas.

"The risk then switches to the operator if the unprocessed gas has gas-quality issues relative to pipeline tariff requirements," Barnett says.

“We are trying to manage commodity exposure through various tools, one of those being contract structure. The other is an active hedging program.” — Bruce Northcutt, president and chief executive, Copano Energy LLC

Active risk management

When the contracts with producers fall short of protecting the midstream company from fluctuations in commodity prices, most have active risk-management programs in place. Any commodity risk not covered in a contract with a producer can be hedged with swaps, options or other derivative agreements.

An integrated midstream company, like Enterprise Products Partners LP, Kinder Morgan Inc. or Energy Transfer Partners LP, generally has a wider mixture of assets, including gathering and processing lines, processing units, compression units, storage facilities, fractionation units and marketing units. The diversity of these assets creates more risk exposure.

"It is harder to hedge those exposures because the liquids are a derivative pricing of crude oil, not natural gas. There is a disconnect which is not well organized or well understood based upon correlations between crude oil prices and NGL prices," Barnett says. "Those risks are not always well identified in their financial reports, but it has been a strong business, given the Btu disconnect between crude oil and natural gas in North America."

Stabilize earnings

Also based in Houston, Copano Energy LLC carefully strategizes to manage its commodity-price risk. An important component is to minimize its exposure to price fluctuations, says Bruce Northcutt, president and chief executive of Copano.

Reducing commodity price risk requires Copano to give up some potential upside when commodity prices are favorable, but helps protect the cash flows that support its quarterly distribution payments. "We want to stabilize our earnings," says Northcutt.

To protect itself from fluctuations in commodity prices, Copano engages in a number of strategies. "We are trying to manage that exposure through various tools, one of those being contract structure. The other is an active hedging program," Northcutt says.

The first part of this strategy includes a strong preference for fee-based contracts with volume requirements, which provide Copano a steady revenue stream with a floor. Virtually all of its contracts in its Eagle Ford-Barnett shale combo, Woodford shale and in the Rockies are fee-based contracts that significantly minimize commodity price risk exposure to the company.

Copano also attempts to contract so that particular commodities are bought and sold against the same index.

"We lock in a margin when we do that. There is little or no commodity risk," he says.

For circumstances where Copano's contracts expose it to commodity price risk, it has an active hedging program to protect it. For example, Copano has percent-of-proceeds contracts, predominantly with Oklahoma producers, which gives it the right to a percentage of the gas and liquids produced. In these cases, Copano takes possession of the commodities and markets them, but relies on its hedging strategy to protect it from fluctuations in commodity prices.

Carl Luna, chief financial officer for Copano, says the first step of Copano's hedging program is to identify the commodity exposure its contracts create for the company. Many of Copano's contracts with direct commodity-price exposure leave it "long" for both natural gas and liquids, while others leave it "short" for gas and "long" for liquids.

The second step is to determine the most appropriate price index for the hedge, because there are not liquid forward markets for every contract price index.

"Once we understand those exposures, our approach is to use options to create a price floor. We like options more than swaps because when we buy options, we know the maximum amount we will pay for the hedge and retain the upside to commodity prices," he says.

If, for example, Copano has total exposure to a long position of 4,000 barrels per day of ethane, under its risk-management policy, it can hedge up to 80% of those volumes with options. Since it is long, Copano will buy puts from a highly rated financial institution to protect it from a sudden decline in ethane prices and corresponding drop in cash flow.

Copano's commodity-specific, option-focused strategy provides it with a floor price, which helps to stabilize its cash flows during periods of volatile commodity prices.

No off-system marketing

Going forward, Copano plans to utilize fee-based contracts where possible to reduce impact from commodity price movements. "If we can enter into fee-based deals, we don't have to pay the cost to hedge the exposure. This reduces our hedging costs and it provides us with the cash flow stability we are looking for," he says.

Copano's marketing strategy has historically been to only buy and sell molecules which pass through its own assets. "We don't do off-system marketing," he says.

A recent additional strategy has been for Copano to sell its liquids directly to petrochemical companies along the Texas Gulf Coast, rather than moving them to Mont Belvieu.

"Rather than building liquids pipelines to Mont Belvieu and transporting on third-party pipelines back to the petrochemical companies, we wanted to go directly to the petrochemical companies along the gulf coast. They are buyers of liquids coming out of Mount Belvieu. We both get better pricing than if we had transported liquids to Mont Belvieu, and Copano has saved a significant amount of pipeline construction costs, as well."

Recently, Eagle Ford Gathering (Copano's joint venture with Kinder Morgan) secured long-term contracts to provide gathering, processing and fractionation services to Petrohawk Energy Corp. and Rosetta Energy Partners LP in the Eagle Ford shale. These agreements are in addition to a number of other previously announced agreements between Eagle Ford shale producers and either Eagle Ford Gathering or Copano.

Combining Copano's wholly-owned Eagle Ford activity and its Eagle Ford Gathering activity, the average length of its major gathering contracts in the region is about 8.5 years, and in one case as long as 14 years. The vast majority of these agreements include a deficiency fee component, which provides for a fee if production slips below a specific level.

Copano opted for fee-based contracts because they generate more stable cash flows than keep-whole or percentage-of-proceeds agreements. In the short term, keep-whole agreements may produce more money for midstream companies, given the current value of liquids relative to natural gas, but there is no guarantee the favorable price environment for liquids will hold indefinitely, says Northcutt.

"Right now, the pricing environment favors keep-whole type of agreements, but history has shown that can change over time and change rapidly," he says.

The company expects that by the end of 2012, two-thirds of its gross margins will be generated under fee-based agreements and one-third under commodity-sensitive agreements. During the second quarter of 2011, 41% of Copano's gross margins were derived from fee-based arrangements.

Fee-based agreements are just one component of Copano's business strategy, which includes building stability of cash flow while adding diversity and scale beyond its traditional role as a regional midstream gatherer and processor.

"We have always been a great gathering and processing company, but we are now providing fractionation and NGL transportation and logistics services, and soon we hope to be adding crude oil and condensate transportation services to our portfolio of midstream services," he says.

“Our services help them capture their upside and protect their downside based on where they are in the marketplace at the time they engage us.” — Vincent McConnell, senior vice president of physical commodities marketing, Asset Risk Management LLC

Outsourced help

Although Copano has its own active risk management program, other energy companies turn to outsourced help to help them manage the risk of commodity price fluctuations.

Producers, for example, tend to focus on operational risks, although their primary product is a commodity whose price fluctuates with the open market. To confront that risk, many small and medium-sized energy producers turn to an outsourced risk management team. Houston-based Asset Risk Management LLC (ARM) is one provider of those services.

The company's clients are small- to medium-cap public and private E&P companies who generally want to focus on meeting specific operational goals, rather than worry about the risk posed by swings in commodity prices. Vincent McConnell is the senior vice president in charge of ARM's gas marketing.

"We provide a comprehensive series of energy risk-management tools and services to our clients," says McConnell. "Our existing clients include oil and gas producers that have exposure to commodity-price risk. Our services help them capture their upside and protect their downside, based on where they are in the marketplace at the time they engage us."

ARM's staff analyzes a client's portfolio, its geographic location, identifies its specific risks and then recommends a risk-management strategy. "We use proprietary models, swaps and other risk tools. It's more of a dynamic risk-management approach that we do."

McConnell notes that he often sees clients initiate a hedge that is static, when commodity risks are continually evolving.

"We are constantly looking to improve the positions for our clients and that's where we bring the accretive value. Our clients have expressed a lot of interest in ARM marketing their gas and NGLs, so physical marketing is a natural extension of our current business.

"We will grow the business as a benefit to our current and future clients. In the old days marketing was 'Get what you can and keep going.' That's not the philosophy here by any means," he says.