After a relatively stagnant year in 2016, where gas consumption fell, and production barely rose, U.S. natural gas demand appears poised to accelerate over the next several years. According to an analysis by energy industry research specialist Wood Mackenzie, gas demand should rise 21% by 2021 and 32% by 2026. Fueling that increased demand will be new natural gas-fired power plants and gas-consuming industrial facilities as well as higher exports via pipeline to Mexico and through liquified natural gas (LNG) export facilities to global markets.
That forecast bodes well for the entire natural gas industry. However, while most gas stocks should thrive in that environment, two companies stand above the crowd as the top choices to buy now: EQT Corp (NYSE:EQT) and Kinder Morgan (NYSE:KMI). Not only is this duo the respective leaders in their category, but they trade for dirt-cheap valuations relative to their peers.
The sum of the parts is greater than the whole
EQT Corp is the country's top natural gas producer, which is a title the company claimed when it acquired Rice Energy in November. Aside from the increased size, several other factors drove EQT's desire to buy Rice. First, it would push the company's production costs down to the second lowest in the county. Those lower production costs, when combined with other expense reductions, leads EQT to believe that the deal will increase cash flow per share 20% next year and by 30% in 2019. In addition to that, much of Rice's acreage was adjacent to its land, which would allow the company to drill longer wells. That will cut drilling costs, enabling the company to improve the returns it can earn on future wells from 52% to 70%.
While the deal made sense on paper, several large investors initially voiced their opposition because they believed EQT's stock was significantly undervalued. As such, they didn't think using its cheap shares to make the purchase was in investors' best interests. That led one large investor to unveil a detailed plan on how EQT could unlock as much as $8 billion in value, which would boost the stock price by 50%.
EQT listened to their concerns and will approve a strategy to address its sum-of-the-parts discount by early next year. That plan could see the company separate its production assets from its midstream business and then merge its MLP EQT Midstream Partners (NYSE:EQM) with the former MLP of Rice Energy, Rice Energy Midstream Partners (NYSE:RMP). As it completes those and other initiatives, it should eventually narrow the roughly 50% gap between EQT's current trading price and the underlying value of its premier low-cost gas assets and prime midstream operations. The upside from that catalyst, when combined with an improving natural gas market, is what makes EQT such a compelling gas stock to buy right now.
A best-in-class pipeline company for a rock-bottom price
Like EQT Corp, Kinder Morgan is the top-dog in its sector, controlling the largest natural gas pipeline network in North America. Overall, the company operates 70,000 miles of gas pipeline, which connects it to every major production basin in the country. Those pipelines, as well as its other gas-related infrastructure, provide the company with stable fee-based cash flow as it transports, processes, and stores that gas for producers and end users. That cash flow should grow by a healthy clip in the coming years since the company has $3.4 billion of natural gas infrastructure projects under way and another large gas pipeline project in development, not to mention several billion dollars of oil-related projects in the pipeline. Meanwhile, growing gas demand should fuel the need for $290 billion to $376 billion of additional natural gas infrastructure in North America through 2035, which should provide Kinder Morgan with plenty of opportunities to expand its industry-leading network in the coming years.
Those growth prospects aside, what makes Kinder Morgan such a compelling stock to buy right now is its valuation. Currently, the company sells for an absurdly cheap 8.6 times cash flow, which is well below the 14.6 cash flow multiple of its peer group. It's an inexplicable discount since Kinder Morgan has best-in-class dividend coverage of 4.0 times, well above the 1.2 average coverage ratio of its peers. It also expects to deliver best-in-class dividend growth through 2020, with it projecting a 36% compound annual growth rate while peers only forecast 8% average yearly increases. Though, it's worth pointing out that one of the drivers of Kinder Morgan's outsized dividend growth is the fact that it expects to increase the percentage of cash flow it returns to investors from 25% to 50%. That said, it would still boast a best-in-class coverage ratio of more than 2.0 times.
Investors who buy Kinder Morgan today have two ways to win. In the near term, they'll benefit from the company's plan to return more cash to shareholders, including boosting the dividend 60% next year and 25% in both 2019 and 2020 along with repurchasing as much $2 billion in stock by 2020. Those increased cash returns should help narrow the valuation gap between Kinder Morgan and rival pipeline companies. Meanwhile, over the longer term, investors should benefit from the company's ability to continue expanding its natural gas infrastructure. That combination of ample near-term upside with long-term growth potential is why Kinder Morgan represents an excellent way for investors to profit from the growing need for more natural gas-related infrastructure.
Premium franchises without the expensive price tag
Typically, industry leaders sell for premium prices in the market because their scale and market position helps reduce risk and opens up more opportunities for them to create value for investors. However, that's not the case for these two top natural gas stocks since both sell for a significant discount to rivals. That cheap valuation, when combined with their visible growth prospects in the gas market, is why EQT and Kinder Morgan are the top gas stocks to buy now.
Matthew DiLallo owns shares of Kinder Morgan and has the following options: long January 2018 $30 calls on Kinder Morgan, short December 2017 $19 puts on Kinder Morgan, and short March 2018 $17 puts on Kinder Morgan. The Motley Fool owns shares of and recommends Kinder Morgan. The Motley Fool has a disclosure policy.