Gas Pipelines: Investing Essentials

A primer on the importance of gas pipelines.

Aug 11, 2014 at 12:00AM

Nearly two out of every three American homes use natural gas for heating and cooking. That percentage would be a whole lot smaller if not for the gas pipeline industry. These companies take raw natural gas from the wellhead and move it to processing plants, which separate natural gas liquids and other gases from the methane we commonly know as natural gas. From there the natural gas is sent through the highly integrated U.S. gas pipeline transmission and distribution grid into homes and businesses.

What are gas pipelines?

Kinder Morgan Tennessee Gas Pipeline

Natural gas transmission pipeline. Source: Kinder Morgan.

Natural gas travels from the wellhead to a home or business through a series of five different types of gas pipelines. These are flowlines, gathering lines, transmission lines, distribution lines, and service lines, and each carries the gas at different pressures.

Flowlines carry raw natural gas straight from the wellhead. From there the gas from a number of flowlines goes into gathering lines, which takes raw gas from a producing field to processing facilities. Once processed, natural gas travels though transmission pipelines that can carry the material over long distances and across state boarders. Think of transmission pipelines as being like superhighways for natural gas. Natural gas then enters the distribution lines (or "mains") of natural gas utilities. Finally, natural gas enters service pipelines, which deliver it to homes and businesses.

Natural gas pipelines come in a variety of sizes and materials. Gathering lines are typically steel pipelines that are 18 inches in diameter, while transmission pipelines are up to 42 inches in diameter and also made of steel. Distribution and service lines, on the other hand, can be as small as 2 inches in diameter. These pipelines can be made of steel, cast iron, plastic and even copper.

How big is the gas pipeline industry?

There are more than 200 natural gas pipeline systems in the United States. Within these systems are more than 300,000 miles of interstate and intrastate transmission pipelines, along with another 2.1 million miles of distribution pipelines. Over 1,400 compressor stations maintain the pressure of that natural gas pipeline network and make sure gas moves through the system. There are more than 5,000 receipt points and over 11,000 delivery points, as well as another 1,400 interconnection points that transfer the gas throughout the country. As the following map shows, natural gas pipelines stretch from coast to coast and cover many points in between.

Gas Pipeline Network

Source: EIA.  

How does gas pipeline industry work?

The gas pipeline industry is highly regulated. U.S. onshore and offshore pipelines are regulated by the Pipeline and Hazardous Materials Safety Administration, which is a branch of the U.S. Department of Transportation. The agency is responsible for developing and enforcing regulations that ensure the operations of pipelines are safe, responsible, and environmentally sound.

The Federal Energy Regulatory Commission, or FERC, also regulates gas pipelines. The commission, which is an independent agency within the Department of Energy, determineshow pipeline companies can set rates, as well as setting the rules by which these companies operate. It also reviews and authorizes new natural gas pipeline projects.

Because of FERC regulations on rates, the gas pipeline industry's profits are fairly steady. Most gas pipelines are owned by master limited partnerships or utilities. Master limited partnerships typically sign volume-based contracts with natural gas producers to gather and process the gas. From there it can be sent though transmission pipelines, which often are owned by a different master limited partnership, and on to distribution pipelines and services lines that are typically owed by utilities. Each company profits from its role in the movement of the natural gas through the pipeline system.

What drives the gas pipeline industry?

The gas pipeline industry is driven by supply and demand, as well as by gas prices. Master limited partnerships, for example, will lay flowlines and gathering pipelines to hook up new wells that are being drilled. These wells are only being drilled because the demand and price for gas are high enough to justify the investment. Meanwhile, the gathering company's investment to build these pipelines is typically secured by take-or-pay contracts. These are volume-based contracts in which the shipper, in this case the producer, must pay for the capacity it signed up for whether or not it is sending gas through the pipelines. Because the capacity of these pipelines is secured by long-term contracts, these gathering companies are less sensitive to the volatility of natural gas prices.

Kinder Morgan Gas Pipeline Stack

Source: Kinder Morgan.

Similarly, gas transmission pipelines are also typically secured by take-or-pay contracts. These are generally secured before the pipelines are built to ensure the initial economics of the project, and then renewable thereafter. Again, this means the economics are less affected by the volatility of natural gas prices.

Finally, the utilities that own distribution pipelines and service lines are driven more by supply and demand. In an expanding economy the gas flowing through the pipes to customers increases along with profits. Likewise, in an expanding economy new service lines need to be built to connect new customers. However, in an economic contraction, or if gas prices run too hot, customers can cut back on use, which impacts profits.

The gas pipeline industry is largely  insulated against the volatility of natural gas prices. These companies typically secure long-term fixed-price contracts to ship gas through their pipes. Because of that it's an industry that offers highly desirable income and security that is favored by retirees.

Matt DiLallo has the following options: short January 2016 $32.5 puts on Kinder Morgan and long January 2016 $32.5 calls on Kinder Morgan. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. 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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