Natural Gas Stocks Poised to Rebound

As the financial crisis unfolded, prices of natural gas collapsed, falling from $14 per million British thermal units to $3.10 this year. That hurt profits of gas companies and sent the stocks reeling. Now some fund managers argue that natural gas prices are poised to recover.

The managers say that the gas stocks represent bargains for investors who have the patience to wait for a rebound. “We are at the early stages of a rally that could occur over the next several years,” says Kent Croft, portfolio manager of Croft Value Fund.

Croft says that gas prices sank because of simple supply and demand. When the economy fell into recession, demand dropped as factories and power companies burned less gas. At the same time, supplies increased because of new technologies known as hydraulic fracturing. In this approach, drillers pump water and chemicals to release gas from previously untapped rock formations. The technique has spread rapidly around the country, opening up huge new reserves in Pennsylvania, Texas, Wyoming, and other states.

Now that excess supplies are helping to hold down prices, natural gas is becoming more attractive for many users. Factories that once burned oil are switching to low-cost gas. Besides being cheap, gas causes relatively little pollution. That is encouraging power companies to shut down their coal plants and shift to gas.

Gas is also emerging as a cheap fuel for vehicles. Already, 15% of the country's municipal buses and garbage trucks can run on gas. Commercial trucks have been slow to shift to gas. But now several gas companies have begun investing hundreds of millions of dollars to provide natural gas fuel stations at truck stops.

Until now, U.S. producers could only sell to North American users. Exports have been limited because supplies must be converted to liquefied natural gas (LNG) before the product can be shipped overseas. Few LNG facilities existed because they cost billions of dollars to build. But now companies are racing to open new plants that can support exports. A new facility in Canada should begin shipping supplies to Asian customers in the next two years. Developers are currently seeking government approvals for eight projects in the U.S.

All the growing demand should fatten the bottom lines of gas companies. “Over the next 10 years, demand for gas will grow, and that will push up prices,” says Tim Schwartz, portfolio manager of Schwartz Value Fund.

To profit from the growing demand, investors can buy shares of gas producers. A top choice is Ultra Petroleum, which produces gas in the Marcellus Shale field of Pennsylvania. “The stock is near its lows, but the company will do well in the future because it has huge new reserves,” says Croft.

Schwartz says that it is important to stick with low-cost producers. Because of the current level of low prices, many high-cost companies are barely profitable. But efficient producers can stay afloat in hard times—and deliver outsized earnings when gas prices rally in the future. A producer Schwartz likes is Southwestern Energy, which has a history of profits and large gas fields around the country.

Besides producers, Croft also likes pipeline companies. These charge producers fees for transporting gas. Revenue for the pipeline companies can be particularly reliable because the businesses are virtual monopolies.

Once a pipeline is built, competitors have trouble winning permits to build facilities in the same areas. When gas prices rise, pipeline companies cannot charge more. But their fee income rises as more volume flows through the pipes. So as demand grows, pipeline companies should report more revenues. The pipeline fees are limited by federal regulators. But regulators permit companies to increase fees along with the rate of inflation. A stock that Croft likes is Williams, which operates gas pipelines that serve New York and other areas. The company has healthy profit margins and pays a dividend of 3.9%.  

A cautious way to bet on a gas rebound is Hennessy Gas Utility Index Fund. The fund holds mostly regulated utilities that deliver gas to customers. Holdings include Spectra Energy and TransCanada. Most of the stocks pay reliable dividends. The fund has a dividend yield of 2.7%. Portfolio manager Skip Aylesworth argues that increasing demand for gas should enable the utility industry to grow and support rising dividends. Aylesworth says that the staid utilities can generate solid single-digit returns over long periods. “This is an industry that should grow 6% or 7% annually for years to come,” he says.

Some funds specialize in master limited partnerships (MLPs), which own pipelines. Many of the MLPs yield more than 5%. The yields are so rich partly because of the special tax status of the partnerships. To encourage construction of energy infrastructure, Congress granted tax benefits to MLPs. Under the rules, MLPs do not pay income tax as other corporations do. Instead, the income is passed along to shareholders who pay income taxes on their dividends.

A fund that holds a cross section of MLPs is ALPS Alerian MLP ETF, which yields 6.2%. Holdings include Kinder Morgan Energy Partners and Energy Transfer Partners. During the financial crisis, shares of MLPs sank as investors worried that demand for energy would fall. But in recent years, the stocks have begun to rally as investors have come to believe that the industry is on firmer footing.

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