How To Play The Natural Gas Revolution

by: E.W. Barnaba

Buy natural gas.

You hear it so often in the financial news that it's become a sort of mantra. And for good reason. In the past few years, the widespread adoption of fracking has triggered a boom in the production of natural gas in North America. It stimulates economic growth in the areas where it's produced. It generates power more cleanly and more efficiently than coal. And thanks to the supply glut since the advent of fracking, it's cheap.

The stars are aligning to make natural gas America's fuel of choice for the next few decades, as it can be used as both a fuel for vehicles and power plants, and a feedstock for chemical companies to make myriad plastics and polymers. Access to cheaply abundant nat gas has encouraged numerous manufacturers to ramp up production now that the cost of powering their factories has been slashed.

And most recently, a report commissioned by the Department of Energy has stated that exporting natural gas - while ultimately raising prices on consumers at home - would have a profoundly positive net impact on the American economy.

There's little debate that natural gas will play a large role in America's future. But the best way for investors to capitalize on it is another matter.

Here are a few ideas on how to ensure that natural gas has a profoundly positive net impact on your portfolio as well.

The Direct Play

At first, it would seem to make sense for investors to seek exposure to the commodity itself as a direct way of profiting from the natural gas boom. But I'd recommend against it, for several reasons.

First of all, the chart below demonstrates that the price of natural gas as a commodity is highly volatile, and has recently had difficulty holding on to its gains.


Although it appears to have bottomed at around $3.00, it's formed a double-top with its most recent attempts to breakout above $4.00. The run-up from September through mid-October was fueled by speculation on a cold winter, and therefore higher demand for gas via greater energy usage in the heating of homes.

But the winter hasn't shaped up like it was supposed to, and any play investors make on the commodity itself is subject more to the whims of Mother Nature than anything else at this point.

An investor determined to seek direct exposure to natural gas might try to play the price swings via a tracking ETF like the United States Natural Gas Fund (NYSEARCA:UNG). But since it tracks the futures instead of the hard commodity, it's subject to constant decay through roll-yield and contango, eating away at profits the longer it's held. Additionally, supply is projected to outpace demand for natural gas for the foreseeable future, working to keep its price at or around its current levels.

I wouldn't recommend buying natural gas as a commodity for the reasons above. But there are better ways to buy natural gas than to buy the gas itself.

The Production and Pipeline Play

Just like investors seeking exposure to gold will buy stock in gold mining companies, those who want to benefit from natural gas can buy shares of natural gas exploration and production outfits.

But since the price of the gas is so low, the margins - and therefore the earnings - of most natural gas producers aren't necessarily stellar. That's why one of the best ways to play natural gas isn't to buy shares of the companies that extract it, but rather to buy into the companies that move it around the country.

Linn Energy (LINE) is one of the better buys in this category. The company has a strong balance sheet, an attractive 7.7% yield, and a conservative strategy that appears to be paying off. The company acquires mature oil and natural gas fields with long production lives from other producers - like Chesapeake Energy (NYSE:CHK) - who are in a hurry to raise cash. As a result, it benefits from the natural gas boom without taking on much of the risk associated with exploration and drilling. And as it continues to acquire, its profits will continue to grow.

The company is, however, a Master Limited Partnership, which means that its yield and gains are taxed differently than normal stocks. Luckily, the company recently created LinnCo (LNCO) - an entity with the sole purpose of owning shares of Linn Energy. Investors who buy shares of LinnCo will lose a little bit of the yield (7.5% vs 7.7%), but they will still gain exposure to Linn's growth potential while saving themselves a headache around tax season.

The Speculative Play

Linn Energy and LinnCo are by no means done growing. But they've already experienced their explosive breakouts, leaving their growth at a steady, yet diminished rate.

Investors who are willing to take on more risk for more reward might consider Dejour Energy (DEJ).

I've written previously about why I think Dejour is poised to breakout next quarter, but in short, the company is a Canadian-based oil and natural gas exploration outfit that has just recently begun production at its most promising property - Kokopelli. The company has a $34 million market cap, yet has claims to over $94 million of proven reserves alone at Kokopelli.

Additionally, the company recently announced a deal with an undisclosed oil and gas producer to provide capital for it to further develop its production capacity.

The company's stock is up 25% since I wrote my first article about it, but I think it's still a good time to buy as it's incredibly undervalued and just beginning to produce.

However, there are still risks involved with buying into the fledgling company, as the company has yet to post a profitable quarter despite having produced at another of its properties - Woodrush - for over a year.

The Indirect Play

Lastly, for those looking to make a backdoor bet on natural gas, Quanta Services (NYSE:PWR) offers an interesting option.

Quanta builds energy infrastructure, including power lines and natural gas pipelines. Its latest quarterly statement shows a strong balance sheet with over $5 billion in assets and under $2 billion in liabilities. The same statement also shows a work backlog of about $4 billion, roughly $800 million of which stems from orders to build natural gas pipelines. Considering that the market current values Quanta at $5 billion, it's a good value buy for long-term exposure to natural gas.

As more and more natural gas is produced in this country, more pipelines will need to be built in order to transport it. Additionally, much of the existing energy infrastructure in America is outdated, and Quanta is one of the companies that will help update it.

The company is having a great year so far, with diluted earnings of $0.98 per share through the first three quarters alone, compared with diluted yearly earnings of roughly $0.78 per share on average throughout the past 5 years.

Investors who want to avoid the risk associated with energy producers should strongly consider Quanta. It doesn't matter who produces the gas or how much it costs. As long as Americans are using natural gas to generate power, Quanta will profit.

Parting Thoughts

Obviously, there are literally hundreds of other ways for investors to make a play on natural gas - more than I could ever hope to write about.

But natural gas' rise to prominence in America's energy landscape is inevitable, and the companies mentioned in this article provide reasonable expectations of profits for investors who use them as their vehicles to gain exposure to the trend.

Trade wisely. And buy natural gas.

Disclosure: I am long DEJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.