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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.

For regulated utilities, lower natural gas prices can be a positive since they mean lower customer bills. “It’s just a pass-through to the end user,” says Andy Pusateri, senior utility analyst, Edward Jones, in St. Louis, Missouri, in an interview. “Lower natural gas prices help gas distribution utilities — such as WGL Holdings, Inc. (WGL) — a little bit because the overall customer bill is lower, and there’s less bad-debt expense.”

Further, utilities are able to expand their infrastructure to reach more and more customers who want to take advantage of low gas prices. They’re also “opening up a new source of low-cost electricity and opportunities to increase gas-generation capacity,” Miller notes.

As the key driver for utility business growth, an expanding customer base is what analysts primarily eye. Other criteria include “areas where utilities can invest capital and achieve strong regulated returns on that capital,” Miller says. “Specifically, we look for utilities that are in areas that might need new infrastructure or upgrades to existing infrastructure.”

Some utilities own midstream assets. For example, Spectra Energy Corp. (SE) and CenterPoint Energy, Inc. (CNP), both have natural gas pipelines. Spectra, in addition, owns gathering and processing systems.

“Spectra has good growth opportunities and lower-risk, fee-based projects,” says Pusateri. “The majority of its earnings are coming from regulated or contracted business.  It has the greatest opportunity to grow by doing projects like building more pipelines – and the majority of that growth is regulated growth.”

Several midstream companies are structured similarly to utilities. “The pipeline companies get paid a fee for every molecule of gas they move through the pipeline, and they’re guaranteed the volume. These [firms] are very stable, have a high payout and are a very defensive business model,” Oldham says.

Attractive Rates of Return

Pipeline companies are smart investments because, as do others in the midstream space, they generate consistent cash flow. “The majority of natural gas pipelines are regulated by the Federal Energy Regulatory Commission (FERC). Like regulated utilities, these pipelines are allowed to earn a return on investment to cover their costs, plus a reasonable return,” notes Pusateri in his “Energy Sector” report of January 2012.

“Returns have averaged 10%-13% historically,” he explains. “Gathering pipelines are smaller pipes that move gas from wells to larger pipelines that transport the commodity over larger distances.”

To be sure, increased gas production, and even low natural gas prices, are upbeat developments when it comes to pipeline firms. “For the most part, we view the pipeline companies as toll-takers, just like on a toll road,” Tonet says. “Margins are simply volume times tariffs. In addition to the supply push from liquids-rich production, volumes’ growth is a function of energy demand at the end of the pipe, and we’ve seen that steadily increase over the years. So, to the extent that low [natural gas] prices incentivize increased demand, that is a positive for the midstream space.”

Another chief spur to midstream growth is mergers-and- acquisitions activity. Such melding achieves critical economies of scale. “This highlights the value of the assets of the companies that are purchased,” Tonet says. “They have strong platforms that position the acquirer to expand upon them and continue to grow.”

Two of the largest midstream acquisitions ever are now taking place. They are Kinder Morgan Inc.’s (KMI) purchase of El Paso Energy Corp. (EP) – which says it owns North America’s largest interstate natural gas pipeline systems – and the merger of Southern Union Gas Corp. (SUG) with Energy Transfer Equity (ETE). Kinder Morgan claims that its takeover of El Paso will create the biggest midstream company in North America.

Many upstream companies— the E&Ps — that own midstream businesses are spinning them off into MLPs, Pratt notes. “Historically, a number of upstream companies have midstream businesses collecting, gathering and transporting their gas,” he says. “Over the last year and a half, we’ve seen a trend of their spinning off these assets into a separate public entity, mostly MLPs, which are structured as income-distribution vehicles for shareholders.”

Other potential opportunities include exporting liquefied natural gas (LNG) and deep-water drilling production. Exporting natural gas as LNG, which requires the gas to be frozen and condensed into a liquid to reduce its size for cheaper transport, calls for midstream firms’ expertise and systems, to be sure.

All the new natural gas production is “backing out imports from Canada, which we’ve seen start to decrease,” says Tonet. “That’s part of the case for new pipeline build-out.”

Exporting would lead to higher natural gas prices and, notes Oldham, “the need for more infrastructure, higher spending and therefore higher asset opportunities, which leads to the ability to eventually distribute more cash.”

Technological improvements in seismic wave techniques now allow companies to discover new resources below the ocean floor. Once offshore gas production picks up significantly — in the wake of events such as Hurricanes Katrina and Rita — natural gas deep-water drilling is forecast to increase as well.

“You’ll begin to see more projects to bring offshore hydrocarbons back onshore. Midstream companies will play a large role in that,” Stevens says.

By and large, the ultimate driver of the natural gas industry is energy demand. “The more we consume, the more pipeline [that] companies transport — and the more growth opportunities there are for them,” says Tonet.

More good news: Discovery of new unconventional gas fields will trigger the need for some companies to make additional major investments in infrastructure. “Midstream companies will benefit from all the activity that will be going on,” Pratt notes.

An exciting example was the reawakening, a few years back, of the Marcellus Shale, a large unconventional gas field in the Appalachian Mountains from West Virginia to New York. “Marcellus had many pipelines running across the area, but it wasn’t a material producing region for more than 50 years,” Stevens says. “When unconventional natural gas was found, there was no real gathering or processing infrastructure in Pennsylvania. So, in the last three years, we’ve seen companies go in and aggressively build out gathering and processing infrastructure to support the Marcellus’ upstream development.”

There is no doubt that unconventional natural gas has been a game-changer not only for the industry but for the future energy supply of the United States. And with a substantial rebound in the economy, demand for natural gas should generally increase.

Natural gas firms stand to benefit, Oldham says, “as long as investors want and crave dividend yields and as long as the firms can continue to allocate capital at accretive rates of return and grow their distribution. As long as interest rates stay low, people will probably want companies that pay a nice yield. The utility space and the midstream/pipeline space is a good place to find that.”


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