Put Money in Those Pipelines

 | Apr 01, 2013 | 1:05 PM EDT  | Comments
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Stock quotes in this article:

xom

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cvx

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rds.a

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chk

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eog

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nbl

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se

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sep

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wmb

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wpz

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kmi

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kmp

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trp

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d

For natural gas, opportunities are just beginning to surface, and more will emerge as it becomes clear that natural gas has become the fuel of choice. Speculative investors may prefer the exploration and production (E&P) end of the value chain. However, those seeking safer returns may prefer the middle ground, where the nation's interstate pipeline companies operate.

Fuel competitors hate natural gas, and coal and nuclear industries believe natural gas is just a flash in the pan. They argue price volatilities make natural gas an unreliable fuel. As evidence, they point to historic prices published by the Energy Information Administration, noting that the price curve resembles the ears of the devil.

Critics are wrong. Natural gas is not a flash in the pan. While the devil is in the details, past prices have little to do with the future.

Just one decade ago, conventional wisdom argued that North America was rapidly depleting its gas wells. As domestic supplies evaporated, the nation's future depended on imports. Dozens of companies began building liquefied natural gas import facilities to host, process and convert foreign gas. Five years ago, 15 LNG import facilities had been built to serve the North American markets. Each one cost more than $1 billion.

In the international markets, LNG is frequently indexed to crude oil prices. As a result, in order to attract foreign LNG supplies to North America, domestic natural gas prices needed to climb -- and climb they did. For North America, natural gas was becoming as costly as oil. Utilities panicked, building owners freaked and commodity traders engaged.

Then two surprises occurred. The U.S. economy suddenly retreated and shale technologies were quickly adopted. Natural-gas prices sank and LNG import facilities saw revenues evaporate.

Now it appears North America will not need to import natural gas for a long time. The threat of high prices disappeared. The devil will not grow another ear, and price spikes are not imminent.

It is slowly occurring to policymakers, utilities and consumers that the fundamentals have changed. The change appears permanent; concerns of the past seem irrelevant today.

Thank the markets -- they are doing the hard work. As more supplies become available, the market has been responding. When supplies tighten and prices elevate, producers respond and prices drift to a retreat. With more transparency and liquidity, backbreaking price volatilities seem to have become history.

Investment Framework

Natural gas has a value chain that is long, complex and full of opportunities. But the sweet spot for investors seeking a balance among risk, reward and income is in the middle -- specifically, it's in the pipelines that link consuming customers to the wellheads.

As one who has worked in the industry, I've learned that the other segments of the value chain introduce different risks and rewards. For example, the closer investors operate to the consumer end, the higher the risk and the more intense government regulation -- and the lower the return. It seems that, at the very end of the value chain -- where energy service providers traditionally operate -- has unwarranted risk and tiny rewards.

At the very beginning of the value chain are E&Ps, and most of them straddle several businesses. Some focus on oil, and these only process natural gas and natural gas liquids (NGLs) as sideline businesses. Some focus on natural gas, and they only process oil and NGLs as sidelines. Yet other companies, like Exxon Mobil (XOM), Chevron (CVX) and Royal Dutch Shell (RDS.A), try to do it all. Finally, others -- like Chesapeake Energy (CHK) and EOG Resources (EOG) -- prioritize one business segment over the other, depending on near-term and localized opportunities.

Interstate Pipelines are Different

The U.S. natural gas pipeline system is huge and growing (see EIA's map of the nation's natural gas pipeline network. Notice that there are two types: interstate and intrastate.

Unlike E&P companies, interstate pipeline companies are lightly regulated by the Federal Energy Regulatory Commission. Most important, FERC regulates them as cost-plus enterprises. This is a key consideration.

As cost-plus enterprises, pipeline companies have minimal exposure to commodity risks. They generally do not own the commodity in their system. In addition, price risk is generally absorbed by commodity owners.

Some of the nation's largest pipeline systems are owned by Spectra Energy (SE/SEP), Williams (WMB/WPZ), Kinder Morgan (KMI/KMP), TransCanada (TRP/TCP) and Dominion Resources (D). In all likelihood, these companies will continue to perform.

As growing amounts of coal exit the power markets, the gas markets will respond -- and, as gas markets incentivize production, pipelines will have to deliver. In the end, it is a wellhead-to-burner-tip business, and pipelines make the connection.

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