Saturday, November 26, 2011
How to Profit from Natural Gas The Safe and Smart Way
(via Wall Street Daily)
Natural gas prices are at historical lows.
Increased production and an abundance of supplies have knocked the price of natural gas down 61% from its highs.
Many investors have given up on trying to profit in this market. But quitters never win. And as a cheap alternative to foreign oil, natural gas demand will inevitably rise in the coming years, which will drive the price higher.
However, our best entry route is a little unconventional – it’s via natural gas master limited partnerships (MLPs).
MLPs – the Toll Roads of the Natural Gas Industry
Simply put, MLPs take a tiny piece of the revenue from each barrel produced, no matter the price of natural gas.
What’s more, with solid fundamentals and favorable market forces behind them, MLPs are easily my favorite investment over the next 12 to 18 months.
You see, because MLPs own and operate natural gas pipelines, they enjoy a beneficial corporate structure: In return for passing on most of their profits in the form of dividends, they receive lower tax rates.
So rather than speculating on natural gas, think of MLPs as a toll road – collecting fees for moving gas.
Their exposure to the price of natural gas itself is actually limited, so there’s no need to speculate on an uncertain future. Yet, they still benefit from the rapid growth in the natural gas industry.
So which MLPs are best?
Natural Gas’ Sweet Spot
The natural gas industry is split into three main areas:
~ Upstream: The exploration and drilling of natural gas.
~ Midstream: Collecting, processing, transporting and storing gas.
~ Downstream: The utility companies that sell to end users (downstream).
The most favorable type of MLPs today operate in the midstream area.
As you can see, the number of natural gas rigs is rising in some key regions:
So with natural gas production on the rise, the infrastructure to deliver it must grow, too. And it will…
Over the next 20 years, between $130 and $210 billion will be spent on expanding natural gas infrastructure, according to the Interstate Natural Gas Association of America.
That means MLPs will own more pipelines and processing facilities. The extra money they make will, in turn, be paid out to investors.
Industry Growth Meets Investor Needs
Aside from the fundamentals, there are also some powerful market forces driving MLPs’ growth prospects…
Market Force #1: Investors Are Shying Away From Risky Assets. As a result of investors’ flight to safety, MLPs have started to shift toward more fee-based contracts and away from those that expose them to natural gas price fluctuations. This increases their stability in a risk-averse environment.
Market Force #2: Low Interest Rates. With MLPs offering high, safe dividends, the sector will continue to attract new investors until interest rates rise.
Market Force #3: Historical Value Suggests a 31% Surge. Over the past 15 years, the average yield on the MLP Index has clocked in 3% higher than the yield on U.S. Treasuries. Today, it’s 4.37% higher. Given the current dividends on MLP stocks, their share prices would need to rise by 31% to bring the yield in line with the historical average.
Market Force #4: Institutional Growth. The MLP industry is just getting large enough – crossing the $215 billion mark – where big pension plans and endowments are starting to invest.
Market Force #5: Merger Activity Ahead. With $145 billion in oil and gas deals already taking place in 2011, expect buyouts to keep driving share prices higher.
Market Force #6: Robust Oil Prices. Natural gas prices don’t mirror oil prices. But the price of by-products – called natural gas liquids (or NGLs) – do. With oil prices rising, MLPs with a heavy NGL business will see bigger profit margins.
Not All MLPs Are Created Equal
When gauging growth MLPs, most investors look at the yield first. But you need to consider a few other things to make sure you’re getting enough return for the risk you take.
To determine growth, the key feature is location, location, location.
The MLPs with assets near the fastest-growing natural gas sources – like the Eagle Ford, Marcellus and Bakken shales – can expand the fastest.
It’s also important to consider MLPs’ exposure to natural gas prices. Do this by looking at their contract mix and how much of their business comes from NGLs. Fewer NGLs and more fee-based contracts means less volatility from energy prices. More NGLs and variable contracts mean more volatility.
With these elements factored in, here are two MLPs that I expect to do very well over the next year.
~ Buckeye Partners LP (NYSE: BPL): If you don’t want exposure to oil or natural gas prices, look at Buckeye. The company focuses heavily on transportation with fee-based contracts. In fact, only about 3% of the company’s earnings are tied to commodity prices. The stock currently yields 6.47% and has grown its dividend by 5.88% per year for the past five years.
~ Enterprise Products Partners (NYSE: EPD): If you think oil and natural gas prices will rise, Enterprise is the business for you. This MLP will benefit from growth in the Eagle Ford shale. Plus, nearly 70% of its contracts are tied to commodity prices. It currently pays a 5.39% dividend that has grown 6% each year.
Ideally, you’ll want to exit these positions before interest rates rise. But that shouldn’t happen for at least a year. Until then, consider natural gas MLPs as your income portfolio’s saviors.
Courtesy Matthew Weinschenk via Wall Street Daily - In a World of Liars, the Truth Starts Here. (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
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