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S&P: How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy Industry
 

S&P: How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy Industry

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A new report by Standard & Poor's which looks at the Marcellus Shale and the key role it's playing in the U.S. natural gas market, as well as America's larger energy picture. In many ways the ...

A new report by Standard & Poor's which looks at the Marcellus Shale and the key role it's playing in the U.S. natural gas market, as well as America's larger energy picture. In many ways the Marcellus is the "king of the shale plays" and this report details why. Full of great information, including the Top 15 Marcellus producers, a breakdown of the rate of return producers make on the Marcellus vs. other shale plays, and more.

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    S&P: How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy Industry S&P: How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy Industry Document Transcript

    • How The Marcellus Shale Is ChangingThe Dynamics Of The U.S. EnergyIndustryPrimary Credit Analysts:Carin Dehne-Kiley, CFA, New York (1) 212-438-1092; Carin_Dehne-Kiley@standardandpoors.comWilliam M Ferara, New York (1) 212-438-1776; bill_ferara@standardandpoors.comSecondary Contact:David C Lundberg, CFA, New York (1) 212-438-7551; david_lundberg@standardandpoors.comTable Of ContentsWhat Is The Marcellus Shale?How Much Production Could The Marcellus Add?Gas Flows Are Changing DirectionThe Appalachian Premium Has Collapsed And Will Likely Remain MinimalMore Northeast Pipeline Takeaway Capacity Will Be NeededMore NGL Processing And Pipeline Infrastructure Will Be NeededWho Could Feel Pressure, And Who Stands To Benefit, From TheDevelopment Of The Marcellus?Related Criteria And ResearchWWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 1 1023527 | 301674531
    • How The Marcellus Shale Is Changing TheDynamics Of The U.S. Energy IndustryThe U.S. natural gas industry is rapidly evolving, largely because of shifting supply dynamics. The Appalachian regionin the Northeast is one of the main proponents of change, as its Marcellus shale could contain recoverable resourcesequal to almost half of the current proven natural gas reserves in the U.S. Exploration and production (E&P)companies have only just started to develop this resource, spurred by the increased use of specialized technologicalcapabilities such as horizontal drilling and hydraulic fracturing. Yet the rapid increase in production has alreadyaffected long-standing gas flows, reducing the areas reliance on natural gas imports from other regions and cuttingpremiums that local producers could realize. Standard & Poors Ratings Services believes many industry players willbenefit from the evolution of the Marcellus, but thinks others could face headwinds.In terms of regional consumption, the Northeast is home to some of the biggest gas consuming cities in the country,including Philadelphia, Boston, and New York City. In that regard, the location of the Marcellus formation, or "play,"holds a significant advantage for producers and consumers of natural gas. Although producers in the Marcellus havereined in drilling activity recently due to weak natural gas prices, we believe that lower all-in costs and a higher naturalgas liquids (NGL) component relative to other producing areas of the U.S. will ensure the Marcellus remains a keycontributor to U.S. natural gas supply. Overview • Development of the Marcellus shale will continue to boost natural gas and NGL production in the Northeast U.S. • Natural gas pipeline flows will continue to shift between U.S. regions (east-to-west versus west-to-east). • Local producers will no longer receive a premium price for Appalachian natural gas. • New natural gas and NGL pipeline infrastructure will be needed. • Credit risks will increase for some natural gas producers and pipeline operators, while others will benefit.We believe the development of the Marcellus will particularly benefit two groups of issuers that we rate: midstreamand pipeline companies that are building or expanding infrastructure in the Northeast; and E&P companies thatproduce natural gas and NGLs in the region. Conversely, two groups of rated issuers could feel ratings pressure fromthe development of the Marcellus if they dont modify their strategies to offset a potential increase in business risk orreduce debt to limit the impact from potential cash flow declines on their financial risk profiles. These issuers include:long-haul pipeline operators that are unlikely or unable to reverse their pipeline flows, face recontracting risk, or havehigh asset concentration; and E&P companies producing natural gas in the U.S. Rockies or Canada that are currentlysending gas to the Northeast. Longer term, once sufficient takeaway capacity is in place, we expect low-costproduction in the Marcellus to displace higher-cost production in other U.S. regions.WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 2 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryWhat Is The Marcellus Shale?The Marcellus shale is a hydrocarbon-bearing formation that extends from southern New York to West Virginia andspans most of Pennsylvania, the eastern part of Ohio, and parts of Maryland, Virginia, and Tennessee (see chart 1). Todate, developers have concentrated most of their activity in Pennsylvania and West Virginia, primarily because amoratorium in New York has prevented them from using hydraulic fracturing, or fracking, to access the formation inthe Empire State. Horizontal drilling requires far more fracking fluid (e.g., water, sand, and chemicals) than verticalwells, and New Yorks moratorium will prevent horizontal development of the Marcellus shale until regulators developmore comprehensive environmental rules. (For more information on fracking, see "How Horizontal Drilling AndFracking Have Reshaped The U.S. Energy Landscape," published on Sept. 17, 2012.)The Marcellus currently accounts for about 6% of total U.S. natural gas production and about 20% of total U.S. gasshale production. The U.S. Energy Information Administration (EIA) estimates that the Marcellus shale could hold upto 141 trillion cubic feet (tcf) of technically recoverable natural gas resources. To put this into perspective, thats about45% of the EIAs estimate of total current proven natural gas reserves in the U.S.WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 3 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryAlthough not a focus of this report, given the still limited public data on the play, the Utica shale appears poised tobecome the next driver of production and reserves growth in the Appalachian region. Located in eastern Ohio alongthe Pennsylvania border, the Utica shale underlies the Marcellus, and is prospective for liquids-rich natural gas andcrude oil.How Much Production Could The Marcellus Add?Current production volume from the Marcellus shale is a mere drop in the bucket compared with its potential reserves,but its growing rapidly. For example, the Pennsylvania Department of Environmental Production (DEP) says naturalgas production from the states portion of the Marcellus shale increased to 4.4 billion cubic feet per day (bcf/d) in thefirst half of 2012 from less than 0.5 bcf/d in 2009. This dramatic growth has boosted total production in the Northeastto 7.8 bcf/d in July, compared with about 7.0 bcf/d in the first half of 2012. Startlingly, the average stood at just over2.0 bcf/d in 2009. Energy market analytics company Bentek Energy LLC (Bentek, like Standard & Poors, is asubsidiary of The McGraw Hill Cos.) expects this rapid pace to continue and has projected that Northeast volumes willincrease to more than 10 bcf/d in 2013 and climb to 17 bcf/d in 2017. Benteks forecast notes that the Marcellus (andUtica) formations will account for 9.5 bcf/d of this production in 2013 and 16 bcf/d in 2017. In contrast, the EIAprojects that total U.S. natural gas production will grow by about 1% per year through 2017.We believe the discrepancy between the growth projections for the Marcellus and the overall U.S. reflects the higherreturns associated with the Marcellus shale compared with those of other key natural gas-producing plays in the U.S.Based on company-specific data and using Standard & Poors long-term price deck assumptions of $3.50/mmBTU forHenry Hub natural gas, we estimate that Marcellus "dry" gas (e.g., pipeline quality) generates an internal rate of returnof around 12%, while Marcellus "wet" gas (e.g., gas that contains NGLs) generates an internal rate of return (IRR) ofclose to 30% due to the higher revenues associated with NGLs. These rates of return are significantly higher than forthe other key gas shale plays, including the Haynesville, Fayetteville, Barnett, Woodford, and Eagle Ford gas, dueprimarily to the lower finding, development and production costs associated with the Marcellus.WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 4 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryChart 2Spot natural gas prices are currently below our $3.50/mmBTU long-term price deck, so many operators have putdrilling activity for dry gas shale on hold, even in the Marcellus. However, the lower costs associated withdevelopment and production of the Marcellus shale means operators are likely to resume drilling in that region first ifand when natural gas prices improve. Thus, we believe the Marcellus will be one of the first areas that operators willreturn to if and when natural gas prices improve, as we expect they will over the next 12-18 months. (For moreinformation on Standard & Poors pricing assumptions, see "Standard & Poors Raises Its U. S. Natural Gas PriceAssumptions; Oil Price Assumptions Are Unchanged," published July 24, 2012.)To date, independent E&P companies have led the growth in Marcellus production, while the major integrated oilcompanies and national oil companies entered the play more recently through acquisitions and joint ventures (JVs).Table 1 lists the top 15 Marcellus producers as of fourth-quarter 2011.Table 1Top 15 Marcellus ProducersAs of fourth-quarter 2011 Bloomberg estimated Marcellus Estimated marcellus natural natural gas production, 4Q11 gas production, 4Q11 % of companys total Marcellus netCompany (mmcf/d) (mmcf/d) production acres, 1Q12Chesapeake Energy 909.8 450.0 13 1,780,000Corp.Talisman Energy Inc. 622.0 429.1 20 217,000WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 5 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryTable 1Top 15 Marcellus Producers (cont.)Range Resources 534.0 375.0 60 900,000Corp.Cabot Oil & Gas 460.3 300.0 50 188,000Corp.EQT Corp. 232.7 268.5 47 532,000Royal Dutch Shell 213.4 213.4 1 650,000PLCAnadarko Petroleum 328.0 193.0 5 260,000Corp.Chevron Corp. 140.3 140.3 1 714,000Southwestern Energy 125.7 125.7 9 187,000Co.National Fuel Gas 128.5 124.2 62 745,000Cp.ExxonMobil Corp. 102.9 102.9 1 660,000Consol Energy Inc. 173.3 70.0 16 361,000EOG Resources Inc. 79.1 40.0 2 210,000Exco Resources Inc. 74.5 40.0 7 140,000Rex Energy Corp.* 45.5 35.0 71 69,700*Total Appalachian production. Sources: Company Web sites, Bloomberg.Gas Flows Are Changing DirectionThe surge in production from the Marcellus is materially affecting natural gas flows throughout North America. Inparticular, Marcellus production has diminished the Northeast regions need to receive natural gas from elsewhere inthe country, which has reduced natural gas flows along traditional west-to-east routes. This has effectively left somepipeline capacity underutilized (see "The Shale Gas Boom Is Shaping U.S. Gas Pipelines New Reality," published June5, 2012).The Northeast U.S.* has historically been a natural gas importer, due to its limited local supply and high demand fromNew York, Boston, and Philadelphia. Nine main pipelines bring natural gas into the northeast from the majorproducing regions of the Gulf Coast, Rockies, and Canada (see table 2). Although these pipelines have a combinedaggregate capacity of nearly 47 bcf/d, they have multiple delivery points along their routes with firm contracts todeliver gas prior to reaching their endpoints in the Northeast.*The Northeast U.S. includes Connecticut, Delaware, Massachusetts, Maine, New Hampshire, New Jersey, New York,Pennsylvania, Rhode Island, Virginia, and West Virginia.Table 2Main Pipelines Into The NortheastPipeline name Pipeline owner Capacity mmcf/dFrom the Gulf CoastColumbia Gulf Transmission NiSource Inc. 9,350Tennessee Gas Pipeline Co Kinder Morgan Energy Partners L.P. 7,500WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 6 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryTable 2 Main Pipelines Into The Northeast (cont.) Texas Eastern Transmission Spectra Energy Corp. 9,600 Transcontinental Gas Pipeline The Williams Cos. Inc. 8,500 Dominion Transmission Co. Dominion Resources Inc. 7,200 From the West Rockies Express Pipeline Tallgrass Energy Partners L.P.* (50%), Sempra Energy (25%), Phillips 66 (25%) 1,800 From Canada Iroquois Gas Transmission System TransCanada Corp., Dominion Resources Inc. (25%), National Grid PLC, Iberdrola SA 1,500 (5%), NJ Resources Corp. (5%) Empire Pipeline National Fuel Gas Co. 750 Maritimes & Northeast Pipeline Spectra Energy Corp. (77%), Emera Inc. (13%), ExxonMobil Corp. (10%) 833 *In the process of acquiring this interest from Kinder Morgan Energy Partners L.P. Source: Company Web sites, Standard & Poor’s.Increased production in Marcellus has affected decades-long gas flows from the Gulf Coast and Canada, and morerecently the Rockies, and Appalachia now faces infrastructure bottlenecks because pipeline takeaway solutions havelagged drilling activities in certain pockets of the region.Increased production in the Marcellus has caused a significant reduction in deliveries to the Northeast from othernatural gas producing areas along the long-haul pipelines. According to Bentek, long-haul pipelines have historicallysupplied about 85% of the demand in the northeast (we estimate Northeast "imports" averaged 11 bcf/d-12 bcf/dbetween 2005 and 2010).The supply dropped to 65% in 2011 and is on track to decline further in the coming years.With the newfound capacity, these pipelines are now increasing deliveries to other markets, primarily the Midwest,and in some cases, reversing gas flows through backhaul opportunities, which is partly offsetting the declining need topipe supply to the Marcellus region. Whats A Backhaul? A transaction that results in the transportation of gas in a direction opposite of the aggregate physical flow of gas in the pipeline. A backhaul condition will exist as long as the aggregate backhaul transactions total less than the aggregate forward haul transactions.For instance, Tennessee Gas Pipeline (TGP) expects its Marcellus backhaul volumes under contract to be nearly 1bcf/d in 2012, up from 675 mmcf/d in 2011 and in stark contrast to only 10 mmcf/d in 2008. In addition, someproducers are negotiating "transportation exchange" deals whereby they swap natural gas volumes produced in theGulf Coast for volumes produced and delivered in the northeast—thereby avoiding pipeline transportation fees.The Rockies Express (REX) pipeline is another interesting case study. The pipeline was completed in 2009 to deliver1.8 bcf/d of gas from the Rockies to eastern markets, and its flow patterns have since shifted so that REX mainlydelivers gas into Chicago (rather than at its endpoint in Ohio). Appalachia gas is also now being backhauled to theChicago market, causing the region to be significantly oversupplied. This in turn, redirects more gas from the Rockiesto the West Coast, which displaces Canadian imports into that region.WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 7 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryThe Appalachian Premium Has Collapsed And Will Likely Remain MinimalSince Marcellus production has surged and the area has minimal takeaway capacity, the Appalachian premium hascollapsed (see chart 3). Local producers must now compete with supply shipped in from other regions, which istypically delivered to customers under long-term contracts with midstream or pipeline companies. Because natural gasutilities and gas distribution companies in the Northeast historically contracted for supply on long-haul pipelines fromthe Gulf Coast, Rockies, and Canada, they ended up paying transportation and fuel charges along with the actual gascharges. As a result, Appalachian producers could charge a premium for their gas, relative to other regions, as long asit didnt exceed the all-in cost for the imported supply (regional gas price plus transportation plus fuel costs). Between2005 and 2010, the Marcellus-to-Henry Hub premium averaged about $0.20 per mmBTU.Although gas utilities and gas distribution companies could now theoretically switch to local natural gas suppliers, theyhave not completely done so—in our view due to existing long-term contracts in place and perhaps some skepticismabout the reliability of shale gas, given it is still a fairly recent phenomenon. Consequently, we expect the northeastregion to remain well supplied with natural gas, and the historical northeast gas premium to remain minimal.The flattening Appalachian premium was particularly evident in northeast Pennsylvania, one of the most highlyproductive areas of the Marcellus play. Natural gas production has overwhelmed capacity on the TGP line at zone 4,pushing prices down to $1.00/mmBTU, or about $2.00/mmBTU below Henry Hub, in July 2012. A number of pipelineWWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 8 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy Industryprojects are underway to alleviate this bottleneck.The flattening of the historical Appalachian premium—along with the drop in benchmark natural gas prices—haseffectively clipped the economics of Marcellus dry gas (although the Marcellus still ranks above other gas shales interms of IRR). As a result, many operators—including large producers Chesapeake Energy (BB-/Negative/--),Talisman Energy (BBB/Stable/A-2), Anadarko Petroleum Corp. (BBB-/Positive/--), Range Resources Corp.(BB/Stable/--), EQT Corp. (BBB/Stable/A-2), and National Fuel Gas Co. (BBB/Stable/A-2)—have either cut thenumber of dry gas rigs running in the Marcellus or moved them to the more liquids-rich areas of the play (which stilloffers adequate returns).Flat pricing differentials also limit earnings and cash flow potential for the long-haul pipeline companies and marketersthat could previously capitalize on price spreads between Gulf Coast and Northeast gas.More Northeast Pipeline Takeaway Capacity Will Be NeededUltimately, we believe there will be more local natural gas supply than the Appalachian region can consume, so newpipeline takeaway capacity will be needed to move the excess gas to other regions.Between 2007 and 2011, Northeast natural gas demand averaged between 14 bcf/d and 15 bcf/d, but actual usagevaried widely from as low as 10 bcf/d in the summer to nearly 20 bcf/d in the winter due to gas-fired heating demand.Based on our natural gas supply growth assumptions from the Marcellus/Utica (reaching 9.5 bcf/d in 2013 and 16bcf/d in 2017), and assuming that regional demand grows at a rate of about 2% per year (which is in line with Standard& Poors economists GDP growth forecast), we estimate that the region will need up to 10 bcf/d of additionaltakeaway (or backhaul) capacity from the Marcellus by 2017—potentially more to handle the lower demand months.WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 9 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryChart 4In looking at recent capacity trends, we expect pipeline companies will be working to address the growing need intargeted areas. Southwest Pennsylvania has notably more access to long-haul pipelines than northeast Pennsylvania,which has insufficient takeaway capacity because the extremely productive wells in the area have yielded significantlymore output than originally anticipated. Production volume is increasing so quickly, in fact, that space on takeawaypipelines is limited or non-existent in certain areas. For instance, TGPs average load factor on two of its pipelinesections that traverse from western Pennsylvania to the New York City and Boston areas were about 90% in the winterof 2011-2012, well above the mid-50% area in 2009.Standard & Poors isnt alone in thinking that additional takeaway capacity is needed in Appalachia. In fact, severalnew build and expansion projects are currently under way (see table 3). Four large new-build pipelines, which are quiterare in the U.S. nowadays, have been proposed with a combined natural gas takeaway capacity of 5.5 bcf/d. However,we dont expect these projects to be operational until late 2015.Table 3Proposed Pipeline ProjectsProject Company Capacity (mmcf/d) Propsed in-service dateAppalachian Gateway Dominion Resources Inc. 484 9/1/2012Northeast Expansion Dominion Resources Inc. 200 2H2012WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 10 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryTable 3Proposed Pipeline Projects (cont.)Northeast Supply Diversification Project Kinder Morgan Energy Partners L.P. 250 11/1/2012Northern Access Expansion National Fuel Gas Co. 320 11/1/2012TEAM 2012 Spectra Energy Corp. 200 2H2012Philadelphia Lateral Expansion Spectra Energy Corp. 27 2H2012MPP Project Kinder Morgan Energy Partners L.P. 240 11/1/2013NorthEast Upgrade Project Kinder Morgan Energy Partners L.P. 637 11/1/2013New Jersey-New York Expansion Spectra Energy Corp. 800 2H2013Northeast Supply Link The Williams Cos. Inc. 250 11/1/2013Northeast Connector The Williams Cos. Inc. 100 2014Rockaway Delivery Lateral Project The Williams Cos. Inc. 647 2014East Side Expansion Project NiSource Inc. 500 Late 2014West Side Expansion Project NiSource Inc. 444 Late 2014Rose Lake Expansion Kinder Morgan Energy Partners L.P. 230 11/1/2014TEAM 2014 Spectra Energy Corp. 600 2H2014Keystone Connector Dominion Resources Inc. TBD TBDOhio Pipeline Energy Network (Open) Spectra Energy Corp. 1000 2014/15Commonwealth Pipeline UGI Corp., Inergy L.P., WGL Holdings Inc. 1200 2015Nexus Pipeline Spectra Energy Corp., Enbridge Inc., DTE 1000 Nov-15 Energy Co.Atlantic Access Williams Partners L.P. 2300 Dec-15Leidy Southeast Expansion The Williams Cos. Inc. 800 Late 2015Northeast Expansion Kinder Morgan Energy Partners L.P. 500-1700 2016/17Source: Company Web sites, Standard & Poor’s.More NGL Processing And Pipeline Infrastructure Will Be NeededWhile dry gas production in northeast Pennsylvania has driven much of the plays growth to date the wide pricediscrepancy between natural gas and NGLs has prompted E&P companies to shift their drilling activity toward theNGL-rich (i.e., wet gas) areas in southwest Pennsylvania.We estimate that based on current one-year futures strip prices ($3.50/mmBTU for Henry Hub natural gas, $92.50/bblfor WTI crude oil, and assuming NGLs at 50% of WTI), internal rates of return for Marcellus wet gas would be over30%, compared with around 10% returns for dry gas. Therefore, its not surprising that producers are shifting rigs tothe wet gas areas of the Marcellus.According to Bentek, current Marcellus NGL production is running at about 40 thousand barrels per day (mbbls/d),and the company projects that output will increase to 250 mbbls/d in 2017. Because of limited ethane processingcapacity in Appalachia, the area is primarily producing NGLs such as propane and butane. These NGLs are eitherconsumed in local markets or trucked/railed out to other regions. Ethane, which requires a pipeline for transport, is forthe most part being rejected (i.e., left in the natural gas stream) and sold as natural gas (effectively boosting the volumeof natural gas produced). We believe the returns for wet gas will improve above 30% level once ethane infrastructure isWWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 11 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy Industrybuilt out and producers can strip out and sell the ethane separately.Based on current NGL prices at Mt. Belvieu, we estimate that gas producers could increase their revenue for wet gasversus dry gas by about $3.00/mcf for extracting propane and butane and gain another $0.50/mcf for stripping ethane.Midstream companies are well aware of the need for additional infrastructure in Appalachia, and material processingcapacity additions and new ethane takeaway pipeline projects are currently underway. We expect these efforts to keepessentially keep pace with local production increases. A few midstream companies are handling the build out of thenew infrastructure, and the developments are backed by relatively low-risk fee-based contracts. Gathering andprocessing contracts typically have minimum volume commitments (such as Crestwood Midstream Partners L.P.s(B/Stable/--) recent deal with Antero Resources (B+/Stable/--)), which mitigates cash flow risk; although, pipelinesstill need to transport higher volumes to generate adequate economic returns.Beyond the scope of the signed contracts for these developments, which are moderate to long term in length (e.g., a15-year, 275 mmcf/d gathering deal between subsidiaries of midstream company Boardwalk Pipeline Partners L.P.(BBB/Stable/--) and producer Southwestern Energy Co. (BBB-/Stable/--)), recontracting risk could arise down theroad depending on the production success of the region.We view the NGL pipeline projects as a positive for the prospects of the Marcellus shale because producers needconfidence that future volume flows will be handled before making capital investments. However, midstreamcompanies are typically seeking new projects and are almost always willing to lock in long-term cash flows. Currentlyin the Marcellus, however, most E&P companies are rejecting ethane because of the regions lack of processingcapacity. Thats because the natural gas stream can contain only a specified amount of ethane before it fails to meetpipeline design specifications. This should change over time, though, given the list of processing projects beingcontemplated, as new capacity will ultimately allow producers to capture incremental revenues per mcf produced asthey strip ethane and sell it separately.Existing ethane takeaway pipelines are in heavy competition among one another due to the advantages that thepipeline owners can obtain by leveraging existing pipeline infrastructure and available fractionation capacity. Projectcosts are lower and timetables are shorter because of these pipeline companies use of existing right-of-ways andupgrades and conversions of existing lines. A few pipelines that will facilitate ethane takeaway to fractionators on theGulf Coast and Canada are forthcoming, while Kinder Morgan Energy Partners L.P. (BBB/Stable/A-2) and SpectraEnergy Corp. (BBB+/Stable/--) dropped a proposed JV ethane pipeline because it didnt receive sufficient shipperinterest. We list current ethane projects in table 4.Table 4 Proposed Ethane Projects Project Company Capacity (mbbls/d) Proposed in-service date Mariner West Markwest Energy Partners L.P./Sunoco Logistics 50-65 Jul-13 Partners L.P. Mariner East Markwest Energy Partners L.P./Sunoco Logistics 70 Mid-2013 Partners L.P. Appalachia to Texas (ATEX) Enterprise Products Partners L.P. 190 1Q2014WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 12 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryTable 4 Proposed Ethane Projects (cont.) New ethane cracker in Royal Dutch Shell PLC TBD 2017+ Pennsylvania Source: Company Web sites, Standard & PoorsWho Could Feel Pressure, And Who Stands To Benefit, From The DevelopmentOf The Marcellus?We have identified two groups we believe stand to lose from the development of the Marcellus if they dont modifytheir strategies to offset a potential increase in business risk or reduce debt to limit the impact from potential cash flowdeclines on their financial risk profiles:• Long-haul pipeline companies that transport gas to the Northeast that are unlikely or unable to take backhaul volumes; and• E&P companies producing natural gas in the Rockies and/or Canada that are currently transporting gas to the Northeast.Long-haul pipeline companiesRockies Express Pipeline LLC (REX; BB/Stable/--): REX is being notably negatively affected by sustained compressionin the low basis spread environment and the potential recontracting risk related to a lessening need to ship gas out ofthe Rockies all the way to its terminus in Clarington, Ohio. As such, we lowered our corporate credit rating on REX inJanuary 2012 to BB from BBB-. In addition to these factors, we acknowledged the companys somewhat aggressivefinancial metrics. REXs recontracting risk could be high and cause substantially lower cash flow when the vastmajority of its contracts expire in 2019 (contracts on about 10% of capacity expire in late-2014). REXs contractedtransportation rate of about $1.05/mcf is dramatically above recent basis spreads on the route ranging from about$0.10-$0.40/mcf. While the company could generate additional value by reversing the flow (east to west), we haveprovided minimal credit at this point in our view on the companys credit quality unless contracts of a meaningfulnature occur.TransCanada Pipeline Ltd. (A-/Stable/A-2): TransCanada is in the midst of a major rate restructuring application withthe National Energy Board for the Canadian Mainline. The pipeline has experienced declining throughput volumesover the past several years from changes to the competitive environment, which has meant substantial increases in theper-unit tolls it charges shippers to meet its regulated revenue requirement. Increasing gas supply from basins like theMarcellus has contributed to the volume decline because it has displaced eastern demand for Western CanadianSedimentary Basin (WCSB) gas. Due to the regulated nature of the pipeline, we believe there is little near-termbusiness or financial profile risk; in the longer term, however, we believe two specific factors from increasing Marcellusproduction could affect the pipelines viability, and ultimately its approximate 40% contribution to consolidatedEBITDA in 2012. The first is the risk of displacement, whereby imported Marcellus production would be consumedinstead of volumes from the WCSB, thus exacerbating the shift from long-term firm transport to short term, whichincreases toll variability. The second risk is bypass, whereby gas transmission companies/LDCs contract to import gason its network directly, bypassing the TCPL system entirely, which would result in higher tolls on the remainingWWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 13 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy Industrylowered volumes. Both of these scenarios, if they materialize, will pressure tolls and TCPLs ultimate ability to earn areturn on and recovery of the capital invested in the mainline.Maritimes & Northeast LLC (BBB-/Stable/--; U.S. pipeline) and Maritimes & Northeast L.P. (A/Stable/--; Canadianpipeline): While not at risk in the near to medium term, the Maritimes & Northeast pipeline system routing fromNortheast Canada to the Boston area could be at risk in the long term. Increasing Marcellus supplies could be routedto the Boston market, which would entail a shorter shipping distance and likely lower shipping tariff. This couldcircumvent the need to import the traditional off-shore Canada supplies that have supported the pipeline. Capacitylooping projects, such as those by TGP, could extenuate this risk, albeit these projects and their associated planning,permitting, and construction process takes years to execute. As such, the risk for Maritimes & Northeast exists in thelong term. Maritimes U.S. debt comes due in the near term (2014) and is fully supported by existing contracts thathave an average contract life of roughly 20 years. On the Maritimes Canada system, the two tranches of debt (one iseconomically defeased) come due in 2019, but ExxonMobil provides a backstop agreement for them that provide cashflow support through the maturity of both debt issues.Other long-haul gas pipelines to the Northeast: Recontracting risk and potentially declining volumes, especially on thepipelines southern zones, is a potential risk to cash flows in the near term. Abundant and rising production in closeproximity to the terminus of these pipeline routes is also a general concern. However, there are some mitigants. Thesepipelines are increasing cash flows via looping and lateral projects in the region to meet producers needs, which willenhance their competitive positions. In addition, backhaul volumes to the south from the north are increasing. Overall,we expect the impact on consolidated credit quality for each pipelines owner to be minor given the relatively modestsize of the pipelines relative to each companys much larger asset bases. Some of the larger long-haul pipelines areowned by:• Dominion Resources Inc. (A/Stable/A-2)-Dominion Gas Transmission;• Kinder Morgan Energy Partners L.P.-Tennessee Gas Pipeline;• NiSource Inc. (BBB-/Stable/A-3)-Columbia Gas Transmission;• Spectra Energy Corp.-Texas Eastern Transmission; and• The Williams Cos. (BBB/Stable/--)-Transcontinental Gas.Exploration and production companiesEnCana Corp. (BBB/Stable/--): About 25% of Canadian E&P company EnCanas production is in the U.S. Rockies, aregion that is already seeing its deliveries to Appalachia affected by Marcellus gas. EnCana is the largest firm capacityholder on the Rockies Express pipeline, as it has 500 mmcf/d contracted through 2019. Given the minimal spreadbetween Appalachian and Rockies natural gas prices and the likely high transportation costs on REX (we estimateabout $1.05/mcf plus fuel charges), we believe EnCana is generating marginal economic returns on its natural gasshipped along this pipeline. Importantly though, EnCanas REX commitment equates to just 15% of its total natural gasproduction, so poor returns on just this amount are unlikely to move the overall rating. In addition, the company isworking to transition to a more oil and liquids-rich portfolio, and our stable outlook incorporates a successfultransition.Bill Barrett Corp. (BB-/Negative/--): Bill Barrett is a U.S. E&P company focused exclusively in the Rocky Mountainregion. The company holds 25 mmcf/d of firm capacity on the Rockies Express pipeline, which equates to about 8% ofWWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 14 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy Industryits current total equivalent production. We estimate transportation costs on REX are about $1.05/mcf plus fuelcharges. Given the current minimal spread between Appalachian and Rockies natural gas prices, we estimate that BillBarrett is generating marginal economic returns on its natural gas shipped along the pipeline. However, Bill Barrettalso has 50 mmcf/d of firm capacity, contracted through mid-2021, on the Ruby pipeline, which runs from the Rockiesto the West Coast. Transportation costs on this line are much lower than on REX, which should allow Bill Barrett togenerate positive economic returns.We have also identified two key groups of companies that we believe stand to benefit from future development of theMarcellus:• Midstream and pipeline companies that are building/expanding infrastructure in the region; and• E&P companies that produce natural gas and NGLs in the region.Midstream and pipeline companiesMarkWest Energy Partners L.P. (BB/Stable/--): MarkWests strategy and growth plans are heavily influenced by itssuite of new projects throughout the midstream energy value chain in the Marcellus. We believe new projects in theregion will notably increase the companys cash flows and, relative to the debt expected to be incurred, will helpreduce its debt-to-EBITDA ratio. The new projects will also further diversify the companys cash flow stream. Whilethese are all credit positives for the company in the long term, risks related to construction and securing sufficientcapital to build-out its infrastructure capacity in 2012-2013 limit near-term ratings improvement. The company expectsto increase processing capacity at its Majorsville complex to 670 mmcf/d (up from 270 mmcf/d currently—half ofwhich was built in second-quarter 2011), another 200 mmcf/d is under construction at Sherwood Complex to becompleted in the second half of 2012 (with another 200 mmcf/d announced at the same complex for 2013, another320 mmcf/d under construction in Mobley, W.V., and has 355 mmcf/d existing capacity at the Houston Complex(which increased by 200 mmcf/d in second-quarter 2011. MarkWest is also a JV partner with Sunoco LogisticsPartners L.P. on two ethane takeaway pipelines.Sunoco Logistics Partners L.P. (BBB-/Stable/--): Sunoco Logistics (SXL) is a JV partner in two key Marcellus ethanetakeaway pipelines that will help boost cash flows and further embed its competitive position in the Northeast. SXLsgrowing NGL business, as well as its refined products and crude logistics assets, are a primary reason Energy TransferPartners L.P. (BBB-/Stable/--) announced the $5.3 billion acquisition of Sunoco Inc., SXLs general partner, in April2012. We expect to rate SXL in-line with ETP when the transaction is complete, although SXLs integration into ETP iskey as it seeks to extend its scale and enhance its competitive position across the natural gas, oil, and NGL valuechain.Iroquois Gas Transmission System L.P. (A-/Stable/--): Iroquois is strategically located within the Marcellus region andstands to benefit from new infrastructure coming online over the next few years. While opportunities are limited in thenear term, projects targeted for 2015, such as the Constitution Pipeline (a JV between Williams Partners L.P.(BBB/Stable/--) and Cabot Pipeline Holdings LLC) and Spectra Energys Algonquin Incremental Market Project (AIM),will enhance Iroquois competitive position by offering additional supply diversity to its shippers. New interconnectswill allow Iroquois to replace disadvantaged volumes that TransCanadas Mainline currently supplies with cheaperMarcellus gas.WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 15 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryE&P companiesRange Resources Corp.: Range Resources is one of the largest natural gas and NGL producers in the Marcellus. Ourratings incorporate Ranges aggressive production growth plans from the Marcellus shale, which are now primarilyfocused on the wet gas areas. Ranges Marcellus production reached 500 mmcfe/d net at the end of the second quarterof 2012, accounting for about 70% of its total equivalent production, and the company remains on track to reach 600mmcfe/d by year-end (up from 300 mmcfe/d on average in 2011). The company holds over 750,000 net acres in theMarcellus fairway, about 45% of which are in the liquids-rich southwest regions. The company is directing more than85% of its $1.6 billion 2012 capital budget toward the Marcellus shale, which will be Ranges primary growth driver forthe next several years. Range also holds 190,000 net acres in the Utica shale, which could add further liquids growthover the medium term. Although Ranges expected Marcellus production growth provides positive momentum for therating, our stable outlook also incorporates the companys high exposure to weak natural gas prices.EQT Corp.: EQT is a diversified energy company exclusively focused on the Appalachian region. Our ratings on EQTincorporate the companys aggressive production growth plans from the Marcellus shale, along with its developmentof infrastructure to facilitate this growth. EQTs Marcellus production averaged 295 mmcf/d during the three monthsended March 31, 2012, which represented 50% of its total equivalent production. The company holds 530,000 netacres prospective for the Marcellus, about 35% of which is in the liquids rich areas. While the company decided tosuspend drilling in its dry gas Huron shale acreage (also in Appalachia) in January due to low natural gas prices, itcontinues to drill in the Marcellus as reduced service costs, better performance, and a liquids component keep drillingin the play economic. EQTs midstream business is also benefitting from the development of the play, with thecompany on track to add 445 mmcf/d of gathering capacity (85% of its year-end 2011 total) in 2012. The companyalso plans to expand its Equitrans Pipeline this year by 70%, as this pipeline runs right through the Marcellus shale andis operating near full capacity.National Fuel Gas Co.: National Fuel Gas (NFG) is a diversified energy company primarily focused in the Appalachianregion. Our ratings on NFG primarily reflect the cash flow diversification and stability benefits of the companysregulated pipeline and storage and utility businesses, which mitigate its exposure to higher-risk oil and gas E&Pactivities through its subsidiary, Seneca Resources Corp. NFG has a long operating history in the Appalachian regionand holds one of the largest positions in our rated company universe in the Marcellus play—745,000 net acres. NFGsnet Marcellus production reached 200 mmcf/d in July 2012, accounting for over 65% of the companys total volumes.As a result of low natural gas prices, NFG has reduced its fiscal 2013 cap-ex budget in the Marcellus. Despite areduced drilling program, the company still expects its Marcellus production to increase by 35% in fiscal 2013.Although most of the companys acreage is in the dry gas window, and is therefore not currently generating strongreturns on the upstream side, the company is benefitting from midstream opportunities. NFG has nearly 2.0 bcf/d ofpipeline and gathering system expansions underway, which would more than double its current capacity in the area.These expansions are primarily geared toward third-party volumes rather than the companys own use, given that itsdry gas economics are currently challenged.WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 16 1023527 | 301674531
    • How The Marcellus Shale Is Changing The Dynamics Of The U.S. Energy IndustryRelated Criteria And Research• How Horizontal Drilling And Fracking Have Reshaped The U.S. Energy Landscape, Sept 17, 2012• The Shale Gas Boom Is Shaping U.S. Gas Pipelines New Reality, June 5, 2012• Standard & Poors Raises Its U.S. Natural Gas Price Assumptions; Oil Price Assumptions Are Unchanged, July 24, 2012• Standard & Poors Revises Its Natural Gas Liquids Price Assumptions For 2012, 2013, And 2014, June 11, 2012• Key Credit Factors: Criteria For Rating The Global Midstream Energy Industry, April 18, 2012• Key Credit Factors: Global Criteria For Rating The Oil And Gas Exploration And Production Industry, Jan. 20, 2012Additional Contact:Jack R Kilgallen, New York (1) 212-438-3303; jack_kilgallen@standardandpoors.comWWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 15, 2012 17 1023527 | 301674531
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