Oil Is on the Outs in This Key End Market

Oil is a vital fuel source, but there's one area in which it is slowly and steadily losing its clout.

May 20, 2014 at 2:29PM

For years, oil has driven the world economy. It still does in many ways, but the availability of cheap natural gas in the United States is creating a problem for oil. While your first reaction may be natural gas-powered vehicles, the bigger problem oil faces is actually on the home front—home heating, that is.

Rolling it up
Star Gas Partners (NYSE:SGU) delivers home heating oil. For a very long time that was the fuel of choice for heating applications because it was easy and relatively safe to distribute. However, Star Gas ran into trouble a few years ago when oil prices spiked, leading the partnership to eliminate its distribution. That's a no-no for a limited partnership, and the units fell precipitously.

SGU Chart

SGU data by YCharts

Part of Star Gas' problem was, and still is, that its business model revolves around consolidating the fragmented oil delivery business. That requires the use of debt. However a large percentage of its customers had locked in oil prices in advance, a typical practice in the industry at the time. So when the commodity's price spiked, Star Gas' margins were painfully squeezed.

The distribution was the loser. After a distribution hiatus of nearly five years, Star Gas is back on its feet. The $0.09 a unit quarterly distribution, however, is still well below the $0.58 a unit quarterly payout back in 2004. That said, the new lower payment, which equates to an around 5% yield, is more sustainable.

The longer-term issue for Star Gas, however, is customer attrition. The partnership continues to buy new oil delivery services to offset customer losses. It has no choice. For example, when discussing solid fiscal second quarter results (years end September), management pointed out that "colder temperatures and the additional volume provided by acquisitions more than offset the impact of net customer attrition in the base business for the twelve months ended March 31, 2014."

A perpetual treadmill
Essentially, Star Gas has to be on a perpetual treadmill, always buying new distribution businesses so it can make up for customer losses. That isn't to suggest that Star Gas can't keep this model going and make plenty of money along the way, it can—particularly since it hit the reset button in 2004. However, it is an industry leader in a dying business.

Gasfurnace

(Source: Muggle99102, via Wikimedia Commons)

The interesting thing is that natural gas is the industry that's killing Star Gas's business. For example, New Jersey Resources (NYSE:NJR) noted in its annual report, "thanks to the current low price and convenience of natural gas, our conversion market remains strong, accounting for approximately 51 percent of our new customer additions." Those conversions are from oil to gas. And I'm living proof: The condo I live in made such a switch over the past year saving us thousands of dollars a year in heating oil bills.

So while Star Gas is always looking to buy new customers, natural gas utilities like New Jersey Resources have them lining up to come aboard. In fiscal 2013 (years end September) the company increased its customer base by 10%. New customer adds are expected to "contribute approximately $3.7 million annually in utility gross margin." And, New Jersey Resources expects to add "between 14,000 and 16,000 new customers over the next two fiscal years."

New Jersey Resources' dividend has headed higher every year for a decade. It currently yields around 3.4%. Although earnings can be volatile because of natural gas prices and weather patterns, the company's hedging efforts have kept non-GAAP earnings heading higher, as well, over the last few years. Notably in fiscal 2012, when the top line fell 25%, but hedges added around $20 million to the bottom line, salvaging what would have otherwise been a disastrous year.

Another gas market to examine
While natural gas ousting coal gets the big headlines, heating oil is losing big, too. Specialist Star Gas is proof of the impact of this transition, which makes boring natural gas utilities like New Jersey Resources an alternative play on cheap natural gas for those who don't want the volatility of owning a driller or prefer to avoid the hype surrounding midstream companies.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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