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The Smart Way to Play the Natural Gas Boom

By Mad Hedge Fund Trader | Wed, 05 December 2012 22:01 | 1

Throughout my travels around the world there is one question I can count on getting from every audience, be it in the US, China, Europe, and even the Middle East: Where can I find some yield?

The favored answers are junk bonds, high-dividend equities, and emerging market sovereign debt issued by countries like double-digit yielding Brazil. In the US, yield-motivated investors have gravitated towards Master Limited Partnerships to focus their activities on the oil industry. The only problem is that over the last 14 years, crude has soared from $10 to $150, then back down to $90. It's enough price volatility to leave owners reaching for the Dramamine.

There is a way to capture these eye-popping returns without having to take an "E-ticket" ride. That is to focus on MLP's that only invest in the natural gas industry. Its 14-year price history saw it soar from $2 to $17, then back to $2. It now hovers around $3.70. The smart way to play here is to own securities that benefit from the increasing volume of natural gas production, and not the price.

The horrific downside risks that hang over oil investments are missing with that simplest of molecules, CH4. That means investors can lock these up in long-term portfolio's without fear of them vaporizing when they are not looking, and let the, sometimes, double digit generous cash flows roll in. The great thing about gas is that it has already crashed.

Until very recently, natural gas was considered an energy source of the past. Up until the mid 2000's, energy experts believed that our natural gas reserves had all but dried up and what was left was inaccessible. Hurried plans were made to import gas from the Middle East, with Qatar and other countries building extraction wells which would eventually supply the U.S. and Europe.

Natural Gas Spot Price

Oil, alternative energy, nuclear, and coal became the focus of the media and equity research community. Due to sudden technological advances in hydro-fracking and dual-sleeve piping, this long-forgotten energy source is now at the forefront of energy development in the United States. Natural Gas is playing an increasingly crucial role in our overall energy makeup.

Natural Gas Extraction

The International Energy Agency (IEA) in their 2012 World Energy Outlook pumped up natural gas as the dominant fuel source in the future global energy composition. By 2035, total energy demand will increase by over one-third of today's levels, with China, India, and the Middle East accounting for 60% of that increase. The IEA predicts that hydropower, wind, and solar energy will account for almost one-third of the total energy output by 2035.

Due to the Fukushima Daiichi disaster caused by the tsunami in Japan, there will be a reduced role for nuclear power. France and Japan, two heavily nuclear reliant countries, have affirmed their intention to reduce the use of this controversial source. In the United States and Canada, nuclear power is being challenged by relatively cheap and domestic oil and natural gas.

The IEA projects the United States to become the largest global oil producer within a decade, surpassing Saudi Arabia by 2020. Natural gas predictions tell a similar, yet distinctive, story. Gas is the only energy source for which global demand increases in all scenarios.  As the U.S. becomes more dependent on natural gas, our coal and oil resources will be exported to China, India, and Europe. In fact the IEA estimates that by 2030, natural gas will overtake oil as being the largest fuel in our energy mix.

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Currently, America is spending $35 billion dollars a month importing oil from the Middle East and Canada; this accounts for 58% of our total energy use. These imports come with huge tax subsidies provided by the government, so oil companies can reap windfall profits and consumers can pay lower prices at the pump. In addition to the financial burden oil causes, it has fueled political turmoil in the Middle East and Africa for almost half a century. Natural gas is clean, cheap, and above all, a domestic resource. The continued expansion of natural gas in America comes with fewer financial, political, and environmental consequences in comparison to other fossil fuels.

Gas has environmental benefits as well. Its "fossil fuel" status has put many environmentalists in violent opposition to the idea that it will become the dominant fuel source of the future. Although their concerns about water table contamination and CO2 emissions are valid, natural gas is definitely a lesser evil. Gas emits no toxic particulates when released into the atmosphere. It emits 50% less CO2 than gasoline and coal. In terms of fossil fuels, it is by far the cleanest and safest resource available.

Monthly Dry Shale Gas Production 1

Furthermore, natural gas fueled power plants are much cheaper and easier to operate compared to its dirty counterparts. Regarding water pollution, most, but not all natural gas reserves are located more than 5,000 feet below the water table. If fracking and gas extraction are done properly, ground water contamination should be non-existent.

The United States already has the most extensive natural gas pipeline network in the world. This includes over 2 million miles of pipeline connecting all the major cities and millions of homes in America. Its cost is far less than the price of oil. Natural gas currently trades at $3.70/MMBTU, while oil costs $88/barrel. That means gas is 75% cheaper than Texas tea on a BTU equivalent basis.

Billions of dollars will be saved on transportation costs, as our gas production will be purely local. The United States has uncovered abundant reserves which some predict will last for 150-200 years. Not only do the main 48 states have huge reserves, but large deposits have been found in Alaska as well.

The recent discovery of new sources of natural gas is not just limited to the United States, but other countries as well. China is estimated to have more gas than the United States. The problem is that China has 1.4 billion people living on top of these reserves and their tap water is already undrinkable. China faces much more political and environmental complications with gas extraction compared to the United States. With different geology, gas in the Middle Kingdom can only be found in smaller, deeper pools that are farther apart than in the US, doubling their production costs.

Many of the mammoth natural gas reserves in the U.S. are in areas that are sparsely populated, making extraction less complicated; America's pre-existing pipeline network also gives it a huge jumpstart in the industry. Gas has also been discovered in Australia, Russia, Qatar, Iran, and in offshore areas of East Africa and Israel.

Natural gas exploration will have a profound effect on numerous industries. Oil companies already know this and many of them have been spearheading the development of natural gas technology as fast as possible. Car companies can also expect to see a huge shift towards natural gas vehicles (NGVs) as gasoline powered cars will be a thing of the past. Natural gas, like oil, has many tradable and liquid master-limited partnerships (MLPs). This is where things get really interesting for the individual investor.

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MLPs were enabled by an act of congress about 25 years ago to foster U.S. domestic energy independence. Today there are about 78 publicly traded MLP's, a few of which I mentioned in my oil MLP piece (click here for "Reach for Yield With Master Limited Partnerships"). MLPs trade just like stocks, pay large dividends quarterly, and are not highly correlated to the S&P 500, the bond, or commodities market. This unique non-correlation feature adds diversification to any portfolio.

MLPs also have attractive yields that grow with dividends that increase an average of 6% rate per year. They offer tax-deferred income and have annuity-like cash flows with inflation adjustments. MLPs have cash flow generating assets such as pipelines, storage facilities, and processing plants. As the Bush tax cuts are due to expire and tax rates go up, the high yields and tax advantages of MLPs will increase in value.

Natural Gas MLP Investments

Spectra Energy Partners LP (SEP) is a natural gas MLP that extracts, transports, and stores natural gas. They have access to over 3,200 miles of interstate pipelines and numerous long-term delivery contracts. It operates in the Southeastern part of the United States, primarily in the states of Texas, Virginia, and Louisiana. On July 2011, it expanded its assets by buying the Big Sandy Pipeline from the EQT Corporation. This has caused a $4 million increase in their EBITDA through lower operating expenses, and higher than forecasted equity earnings.

(SEP) has increased their dividend 19 consecutive quarters and its current dividend yield stands at a robust 6.58%. On October of this year, they announced plans to buy a 38.8% stake in Maritimes & Northeast Pipeline for $545 million. The Company is growing through leaps and bounds, with a 79.51% profit margin this year. It has a smaller market cap compared to its competitors, but it intends to grow significantly in the near future.

Spectra Energy Partners

Cheniere Energy, Inc. (LNG) is one of the few producers of natural gas liquids (NGLs) in the United States. The company runs a limited partnership MLP called Cheniere Energy Partners LP (CQP). Any company that is involved with processing, storing, fracking, or transporting liquid natural gas is doing extremely well. Due to Hurricane Sandy the company faced a recent drop in stock value, but it is on the rise again. (CQP) has a current dividend yield of 8.15% with an annualized dividend of $1.70. As a natural gas MLP investment, (CQP) should be at the top of your list.

Cheniere Energy Partners

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El Paso Pipeline (EPB) is a natural gas MLP that was acquired by Kinder Morgan just this year. It has expanded to 42,000 miles of pipeline and growth is expected to continue as the United States accelerates its move towards natural gas. El Paso's net income has grown 7.2% this past year and will continue to hit similar targets for the next five years. Its forward earnings multiple is 17.3, which is strong compared to the rest of the industry. El Paso Pipeline acquired large stakes in Cheyenne Plains Investment Company, LLC (CPI) and Colorado Interstate Gas Company, LLC (CIG) on May 24, 2012, which further boosted their earnings potential. The company has a dividend yield of 6.3% and a market cap of 8 billion. I would recommend investing in this MLP.

EL Paso Pipeline Partners

Buckeye Partners (BPL) is another MLP that is high yield, but also high risk. The company has spent around $270 million on expansion and cost reduction efforts this year. This boost has helped the company gain stronger ground with its competitors. Although they faced some damage recently due to Hurricane Sandy, the company reports that they successfully restarted operations.

Buckeye Partners owns and operates one of the largest independent liquid petroleum products pipeline systems in the U.S. and has over 6,000 miles of pipeline. They also own some of the largest high-performance natural gas storage facilities in California. The company has a profit margin of 5.56% and a forward P/E of 15.14. Their 5-year expected PEG ratio is 3.93 and its price to book is 2.03. These strong numbers and a dividend yield of 8.27% make the company worth considering.

Buckeye Partners

By. The Mad Hedge Fund Trader

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  • max on December 07 2012 said:
    you wrote: " The smart way to play here is to own securities that benefit from the increasing volume of natural gas production, and not the price."

    What the hell does this mean ?

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