Why Pipelines Are the Next Phase of the Energy Revolution

Though we are in an oil and gas boom in North America, spending is shifting quickly from the drillbit to the pipeline. Therefore, the investment strategies which worked well just a couple years ago may not work as well in the coming years.

Jul 1, 2014 at 10:33AM

Pipeline Panama Gunvorgroup

A crude oil pipeline in Panama. Source: Gunvorgroup

In the 1930s, JP Morgan once quipped that he knew a stock market disaster was imminent when his shoe-shiner was bullish on the market and was giving Morgan advice. I feel a tinge of the same thing every time I surf the web, go to a website unrelated to finance, and an ad like this pops up: 

"The oil and gas boom is on! Click here to get in on the action before it's too late!"

It's true that there is an oil and gas boom going on, but it's been going on for five years now, and I've only started seeing these ads recently.

In some ways, these ads are at least a year too late. The strategies that worked well just a couple years ago will not work as well going forward. For example, in both the Eagle Ford and the Bakken, which are easily the two best shale plays, the parabolic growth is already over. While there are probably still a couple good, new shales yet to be developed, the North American energy revolution is moving decisively into a new phase.

Over the last few years, investment capital for exploration and production flooded into North America; spending rose 46% from $243 billion in 2009 to $354.4 billion in 2012. In 2013, however, spending flattened out at just $354.8 billion. In other words, producers are no longer expanding their land and drilling budgets in North America. This means that the fantastic growth in oil and gas production over the past few years will continue, but at a decelerating pace. 

Look beyond the drill bit
Midstream spending has gone from just $12.8 billion in 2012 to $46.4 billion in 2013, a stupendous 263% increase in just one year. Basically, the spending spree has moved from the drill bit to the pipeline: It's now the midstream sector's turn to grow. 

The best prospects for midstream growth will likely be in those pipelines which transport natural gas. After all, demand for natural gas in the US is steadily increasing, while demand for oil is flat at best. 

The most well-known choice is Kinder Morgan Energy Partners (NYSE:KMP), which is the second largest pipeline company by market cap and the biggest transporter of natural gas in the country. However, Kinder Morgan will not likely offer leading returns, simply because the company is already so big: The combined market cap from Kinder Morgan Energy Partners and its general partner, Kinder Morgan Inc, is over $70 billion already. 

Instead, look to smaller partnerships that are growing distributable cash flow at a faster clip. Consider first Spectra Energy Partners (NYSE:SEP). This partnership is one of the stakeholders in the Express-Platte pipeline, a 'backbone' system that transports oil sands and Bakken oil into the Wood River refinery complex. Spectra is also building a bi-directional natural gas pipeline between the Marcellus and the Gulf Coast, where supply will flow from the former to the latter. Management expects 11% distributable cash flow growth, or DCF growth, in 2014, and 8%-9% DCF growth through 2016. After that, when its new Marcellus-Gulf Coast pipeline system is ready, I believe that growth will accelerate. 

Williams Partners (NYSE:WPZ) is another strong candidate. This $25 billion pipeline expects 14.6% DCF growth between 2014 and 2016, thanks largely to its strong pipeline network in the Marcellus Shale, where cost of dry gas production is among the lowest in the country. Just recently Williams announced it would acquire Access Midstream Partners, another Marcellus pipeline operator. This acquisition should, if anything, accelerate DCF growth for Williams Partners.

Bottom line
The flattening of exploration and production spending in 2013, coupled with a sharp increase in midstream spending, signifies a big shift from the drillbit to the pipeline. Adhering to the strategy of looking for the biggest production growers may not be the best way to approach today's situation. Instead, look for pipelines exposed to transportation of natural gas. Williams and Spectra are two great places to start. 

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Casey Hoerth owns shares of Kinder Morgan Energy Partners LP. 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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