Steady Streams

An unusual — and stunning — thing happened on the way out of the financial crisis: In 2009, the United States became the world’s largest producer of natural gas.

That feat was made possible by the development of new drilling techniques that allow some energy companies to recover oil and natural gas — a mixture of hydrocarbons and non-hydrocarbon gases in rock formations, and the cleanest fossil fuel — in places they were previously inaccessible or too costly to capture, especially shale rock.

The industry-changing techniques are horizontal drilling, in which the drill bit curves and becomes horizontal underground,  in combination with hydraulic fracturing (fracking), which breaks up rock formations with chemicals and water pressure.

In fact, U.S. companies have so excelled at producing unconventional natural gas — gas that cannot be drilled and extracted vertically — that U.S. demand has not been able to keep up with supply. In 2011, demand rose 2%, but production continued to grow at about 6% or 7% year over year. Indeed, there is sufficient recoverable natural gas to supply America for at least a century.

As recently as 2006, conventional wisdom said that America would need to import natural gas. Now, with the development of shale gas fields, that outlook has been turned 180 degrees; and there are even plans to export our natural gas.

The discovery of new shale plays over the past few years — some 20% of production comes from natural gas extracted from shale rock — has, of course, brought with it the need to distribute, transport, gather, process and store the gas. This requires new infrastructure for the replacement of aging pipelines and other systems.

The component of the three-stage energy chain that provides this infrastructure is known as the “midstream” space — and it’s a dynamic area. Indeed, the remarkable production increases of exploration and production, or E&P, firms — the “upstream” sector — has also meant boom times for midstream companies. These stable, regulated firms offer attractive investment opportunities that pay out a high percentage of earnings.

“Midstream companies have had so much asset growth and the opportunity to grow their distributable cash because E&P companies have been saying, ‘We need you to build this pipeline, and we’ll give you a 15% on equity in exchange.’ That’s a good investment,” says Ryan Oldham, manager of Fidelity Investments’ Select Natural Gas Portfolio (FSNGX), based in Boston, in an interview.

“Midstream is a highly defensive industry with a growth dynamic — a good news story in a lot of ways,” continues Oldham. “The beauty of these companies is that there’s a backlog of infrastructure to build out. That’s a secular tailwind.”

Utility Developments

Moreover, several utility companies — typically part of the energy chain’s “downstream” space — also own midstream assets. Distribution utilities, which bring the gas to end-users, offer significant investment appeal as well. Utilities are especially attractive investments during this time of ongoing low interest rates: They are stable and pay a large percentage of their earnings in dividends.

With their consistent cash flows and regular dividend hikes, utilities and midstream companies are obviously conservative investments. Midstream firms receive fixed fees from E&Ps; consequently, their business growth is not directly driven by natural gas price fluctuations at the wellhead. Following a months-long dip, prices this year are expected to rise to $3.00-$3.50, analysts say.

Hence, rather than commodity-price movement, midstream companies’ key revenue-growth driver is natural gas volume. Pipeline companies, for instance, charge E&Ps a tariff for transporting the gas, and this tariff remains at the same level throughout the cycle. The addition of new lines of revenue for the midstream sector comes from infrastructure build-out.

“Midstream companies occupy a neat place in the energy value chain,” says Jason Stevens, director of energy research for Morningstar, in Columbus, Ohio, in an interview. “They are typically insulated from direct commodity price exposure but benefit from the increasing costs of gas production. I’d consider diversifying and putting at least a portion of an investor’s energy allocation into midstream companies. You’re going to get a very solid distribution with pretty key growth prospects.”

“In markets like this,” Stevens notes in his “Energy Outlook” report of December 2011, “we favor more defensive stocks, such as pipelines … Midstream stocks are closest to fully valued, at a price/fair value ratio of 0.98.”

Many midstream companies are structured as master limited partnerships (MLPs), which are tax efficient and allow companies to pass on earnings power to their limited partners, the investors. Stevens is watching several MLPs that he believes are well positioned to benefit from the current surge of natural gas liquids production.

Earlier this year, several E&P companies shifted focus to liquids-rich production in response to lower “dry” gas prices. The move emphasizes oil production, with firms drilling for “wet” gas, which contains oil. Such liquids-rich plays often have a fairly high gas component too.

One natural-gas firm that Stevens singles out is Oneok Partners, a segment of Oneok, Inc. (OKE). Oneok Partners gathers, processes, stores and transports natural gas. Further, it owns systems that connect natural gas liquids supply with major market centers.

Liquids-rich gas is drawing great interest. “We think that both the gathering and processing of liquids-rich natural gas and the long-haul transportation of liquids are attractive parts of the energy value chain to invest in,” says Jeremy Tonet, senior analyst-energy/master limited partnerships, J.P. Morgan, in New York City, in an interview. “There are secular trends that underpin longer-term growth in these areas. Increased production is overwhelming existing infrastructure; therefore, we need a significant build-out of new energy infrastructure to bring these commodities to market.” Stable Sales

Like midstream companies, rate-based utilities boast a notably stable revenue stream since they also operate on fixed contracts to move the gas through their systems. With their concentration on low-risk, fee-based projects, utilities are gaining from the huge increase in natural gas production. And nowadays, they clearly represent a good alternative to investing in bonds.

“When interest rates are low, it makes sense for investors to shift to higher dividend equities like utilities. It’s a counter-investment to bonds,” says Daniel Pratt, director of E&P coverage for the research firm, IHS Herold, in Norwalk, Conn., in an interview.

Right now, dividend yields are particularly attractive when examined in relation to interest rates, and income-oriented investors can find good values. “Whether or not we have an economic rebound in the U.S., we expect utilities to continue to be a consistent source of earnings, as historically there has been relatively little change in energy consumption through the economic cycle,” says Travis Miller, director of utilities research for Morningstar in Chicago, in an interview.

Miller’s top picks include Exelon Corp. (EXC), National Grid (NG) and PPL Corp. (PPL). Nation Grid, for instance, offers “one of the most attractive total-return packages in the sector,” explains the analyst in his “Utility Outlook” of January 2012.