tph midstream update and primer 11-14-08 website

Midstream Update & PrimerNovember 2008

Becca Followill

[email protected]

(713) 333-2995

Dave Pursell

[email protected]

(713) 333-2962

Anson Williams

[email protected]

(713) 333-2951

2

Midstream OverviewNatural gas processing, natural gas liquids (NGL) transportation and fractionation are major segments of the oil and natural gasindustry, distinct from oil and gas production and separate from oil refining. They are critical and indispensable in the energy value chain. They are some of the most complex, yet least known and least understood segments.

The industry has gone through a major structural change, from the assets being held by major oil and integrated E&P companies as a “necessity” to being held by MLPs and integrated infrastructure companies as a profit center. As an investor, you can now “play” the Midstream sector.

Midstream profitability and growth is tied primarily to four factors (which can vary depending on business mix):□ Domestic natural gas production: growing production = higher Midstream throughput.□ Supply of NGLs: tied to gas production and whether processors choose to extract ethane from the gas stream. If there are

too many NGLs compared with demand, prices decline.□ Demand for NGLs: driven primarily by petrochemical companies and therefore, the economy. Higher demand for NGLs =

higher pricing.□ Relationship between the price of natural gas and the price of NGLs: NGLs generally move with crude oil prices. If ethane

(~40% of NGL stream) is more valuable in liquid form than gaseous form (liquids priced higher than gas), then more gas processed and more money made.

Increased U.S. gas production, coupled with the completion of NGL take-away pipelines, has resulted in increased NGL supply, just as the U.S. economy is entering a recession and chemical/NGL demand is falling. So, the fundamentals behind all four of these midstream drivers are deteriorating.

Worldwide, companies are idling propylene and ethylene plants (use NGLs as feedstock) and chemical companies are issuing cautious outlooks for 2009.

NGL prices, which have historically traded at ~65-70% of crude oil (1999-2007), have more recently traded at ~45% of crude oil. Frac spreads, the most frequently quoted measure of processing profitability, have dropped into negative territory from a high of $11/mmbtu in July ‘08. Prices for naphtha, the alternate feedstock for some petrochemical companies, have fallen to less than $300/ton in some areas, from as high as $1,200/ton this summer, a 75% decline. Ethane prices have also fallen 75% from summer highs (39c/gal currently vs 154c/gal in July).

Fortunately, the industry is self-correcting. If frac spreads continue to decline, we are likely to see more ethane rejection (40% of NGL stream stays in gaseous form). This decreases NGL supply, but has the potential to add as much as 2-2.5 bcf/d to domestic gas supply. If that happens, gas prices fall, producers slow down drilling, and gas supply falls - reducing gas available to process, which in turn reduces NGL supply, and ethylene inventories deplete. Then NGL prices rise, creating favorable NGL economics once again. The cycles can be very quick.

So, as we go to print today, the Midstream industry, like much of the energy patch, is facing negative fundamentals. Six monthsfrom now, we suspect the outlook will be very different. Throughout the cycles, we hope this primer provides a better understanding of a very complex, yet integral segment of the energy industry.

3

Part I – An OverviewFrequently overlooked, the midstream industry is a critical link to turn raw natural gas into usable products.

Natural gas is comprised of two parts - a light gas component and a heavier liquids component. The light gas consists of methane, while the liquids consist of ethane, propane, n-butane, iso-butane and natural gasoline. These natural gas liquids (NGLs) are used in the petrochemical industry, as refinery blend-stock, in home heating, and in many other common applications.

Most wellhead gas does not meet the quality standards required by interstate pipelines, so it must be processed, removing contaminates and the heavier components (propane+).

After the NGLs and contaminants are removed, what’s left is marketable gas (or dry gas), consisting of methane with some ethane. That gas is then ready to be delivered to interstate gas pipelines.

The raw NGLs are then sent to large fractionators to break the stream into usable components (ethane, propane, etc.).

Dry or Marketable

Gas

Industrial/ Heating

FractionatorRefineries

Petrochemical Industry

Onshore and Offshore Wells

Midstream Overview

Raw NGL Mix

Finished NGLs

Source: Tudor, Pickering, Holt & Co.

Interstate PipelinesWet Gas

Gathering

Normal Butane

Isobutane

EthanePropane

Natural gasoline

Processing Plant

4

NGL Removal is Non-Discretionary

The typical NGL “barrel” looks like this: We stress: propanes and heavier components (propanes+), make up ~60% of the NGL stream, and have to come out of the wet gas produced from the wellhead. Pipeline specs mandate it.

Ethane is “discretionary,” meaning producers/processors can opt to keep it in the stream or remove it, depending on economics.

Keeping ethane in the steam is called “ethane rejection” (we know, it is the opposite of what is intuitive, but think of it from the processors’standpoint). The amount of Btus is always the same - it’s just the state of matter that’s different.

Ethane rejection = more gas, fewer NGLs

Normal processing = less gas, more NGLs10% Isobutane

25-30% Propane

40-45% Ethane

5-10% Normal Butane

10-15% Natural Gasoline

5

What Drives Midstream Economics?

Contract StructureCommodity Sensitive?

Gathering Fee N

Processing Fee N

Keep Whole Y

Percent of Proceeds Y

Raw NGL Pipelines Fee N

Finished NGL Pipelines Fee N

Fractionation Fee N

Storage Fee N

Marketing Fee N

There are lots of ways to make money through the midstream value chain. While most are fee-based, processing is usually commodity sensitive.

Since processing involves converting MMBtus from a gaseous form to a combo of liquids and gas, non fee-based processing economics are dictated by the spread between the price of gas and the price of NGLs (the “frac spread”).

Low gas prices/High NGL prices = Favorable processing economics(Btus worth more taken out of gas stream)

High gas prices/Low NGL prices =Unfavorable processing economics(Btus worth more in gaseous form)

6

Frac Spreads – The Midstream Economic Bellweather

Gulf Coast Frac Spread (45% Ethane)

($6)

($4)

($2)

$0

$2

$4

$6

$8

$10

$12

JanFeb

MarApr

May Jun JulAug

SeptOct

NovDec

$/m

mbt

u

* 7-yr avg Gulf Coast Frac Spread ~$1.75/mmbtu

7-yr High

2008

7-yr Low

Frac spreads, like refiners’ crack spreads or power producers’ spark spreads, are a measure of gross margin. It is the delta between the cost of gas (processing input) and its value in NGL form (processing output).

Frac spread = NGL Value – Cost of Gas

These spreads are an industry bellweather when watching processing economics.

If frac spreads are positive, the MMBtusare more valuable in NGL form. If spreads are negative, the MMBtus are more valuable in gaseous form.

Shown here is a Gulf Coast frac spread, but frac spreads can vary significantly by region.

Gulf Coast Frac Spread, 1999 to Present

($5.00)

($3.00)

($1.00)

$1.00

$3.00

$5.00

$7.00

$9.00

$11.00

$13.00

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Source: Bloomberg, Tudor, Pickering, Holt & Co.

7

Frac Spread vs Ethane Production

400

450

500

550

600

650

700

750

800

850

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Mbp

d

-$4

-$2

$0

$2

$4

$6

$8

$10

$12

$/mm

btu

Ethane Production Monthly Average Frac Spread

If frac spreads go negative, processors will reject ethane (~35-45% of stream) keeping it in the gas.

Gas supply then increases, gas prices go down, feedstock becomes cheaper, and markets correct.

If frac spreads go negative, most processors have “conditioning language,” which allows them to at least cover costs.

Gas price spikes following Katrina/Rita

Cold winter and gas price spike

Source: EIA/DOE, Tudor, Pickering, Holt & Co.

8

Market for Processing is Self-Correcting

NGL pricesincrease

Gas supply decreases

Fewer NGLs areprocessed

EthanerejectionEthane

productiondecreases &gas supplyincreases

Gas pricesdecrease

E&Pshut-ins

Ethane economicto process – moreethane produced

Too much ethane-prices

decrease

9

U.S. Gas Processing/NGL Snapshot

U.S. Processing Statistics

2005 2006 2007Gas processing capacity, bcfd 70.3 70.2 71.0 % Change -0.1% 1.2%

Gross (Wet) nat gas production, bcfd 64.3 64.4 67.2 % Change 0.2% 4.4%

Gas processing throughput, bcfd 46.8 45.5 45.3 % Change -2.6% -0.4%

NGL production from processing, 1,000 bpd 1,717 1,739 1,783 % Change 1.3% 2.5%

U.S. gas processing capacity and wellhead NGL production have been relatively flat since 2005, increasing at a slower rate than gas production.

Seven gas plant projects were completed in 2007, adding ~0.8 Bcfd of capacity. For 2008, seven more projects either have been completed or are expected in-service, which will add ~1.9 Bcfd of additional capacity.

An additional 2.0 Bcfd of expansions are planned for 2010+.

Two major NGL pipelines recently completed or under construction, Arbuckle and Overland Pass, should add 270k bpd of NGL pipeline capacity by Q1’09.

Source: Oil and Gas Journal 2008 & 2005, EIA/DOE, Tudor, Pickering, Holt

Gas processing

73%

Imports10%

Crude refining

17%

Gasoline blending

25%

Heating & fuel17%

Exports3%

Petrochemicals55%

NGL Sources NGL Uses


10

Major U.S. Gas Processors

The table to the left shows the major U.S. gas processors. Gas processing represents only one segment of the midstream value chain.

E&P companies used to be the primary owners of gas processing plants, in order to support their E&P operations. In the 1990s, companies began selling off midstream assets to focus on their core E&P business.

The industry consolidated further as pure “midstream” plays developed. In 2008, the top ten gas processors held two-thirds of U.S. processing capacity (excluding Alaska).

MLPs now dominate the space, as midstream earnings are perceived to provide a certain degree of stable, reliable cash flows, especially when exposure to the frac spread is minimized.

Source: Oil and Gas Journal 2008, Tudor, Pickering, Holt (Excludes Alaska)

Top U.S. Gas ProcessorsProcessing

Stock Capacity % of

Company Symbol MMcf/d U.S. Total

DCP Midstream LLC SE/COP/DPM 13,117 21%

Enterprise Products Partners LP EPD 4,666 8%

Williams Cos. WMB/WPZ 4,376 7%

Targa Resources Private/NGLS 4,341 7%

BP PLC BP 4,163 7%

Crosstex Energy LP XTEX 2,936 5%

Aux Sable Liquid Products LP EEP/FCE.UN/WMB 2,200 4%

ONEOK OKS/OKE 1,751 3%

Enbridge Energy Partners LP EEP 1,470 2%

Kinder Morgan Energy Partners LP KMP 1,293 2%

ExxonMobil Corp. XOM 1,195 2%

CDM Max LLC Private 1,100 2%

Copano Energy LLC CPNO 1,058 2%

Chevron Corp. CVX 854 1%

Total 44,520 72%

11

U.S. NGL Production by Region (2007)

3.6%(64 Mbpd)


12.1%(216 Mbpd)

4.9%(87 Mbpd)

12.3%(219 Mbpd)

10.2%(182 Mbpd) 36.0%

(641 Mbpd)

5.4%(97 Mbpd)

14.5%(258 Mbpd)

1.1%(20 Mbpd)

Gas processors describe natural gas as “rich” (wet) or “lean” (dry), depending on the amount of heavy recoverable components contained.

A very rich gas may contain 5-6 gallons of recoverable liquids per mcf (gpm). A lean gas usually contains 1 gpm or less.

Deepwater Gulf of Mexico (GoM) gas can have 4+ gpm, compared with 1-1.5 gpm for the GoM shelf and 2-3 gpm on the Texas Gulf Coast. West Texas gas is also very rich.

Coal bed methane gas is essentially free of NGLs and is comprised of only methane, water and sometimes CO2.

12

Processing Plants Follow Major Producing Areas

Source: EIA/DOE

U.S. Gas Processing Plants There were 539 gas processing plants and 32 fractionators operating in the U.S. as of January 1st, 2008.

About 33% of U.S. gas processing capacity is located along the Gulf Coast. But the bulk of new adds are planned for the Rockies (currently 11% of capacity) and Ark/La/TX (20% of current capacity).

About 80-85% of fractionation takes place along the Gulf Coast; the NGLs are produced close to the primary end-users –petrochemical companies.

The average gas processing plant is getting larger and more efficient.

13

Getting NGLs to Market

Source: Canadian NEB, edited for changing ownership & new pipelines proposed

There are 2 major U.S NGL trading hubs and 2 Canadian hubs: Mont Belvieu, TX; Conway, KS; Edmonton/Fort Saskatchewan, Alberta; and Sarnia, Ontario.

NGL pipelines transport NGLsfrom producing fields to these hubs, where they are stored, fractionated, and/or distributed for end use.

Mont Belvieu, the largest of these hubs, is located on the Texas Gulf Coast where there is the highest concentration of petrochemical, storage, pipeline, fractionation, and refinery infrastructure.

Given its strategic location, Mont Belvieu is considered the price setter for North American NGL markets.

14

U.S. Petrochemical Plants

Puget Sound

CVX

CVX

Ineos

LA Refining

Frontier

Alon

Flint Hills

Premcor

Lyondell

Lyondell

CVX

Westlake

Sunoco

Marathon

IneosIneos

Sunoco

Marathon

BP

WMB

Sunoco

Sunoco CVX

Motiva

Sunoco

Sunoco

TX Eastern

XOMEPD

LyondellValero

LyondellIneos

Formosa

Lyondell

Javelina

MarkWestFlint Hills

Citgo

Dow

Westlake

MarathonValeroCVX Louis Dreyfus

Dow Shell

Lyondell

CitgoSasol

ValeroBRPC

XOMWMB

MarathonDow

Murphy

CVX

Ineos

El DupontBASF

MotivaHuntsman

Source: ICIS Plants & Projects Database, Company Press Releases, Tudor, Pickering, Holt

15

Part II – Summary and Historic Trends

The first section of this primer discussed four drivers of Midstream profitability:

U.S. gas production

NGL supply

NGL demand

Relationship between price of gas, crude oil, and NGLs

This section reviews the historic trends of each of these drivers. With the recent collapse in commodity prices and economic conditions, everything has been turned on its head. While historic trends aren’t always indicative of where things are headed, the perspective should be helpful. Part III of this primer (p. 25) tackles where we think things are headed.

In the meantime, a brief summary of historical trends:

U.S. gas production: On the rise, +9% ytd after years of stagnant production. But, rig count is falling (and with it, we hope, production).

NGL supply: Also on the rise, albeit at a slower pace than gas production as NGL yields have fallen (movement to leaner onshore gas production from richer offshore).

NGL demand: Until quite recently, on the rise amid strong worldwide economies and a weak U.S. dollar. Recently…in the tank.

Relationship between gas, crude oil and NGLs: Midstream economics are most favorable when gas trades at a discount to crude oil on a mmbtu basis and when NGLs trade at a high percent of crude oil price. Historically NGLs have traded at 65-70% of crude oil, but the recent economic turmoil has pushed NGLsdown to ~45% of crude oil. Historically natural gas has traded at a 6:1 ratio (crude:gas). Over the past couple of years, with the spike in crude, that ratio expanded to as high as 14:1. With the recent decline in crude, the ratio is back to ~10:1.

16

U.S. Gas Production – On the Rise

Change in Gross U.S. Nat Gas ProductionYTD Change

Region Thru Aug

Texas 16.0%

Wyoming 11.4%

New Mexico -3.0%

Oklahoma 4.2%

Louisiana 4.3%

Other 12.6%

Onshore Total 10.9%

GoM -3.2%

Total 9.0%

Source: EIA/DOE

After stagnant/declining production since 1997, U.S. domestic production has been on the rise since mid-2006, driven by a step change in gas prices, above $6/mcf.

Biggest increases in Texas (Barnett Shale) and the Rockies (Piceance, Powder River Basin and Green River Basin), tempered by declines in New Mexico and the GoM.

Excluding 2 months of Independence Hub downtime (at almost 1 bcf/d), GOM production year-to-date is +0.6% y/y.

EIA-914 Gross U.S. Natural Gas Production Data

35

40

45

50

55

60

65

Jan-

05Mar

-05

May-05

Jul-0

5Se

p-05

Nov-0

5Ja

n-06

Mar-0

6May

-06Ju

l-06

Sep-

06No

v-06

Jan-

07Mar

-07

May-07

Jul-0

7Se

p-07

Nov-0

7Ja

n-08

Mar-0

8May

-08Ju

l-08

Prod

ucti

on (

Bcf/

d)

6%

8%

10%

12%

14%

16%

18%

20%

Total Production Onshore Production Offshore as % of Total Production

17

NGL supply growing at a slower rate…

U.S. Monthly NGL Production (Jan '01- Aug '08)

1,300

1,500

1,700

1,900

2,100

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

1,00

0 bp

d

Source: EIA/DOE and Tudor, Pickering, Holt & Co.

Since early 2001, U.S. gas production is +0.2%/yr on average.

During the same period, NGL production is -0.9%/yr on average.

The slower pace of growth of NGLs is due to periods of ethane rejection (ethane kept in gas stream, resulting in less NGLs processed out) as well as lower NGL yields (leaner gas).

More recently, with the surge in U.S. drilling, natural gas production is +9.0% while NGL production is +5.2% (year-to-date vs. ’07).

18

… driven by lower NGL yields

Annual U.S. Historical NGL Yield (1970-2007)

0.95

1.00

1.05

1.10

1.15

1.20

1.25

1.30

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

gal/

Mcf

NGL yields (measured in GPM or gallons of liquids per mcf) have been declining since 1982.

The shift to drilling in lower GPM/leaner gas resource plays has influenced the decline in yield.

Declines have also occurred despite adding more “deep cut”cryogenic processing.

Monthly U.S. Historical NGL Yield (Jan '01 to Aug '08)

1.10

1.20

1.301.40

1.50

1.60

Jan-

01Ju

l-01

Jan-

02Ju

l-02

Jan-

03Ju

l-03

Jan-

04Ju

l-04

Jan-

05Ju

l-05

Jan-

06Ju

l-06

Jan-

07Ju

l-07

Jan-

08Ju

l-08

gal/

Mcf

Declining NGL yields

Leaner onshore production


19

NGL Stream – Components and End Users

Component % UseOptional to

Process?

Historical Price Relationship to

Crude2000-2003: 51%

2004-2007: 46%

2008 YTD: 37%

2000-2003: 75%

2004-2007: 69%

2008 YTD: 60%

Petrochemical feedstock, 2000-2003: 87%

fuel, gasoline blending, 2004-2007: 82%

propellant 2008 YTD: 71%

Petrochemical feedstock, 2000-2003: 92%

gasoline blending, 2004-2007: 85%

refrigerant, propellant 2008 YTD: 73%

2000-2003: 97%

2004-2007: 96%

2008 YTD: 89%

Petrochemical feedstock,

gasoline blending

Yes

Partially

No

No

No

Petrochemical feedstock

Petrochemical feedstock,

heating & fuel

Natural Gasoline

40-45%

25-30%

5-10%

10%

10-15%

Ethane

Propane

Normal Butane

Isobutane


20

Demand Drivers for NGLs: Ethylene

Ethylene is the simplest alkene and the most widely produced organic compound in the world. 97% of ethane is used for ethylene production.

About 50% of ethylene is polymerized into polyethylene. This polymer is used most commonly to form lightweight packaging products (i.e. shopping bags) from low-density polyethylene (LDPE) and as a medium for injection molding (to make products like plastic containers) from high-density polyethylene (HDPE).

Uses of Ethane & Ethylene

Surfactants: Ethylene glycol Paints (antifreeze)

Fabric Softener

Adhesives Detergents

Inks

Insecticides Construction

Laxatives

Ethyline oxidePVC

Ethylene dichloride Vinyl chloride monomer Polyvinyl chloride

Ethane EthylenePolyethylene Upholstery

High density (HDPE): Flooring

Containers Clothing

Welding gas Low density (LDPE): Automotive fittings Signs

Fruit ripener Packaging Plumbing ElectronicsAnesthetic Films

VCM

30%

Other

97%

50%

Other Uses

50%Petrochemicals


21

Demand Drivers for NGLs: Propylene

Propylene is the second simplest alkene and is most commonly produced as a byproduct in ethylene production. About 62% of propylene is polymerized into polypropylene. This polymer is most commonly used as a medium for injection molding (for plastic products like containers) and in the fibers market (i.e. carpeting, textiles).

Propane demand has two seasonal offsets. Residential/commercial demand (40% of total) peaks during the winter heating season and troughs in the summer. Petrochemical demand (49%) peaks during the summer when propane prices are lower, as the petrochemical industry switches between feedstocks depending upon price.

Uses of Propane & Propylene

Medicines

Cosmetics

Cumene Nailpolish remover

Butanols Construction

Residential/Commercial (solvents)

Heating Transportation

Cooking Propylene Oxide

Furniture/Bedding

Propane Propylene Polypropylene Packaging

Textiles

Stationary

Acrylonitrile Plastics

Farming Paints Auto components

Crop drying Adhesives Banknotes

Weed control Detergents Acrylic fibers Synthetic rubber

Fuel PVC

Rubbing alcohol

Conveyor belts

62%%

49%%

Other Uses 8%%

6%%

6%%

27%% 24%

%21%%40%

% 8%%

5%%

Petrochemicals


22

AAR Weekly Chemical Car Loadings

20,000

22,000

24,000

26,000

28,000

30,000

32,000

34,000

36,000

38,000

Jan

Feb

Mar Apr

May Jun

Aug

Sep

Oct Nov

Dec

Car

Loa

ding

s

10-Yr Average

10-Yr Low

10-Yr High

2008

Petrochemical Demand

Ideally, we would have outlined ethylene and propylene consumption, but we just couldn’t find any good source (if you have one, please tell us!) However, we feel that chemical rail car loadings are a good proxy for petrochemdemand/NGL demand.

2007 and 2008 saw a big pick-up in loadings, driven by strong world-wide economies and a weak U.S. dollar.

The sharp fall-off in 2H’08 reflects the immediate impact of Hurricane Ike, which slammed into the heart of part of the Gulf Coast petrochemical sector. But more than a month later, railcar loadings are still at 10-year lows as a weak economy takes its toll.

Source: Association of American Railroads (AAR), Tudor, Pickering, Holt

Annual Chemical Carloads (1993-2007)

1.3

1.4

1.5

1.6

1.7

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Mill

ion

Car

Load

ings

Economic weakness

23

NGLs, Crude and Nat Gas have historically been highly correlated

0%

20%

40%

60%

80%

100%

120%

140%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

NGLs

as

% o

f Cru

de

$0

$20

$40

$60

$80

$100

$120

$140

$160

WTI ($/bbl)

NGL Composite (% Crude) WTI ($/Bbl)

From a price standpoint, midstream economics are dictated by 2 key factors: 1) the relationship between crude oil and natural gas; and 2) the price of NGLs relative to crude oil.

The crude oil/gas relationship is important because gas needs to trade at a discount to crude/NGLs in order to have an economic incentive to convert the btus from a gaseous form to a liquid form. Generally, crude forms the ceiling while natural gas forms the floor.

Processing economics have directionally improved over the past 10 years, as crude traded at higher and higher premiums to nat gas.

NGL prices are mainly influenced by the price of crude oil, as NGL feedstocks compete most directly with crude oil-based feedstocks such as naphtha and heating oil.

NGLs trade near parity with oil on a heat content, or Btu basis. However, on a volume basis, they have historically traded at about 65-70% of crude oil.

More recently, with the decline in crude oil prices and softening chemical demand, NGLs have traded at closer to 45% of crude oil on a volumetric basis.

Part of the reason for the declining relationship between NGLs and crude oil is that NGLs are almost purely a physical commodity influenced by end-user supply/demand. Crude is influenced much more significantly by financial markets.

Source: Bloomberg, Tudor, Pickering, Holt

Relationship Between Nat Gas & Crude

NGL Basket as Percent of Crude Price

-

2

4

6

8

10

12

14

16

18

20

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Crud

e/G

as R

atio

$0

$20

$40

$60

$80

$100

$120

$140

$160

WTI ($/bbl)

Crude/Gas Ratio WTI ($/Bbl)

24

Ethane Propane N-Butane I-Butane N-Gasoline Composite1999 61% 74% 88% 91% 93% 73%

2000 56% 81% 93% 95% 101% 74%

2001 52% 76% 86% 92% 95% 69%

2002 41% 66% 79% 87% 93% 60%

2003 53% 78% 90% 93% 98% 71%

2004 51% 75% 89% 89% 101% 69%

2005 45% 68% 81% 85% 93% 63%

2006 41% 64% 77% 79% 91% 59%

2007 45% 70% 82% 87% 98% 64%

2008TD 37% 60% 71% 73% 89% 54%

NGL Products (% of Crude)

Ethane/Crude –The Critical NGL Component

Since ethane is the largest component of the NGL stream and is the only discretionary NGL, its price and relationship to crude is the most volatile and closely watched.

The ethane market is domestic, with very little storage (30mmbbls or ~40 days of supply). Most ethane is used real-time in the petrochemical industry, so prices reflect real demand.

The historic relationship between NGL components and crude oil is shown below.0%

20%

40%

60%

80%

100%

120%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

$0

$10

$20

$30

$40

$50

$60

$70

Ethane (% of Crude) Ethane ($/Bbl)

Source: Bloomberg, Tudor, Pickering, Holt

25

Part III – What is Changing?What a difference a few months make! This summer, the midstream industry was experiencing record frac spreads, rig count was at record highs, and massive investment was planned to increase ethylene and propylene capacity.

There was mounting concern that the U.S. would not be able to absorb the incremental ethane coming on as a result of the surge in drilling and de-bottlenecking of NGLs via new pipelines. But there were also a number of petrochemicals looking to expand, driven by a weak U.S. dollar and strong worldwide economies.

Slam on the brakes and put it in reverse. Fracs spreads have fallen from $10+ to negative; ethane is trading at 25% of crude and NGLs 45%; petrochemical plants are idling across the globe; ethylene prices have fallen below US$350/MT in Asia from highs of US$1,650 this summer; and while we haven’t seen it in scale yet, we expect to see major projects cancelled/postponed. It’s about as ugly as it gets.

Fortunately, as we discussed earlier, this business is cyclical, which means rig count/gas production will fall. Processors will reject ethane. Ethane, ethlyene and propylene inventories will fall. And we’ll start the up cycle again.

This downcycle may last a little longer than others because of the potential depth of this recession and the amount of new NGLs coming online – the result of both higher production and NGL debottlenecking due to the completion of NGL take-away pipelines.

As a result, for our Midstream companies, for the next couple of years we are modeling that NGLs trade at ~50% of crude oil (vs. historic 65-70% and 45% currently).

When we first looked at the amount of new ethylene and propylene capacity coming online, it was worrisome (39% increase if everything done, but almost all outside the U.S.). We’re now assuming that only plants currently under construction are completed, resulting in 3.5%/yr average growth in ethylene/propylene capacity worldwide through 2012.

26

Worldwide NGL Production Still on the Rise, While U.S. Contribution Continues to Decline

Global Annual NGL Production 1970-2007

0

2,000

4,000

6,000

8,000

10,000

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

1,00

0 bp

d

0%

20%

40%

60%

80%

Global Production % U.S.

Global Monthly NGL Production (Jan-2001 to Aug '08)

6,000

6,500

7,000

7,500

8,000

8,500

Jan-

01Ju

l-01

Jan-

02Ju

l-02

Jan-

03Ju

l-03

Jan-

04Ju

l-04

Jan-

05Ju

l-05

Jan-

06Ju

l-06

Jan-

07Ju

l-07

Jan-

08Ju

l-08

1,00

0 bp

d

15%

20%

25%

30%

35%

Global Production % U.S.


27

Gas Processing Capacity

U.S. Gas Processing Capacity

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

2007 2008 2009 2010

MM

cf/d

Alaska Other Gulf Coast Ark-La-Tex Mid-Con Rockies

Source: Oil and Gas Journal 2008, Company Press Releases, Tudor, Pickering, Holt

We see only modest gas processing capacity additions 2008-2010, increasing L-48 capacity by 7%.

However, this is in a market where ethane and other NGL demand is weak, so incremental capacity matters.

Gas Processing Capacity (mmcf/d)

Existing Capacity % AddedYE'07 2008 2009 2010 ('08-'10)

Rockies 8,059 1,560 780 350 33%

Ark-La-Tex 14,396 680 565 0 9%

Mid-Con 6,198 610 120 0 12%

Gulf Coast 23,294 120 0 200 1%

Other 9,342 40 20 0 1%

Alaska 9,525 0 0 0 0%

Total 70,813 3,010 1,485 550 7%

Planned/Completed Adds

28

New NGL Pipelines

MAPL Expansion (EPD) 50,000 bpd

Overland Pass (OKS) 110,000 bpd

Arbuckle (OKS) 160,000 bpd

Source: Canadian NEB, edited for changing ownership & new pipelines proposed

The U.S. NGL system has been, and will be, further de-bottlenecked via the completion of several key NGL pipelines.

EPD’s MAPL line was completed earlier this year and OKS’ Overland Pass line began ramping up in early October. Arbuckle (also OKS) should be completed by Q1’09.

All the pipes won’t be full from the beginning. Overland Pass will somewhat cannibalize MAPL, but that simply relieves MAPL’s fully utilized facility.

All told, these pipelines have the capacity to allow an increase in NGL supply by 18%.

Further expansion is possible. OKS has been planning to expand Overland Pass by 145,000 bpd by 2010, but we would not be surprised to see that pushed out a little. Arbuckle is expandable by 50,000 bpd with additional pump stations

29

Changing Dynamics: Ethylene & Propylene

Currently, the U.S. has the most ethylene and propylene processing capacity in the world, at 22% and 27%, respectively. China is second, with 8% of both ethylene and propylene capacity.

Prior to the financial meltdown, there was mounting concern that a massive amount of planned new international ethylene and propylene capacity would flood the market, eventually resulting in the U.S. becoming a net importer, thus backing off demand for domestic NGLs.

The vast majority of the adds are in the Middle East, where they’ll use cheap gas to make NGLs to feed the new petrochemical plants.

Given the economic slowdown, we are now assuming that only the plants currently under construction will be built. In total, these add 15% to existing capacity, or 3.5%/yr growth – not helpful in a weak economy, but not the onerous 39% addition if everything was built.


Worldwide Planned Ethylene Capacity Adds, by Status

Capacity (tonnes/yr) % of ExistingConstruction under way 19,110,000 15%Engineering under way 4,170,000 3%Planned 1,160,000 1%Approved 4,180,000 3%Study 22,010,000 17%Potential Added by 2012 50,630,000 39%

Worldwide Planned Propylene Capacity Adds, by Status

Capacity (tonnes/yr) % of ExistingConstruction under way 11,365,000 15%Engineering under way 3,823,000 5%Planned 1,010,000 1%Approved 1,250,000 2%Study 10,195,000 13%Potential Added by 2012 27,643,000 35%

30

Changing Ethylene Dynamics by Region

Existing Global Ethylene Capacity (2008)

NAM27.0%

Asia/Pac30.3%

W Europe19.6%

Middle East13.5%

Africa0.8% Australia

0.4%SAM3.9%E Europe

4.5%

Planned Ethylene Capacity Under Construction (tonnes/yr)

Existing Planned Adds Total CapacityRegion Capacity to Capacity After Adds % IncreaseNAM 35,170,000 0 35,170,000 0%

Asia/Pac 39,480,000 7,545,000 47,025,000 19%

W Europe 25,560,000 100,000 25,660,000 0%

Middle East 17,568,000 11,080,000 28,648,000 63%

E Europe 5,925,000 185,000 6,110,000 3%

SAM 5,055,000 200,000 5,255,000 4%

Africa 1,075,000 0 1,075,000 0%

Australia 565,000 0 565,000 0%

TOTAL 130,398,000 19,110,000 149,508,000 15%


Global Ethylene Capacity After Adds (2012)

NAM23.5%

Asia/Pac31.5%

W Europe17.2%

Middle East19.2%

E Europe4.1%

SAM3.5%

Australia0.4%

Africa0.7%

31

Changing Propylene Dynamics by Region

Existing Propylene Capacity (2008)

NAM29.5%

Asia/Pac35.3%

W Europe21.5%


0.1%

SAM3.4%

E Europe3.8%

Middle East5.9%

Planned Propylene Capacity Under Construction (tonnes/yr)

Existing Planned Adds Total CapacityRegion Capacity to Capacity After Adds % IncreaseNAM 22,984,000 0 22,984,000 0%

Asia/Pac 27,523,000 6,965,000 34,488,000 25%

W Europe 16,747,000 0 16,747,000 0%

Middle East 4,624,000 4,045,000 8,669,000 87%

E Europe 2,969,000 0 2,969,000 0%

SAM 2,640,000 355,000 2,995,000 13%

Africa 455,000 0 455,000 0%

Australia 60,000 0 60,000 0%

TOTAL 78,002,000 11,365,000 89,367,000 15%


Global Propylene Capacity After Adds (2012)

NAM25.7%

Asia/Pac38.6%

W Europe18.7%

Middle East9.7%


0.1%SAM3.4%E Europe

3.3%

32

NGL Supply Outlook

There are two ways to look at NGL supply –domestically and on a global basis

In the U.S., while gas production is +9% year-to-date, NGL production is up a more modest 5%. Going back to 2001, the trend has been declining NGL production as the overall gas stream becomes drier. We think the recent surge in NGL production is driven, in part, by incredible NGL processing economics, which incent companies to maximize NGL extraction. More recent processing economics (negative-to-breakeven frac spreads) should stem the rate of NGL production growth.

On a global basis, NGL production is clearly on the rise, growing at a CAGR of 5% since 2000 (excluding North America) and 3% including North America. Going forward, most of the incremental production is destined for in-country use, primarily petrochemical, to feed new plants.

The risk to the U.S. NGL industry is over-building of worldwide ethylene and propylene plants, resulting in cheap exports, and a decline in the U.S. petrochemical industry. With the recent economic meltdown, the risk of overbuilding has been greatly reduced.


U.S. Monthly Gas & NGL Production (Jan '01- Aug '08)

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

2,800

Jan-

01Ju

l-01

Jan-

02Ju

l-02

Jan-

03Ju

l-03

Jan-

04Ju

l-04

Jan-

05Ju

l-05

Jan-

06Ju

l-06

Jan-

07Ju

l-07

Jan-

08Ju

l-08

NG

L Pr

oduc

tion

(m

bpd)

4547495153555759616365

Gas Production (Bcf/d)

NGL Production Marketed Gas Production

Global & North American NGL Production (Jan '01 - Aug '08)

0

2,000

4,000

6,000

8,000

10,000

Dec-0

0

Dec-0

1

Dec-0

2

Dec-0

3

Dec-0

4

Dec-0

5

Dec-0

6

Dec-0

7

Dec-0

8

Dec-0

9

NG

L Pr

oduc

tion

(m

bpd)

Global (ex/NAM) North American (NAM) Global

33

Appendix – Midstream Primer

Dry or Marketable

Gas

Industrial/ Heating

FractionatorRefineries

Petrochemical Industry

Onshore and Offshore Wells

Midstream Overview

Raw NGL Mix

Finished NGLs


Interstate PipelinesWet Gas

Gathering

Normal Butane

Isobutane

EthanePropane

Natural gasoline

Processing Plant

There are four primary segments within the Midstream business:

1. Gathering – transports and often compresses natural gas and removes water and other contaminants;

2. Processing – extracts NGLs, resulting in dry/marketable natural gas and a raw NGL stream

3. Fractionation – splits raw NGLs into finished product

4. Marketing – stores, transports and markets finished NGLs

34

Step 1: Gas Gathering

Gas gathering systems simply transports gas from the well-head to the processing facilities.

Gathering lines typically operate at relatively low pressures (just below wellhead pressure) and utilize pipe diameters of less of than 12”. Lower pressure systems reduce the need to install field compression and generally allow for greater production.

At this stage, the gas is usually treated to remove natural gas condensates, water and other contaminants to prevent the components from obstructing flow in or destroying the integrity of the gathering system. Small-scale gas-oil separators, condensate separators, and dehydration units are typical treating equipment.

Gathering System

Processing Plant

Source: Williams Companies and Tudor, Pickering, Holt

35

Step 2: Plant Processing

Plant processing takes “wet” gas from the field and removes the heavier, more liquid components (NGLs) and other contaminants (water, hydrogen sulfide, etc) to create marketable gas – also known as “dry” or “pipeline quality” gas.

For safety and integrity reasons, pipelines impose restrictions on the composition of gas allowed to enter the line. Gas composition is measured in terms of dew point (the temperature at which vaporized liquid will condense at pipeline pressure) and the heat, or BTU content of the gas. A higher BTU content means more liquids in the stream.

Processing economics depend, in part, on the price of the liquids removed vs. their equivalent BTU content if left in the original gas. The difference between the price of the liquids removed vs. their value in gaseous form is called a “frac spread.”

Marketable Gas to Interstate Pipelines

Processing PlantRaw NGL Pipeline

Wet Gas (Wellhead

gas)

(Typical NGL Mix)

Ethane (40-45%)

Propane (25-30%)

Normal Butane (5-10%)

Natural Gasoline (10-15%)


Isobutane (10%)

36

Step 3: Fractionation

Fractionator

NGL Pipeline

Products Pipelines

Storage

Raw NGL “Barrel”

Fractionation

Ethane

Propane

NormalButane

Natural Gasoline

Source: Tudor, Pickering, Holt

Fractionation is the process of turning the raw NGL stream into marketable products.

One-by-one, the hydrocarbons are boiled off, moving lightest (ethane) to heaviest (natural gasolines).

Fractionators are much larger scale than gas processing plants, handling the output from multiple processing plants. They are usually located close to the petrochemical end-users.

Raw NGL pipelines transport NGLsfrom processing plants to fractionators. Finished NGLspipelines transport the product to market.

Isobutane

40-45%

25-30%

10%

5-10%

10-15%

37

Step 4: Marketing

StorageIndustrial & Other

End-Users

Fractionator

Refinery

Chemical Plant


NGL marketers match up sellers (E&P and Midstream companies) with buyers –petrochemicals, industrials, farmers, propane companies, etc.

Services include NGL transportation, storage and risk management services.

NGL marketing is primarily a physical business, with limited liquidity on financial hedging of individual NGL components much beyond 6-12 months. Beware companies with “dirty hedges” – NYMEX crude as proxy for regional NGLs.

38

Gas Processing: Three Major Contract Structures

Keepwhole (KH)

Structure: Processor compensates (“keeps whole”) the producer for the amount of gas removed from the processing stream. Processor gets paid in NGLs, but compensates producer based on gas prices.

Commodity Exposure: Long NGLs, short gas. So two sources of exposure – relative gas/NGL prices and absolute NGL prices.

Volatility: High. Frac spreads can and do move wildly and seasonally. Because midstream assets are held more by MLPs who do not like that exposure, the trend has been to negotiate away from keep whole contracts and to insert, conditioning language, which provides minimum fees if fracs go negative.

Percent of Proceeds (POP)

Structure: Processor is paid by retaining a percent of the outlet stream, either NGLs, gas or a combination.

Commodity Exposure: Long liquids and/or natural gas, depending on contract structure.

Volatility: Moderate. Higher commodity prices = higher POP proceeds.

Fee-Based

Structure: Fixed fee, either volumetric or a demand payment.

Commodity Exposure: None.

Volatility: If volumetric payment, only volatility is throughput based.

Keepwhole Margin =

NGLs Removed (MMBtu) x Frac Spread ($/MMBtu)

Percent of Proceeds Margin =

[NGLs Removed (MMBtu) x NGL Price ($/MMBtu) x % of NGLs Retained] + [Gas Remaining (MMBtu) x Gas Price ($/MMBtu) x % of Gas Retained]

Fee Margin =

Inlet Gas (MMBtu) x Processing Fee ($/MMBtu)

39

Frac Spread – Sum of the Parts is Worth More Than the Whole

Composite

($/gal)

NGL Price ($/gal)

Weighted Average

Conversion Factor

(MMBtu/Gal)

Assumed Mix

F $0.998E 0.0843Total NGL

$0.182$1.8150.01180.117810%Natural Gasoline

$0.148$1.4750.00520.103710%Normal butane

$0.074$1.4800.01000.09975%Iso butane

$0.374$1.2480.02750.091630%Propane

$0.221$0.4900.02990.066445%Ethane

=[D*A]DC=[A*B]

BA

$11.84 – Gas Price = Frac SpreadStep 3: Subtract natural gas price from composite NGL price:

Step 4: Adjust spread for transportation, operating costs, and plant processing fuel.

$11.84Step 2: Divide F by E to get composite NGL price ($/mmbtu):

Step 1: Calculate the NGL value ($/MMBtu). Multiply component prices by the heat content and composition of the gas. Frac spread is the difference

between the value of the processed NGLs and the value of the equivalent btus of gas input into the processing plant.

Frac spreads are negatively correlated with gas prices (gas goes up, fracs go down) and positively correlated with NGL prices (NGLs go up, fracs go up).

Frac spreads are volatile and usually seasonal – narrowing with higher gas prices during the winter.

Source: Targa Resources and Tudor, Pickering, Holt

40

Appendix – Midstream Terminology

Conditioning mode – Processing mode when NGL economics are unfavorable whereby the processor removes only the minimal amount of NGLs, saving on fuel and other operating expenses. Most keep whole contracts now contain conditioning language in the event frac spreads go negative.

Ethane rejection mode – Process of keeping ethane in the gas stream (rejecting it from processing) because economics dictate the btus will receive a higher price for gas than liquids.

Fee Based – Midstream contract – gathering, processing, fractionation, etc. – where services are conducted on a fee/unit basis.

Frac spread - Value of natural gas liquids after they are processed out of natural gas, in excess of the price of the gas itself (i.e. gross margin on NGLs).

Fractionation – process of splitting the raw NGLs into marketable products.

Keepwhole – Contract type whereby processor keeps 100% of the liquids and keeps the producer whole by compensating them for the btus on a gas-equivalent basis.

Naphtha - a distillation product from petroleum or coal tar containing certain hydrocarbons. Naphtha is used primarily as feedstock for producing a high octane gasoline component (via catalytic reforming). It is also used in the petrochemical industry to produce olefins in steam crackers and in the chemical industry for solvent(cleaning) applications.

Natural gas condensate – Output of the processing of wellhead gas.

NGLs (Natural Gas Liquids) – Portions of natural gas that are liquefied via gas processing. They include ethane, propane, butane, and natural gasoline.

NGL shrink – Reduction in gas available for sale as a result of removing NGLs from the gas stream.

Percent of proceeds – Processing contract where processor receives a percent of the outlet stream – either gas, NGLs, or a combination.

41

Analyst Certification:

We, Becca Followill, Dave Pursell and Anson Williams, do hereby certify that, to the best of our knowledge, the views and opinions in this research report accurately reflect our personal views about the company and its securities. We have not nor will we receive direct or indirect compensation in return for expressing specific recommendations or viewpoints in this report.________________________________________________________________________________________________________

Important Disclosures:

The following analysts were involved in creating or supervising the content of this message; Becca Followill, Dave Pursell, and Anson Williams. None of these analysts (or members of their household) have a long or short position in the securities mentioned in this report.

Analysts’ compensation is not based on investment banking revenue and the analysts are not compensated by the subject companies. In the past 12 months, Tudor, Pickering, Holt & Co. Securities, Inc. has received investment banking or other revenue from Equitable Resources and Questar. In the next three months we intend to seek compensation for investment banking services from the companies mentioned within this report.

This communication is based on information which Tudor, Pickering, Holt & Co. Securities, Inc. believes is reliable. However, Tudor, Pickering, Holt & Co. Securities, Inc. does not represent or warrant its accuracy. The viewpoints and opinions expressed in this communication represent the views of Tudor, Pickering, Holt & Co. Securities, Inc. as of the date of this report. These viewpoints and opinions may be subject to change without notice and Tudor, Pickering, Holt & Co. Securities, Inc. will not be responsible for any consequences associated with reliance on any statement or opinion contained in this communication. This communication is confidential and may not be reproduced in whole or in part without prior written permission from Tudor, Pickering, Holt & Co. Securities, Inc.

For detailed rating information, distribution of ratings, price charts and other important disclosures, please visit our website at http://www.tudorpickering.com/Disclosure/ or request a written copy of the disclosures by calling 713-333-2960.

tph midstream update and primer 11-14-08 website

Documents