If you're interested in the energy industry, you might be most interested in the giant oil companies, or maybe in green energy options like solar and wind. However, don't forget about oil's cleaner-burning cousin, natural gas. 

The gas industry and the oil industry go hand in hand, and many oil companies also produce gas (and vice-versa). But unlike oil, the global gas industry -- and particularly the U.S. gas sector -- has changed a lot over the past few years...with more changes in store. Investors in the know could reap huge rewards from this often-overlooked sector. 

Here's what you need to know before you invest in this interesting corner of the energy world. 

A gas burner emits blue flames

Gas is the top home heating fuel in the U.S. Image source: Getty Images.

What are "gas stocks"?

"Gas stocks," are -- simply put -- stocks in companies that deal with natural gas and its derivatives. Because natural gas and oil are often found together in wells, many gas companies are also oil companies, and the entire sector is sometimes referred to as "the oil and gas sector." 

We'll discuss this more later, but many gas stocks aren't actually stocks at all. The master limited partnership (MLP) structure is very common in this sector.

Notable gas stocks include:

  • oil majors like ExxonMobil (NYSE:XOM) and Royal Dutch Shell (NYSE:RDS.A)(NYSE:RDS.B), all of which have both oil and gas drilling operations,
  • independent oil and gas exploration and production companies like Antero Resources (NYSE:AR) and ConocoPhillips (NYSE:COP)
  • pipeline companies like Kinder Morgan (NYSE:KMI) and MLP Enterprise Products Partners (NYSE:EPD)
  • propane distributors like MLP Suburban Propane Partners (NYSE:SPH)
  • existing and would-be LNG exporters like Tellurian (NASDAQ:TELL) and NextDecade Energy (NASDAQ:NEXT)
  • Services companies like Schlumberger (NYSE:SLB) and Halliburton (NYSE:HAL) as well as providers of frac sand specifically for natural gas fracking 

Before we learn more about these different types of gas companies, though, we'll need to learn about the different types of gas. 

Different types of gas

No, this isn't a precursor to a fart joke. Even within the world of natural gas -- which is basically just simple organic hydrocarbons in gas form -- there are some variations, and it can be helpful to know which type of gas is which.

What is "dry gas"?

"Dry gas" refers to natural gas that's in a gaseous form and not a liquid form. It's what we usually mean when we refer to "gas" or "natural gas." Most of the gas produced today is "dry gas," which is also the type that is pumped into your home by your gas utility. It''s also the kind that's most commonly found flowing through U.S. gas pipelines.

Even though dry gas is naturally occurring, it still needs to be processed before it can be used to remove impurities and separate different types of gas from one another. Because natural gas primarily consists of methane (CH4, the simplest hydrocarbon), which is a colorless, odorless gas, it has a "rotten egg" smell artificially added to it before it gets distributed by a utility, so gas leaks can be more easily detected. 

Dry gas is often found in combination with other hydrocarbons. Gas and oil are usually found in the same wells, and pockets of dry gas are also quite common in coal seams. The proverbial "canary in the coal mine" was used to detect the colorless, odorless methane before it could spark an explosion. 

What are "NGLs"?

"NGLs" stands for Natural Gas Liquids. These are types of simple hydrocarbons that occur naturally in liquid form.

Not to get too "science-y," but the more carbon atoms in a hydrocarbon molecule, the less pressure needs to be applied to turn it into a liquid. Methane (CH4) and Ethane (C2H6) are very difficult to turn into liquids, and appear in gaseous form even under the ground, where pressure is high. The two best known NGLs are propane (C3H8) and butane (C4H10), which are gaseous at room temperature and pressure but can be fairly easily liquefied. Other NGLs include the less-common pentane (C5H12) and hexane (C6H14), which are liquid at room temperature.

NGLs are usually separated from dry gas after they are drilled in a process called "fractionation," but are then primarily stored and transported in their liquid forms. 

It's important to understand that NGLs are not "oil" and vice-versa. Oil is a liquid, but tends to be comprised of more complex hydrocarbons as opposed to the simpler varieties that make up natural gas. Oil also contains various impurities that keep it in liquid form and give it its unique dark color and texture. Because of their simple structure and lack of impurities, NGLs are considered to be cleaner fuels than oil or its derivatives. 

What is "LNG"?

"LNG" stands for Liquefied Natural Gas, which is different from NGLs. LNG is dry gas that has been supercooled (to negative 260 degrees Fahrenheit: brrr!) to reduce its volume and make it easier to transport. Liquefying gas reduces its volume by about 600 times, and also makes it less volatile so it can be transported by ship

Today, the largest LNG tankers can hold nearly 9.4 million cubic feet of LNG. That's the equivalent of roughly 5.6 billion cubic feet of dry gas. 

Fun fact: the first documented LNG production occurred during World War I: the U.S. government wanted to extract helium from dry gas to use in British dirigibles, so it liquefied gas from the municipal gas system, extracted the helium, and then immediately regassified it and put it back into the pipes. We've come a long way since then. 

Other types of gas

Obviously, there are plenty of other substances that take a gaseous form (the aforementioned helium, for example), but while these can be important commodities, we don't refer to the companies that manufacture or refine them as "gas stocks."

One sometime exception is carbon dioxide (CO2), a by-product of power generation and some industrial production, which is used in oilfields as well as for refrigeration and cooling. CO2 is often piped long distances through pipeline networks that are owned by gas pipeline companies. For example, the 502-mile Cortez pipeline in the West Texas Permian Basin carries CO2 but is operated by gas pipeline operator Kinder Morgan. But it would be rare for a carbon dioxide pipeline to just be referred to as a "gas pipeline," even though it's transporting CO2 in a gaseous state and is run by a gas pipeline company. 

Finally, of course, there's gas as in "gasoline," which is actually refined from oil. The companies that refine and sell gasoline, like Valero or Phillips 66 are usually considered part of the oil industry as opposed to the gas industry, although many of the largest oil majors like ExxonMobil produce and refine both oil and gas.

How does the gas industry work?

Natural gas takes a long and complex journey from the ground to your gas stove or propane tank. Like the oil industry, companies in the gas industry are divided into three "streams," depending on where they fall in that journey. 

A natural gas fracking rig at sunset.

The U.S. is the top producer of natural gas in the world. Image source: Getty Images.

Upstream (exploration and production)

Upstream companies are responsible for finding the gas and extracting it from under the ground. They use a variety of techniques to explore for oil and gas, often using seismology to send shock waves into the ground and interpret the resulting seismic vibrations to look for underground pockets of liquid -- which could be oil or NGLs -- or gas. This can occur on land or underwater. 

Once a company believes it has discovered a deposit of gas, it drills an exploration well to see if there are, in fact, hydrocarbons in the deposit and of what kind and quality they are. If the results from the exploration well are positive, the company will drill an additional well or wells on the site to begin extracting the gas: this begins the "production" phase. 

What to look for in an upstream gas company

When evaluating an upstream company, one should not only look at its production level -- how much gas and oil it's producing -- but also its production costs -- how much the company has to pay to extract one barrel of oil equivalent (BOE) or thousand cubic feet of gas equivalent (Mcfe) from the ground. Sometimes a company that produces less gas at a lower cost can be a better buy than a company producing a lot of gas at a high cost.

Another consideration is the company's estimated reserves -- how much gas and oil remain in the fields from which the company is producing. Because gas is a finite resource, companies need to continually drill new wells and find new reserves to replace the gas they extract. 

Gas prices are probably the biggest factor affecting upstream gas companies. When gas prices go down, producers' margins go down, which affects their bottom lines.

Midstream (transportation and storage)

Once the gas is extracted from the well, it needs to be transported and stored. This is usually done via pipeline. Companies that own these pipelines and storage terminals are known as "midstream" companies. Midstream facilities also include fractionation plants to separate NGLs from dry gas and liquefaction plants to convert dry gas to LNG. That's a bit different than the oil industry, in which refining is generally considered part of downstream operations. Finally, midstream gas companies can also operate export terminals where LNG is loaded onto tanker ships for transport overseas. 

What to look for in a midstream gas company

For pipeline companies, major considerations for investors include the size and location of a company's pipeline network. Companies with larger networks of pipelines that connect major production centers to key population centers or export terminals have advantages of scale and volume. Companies that operate pipelines along high-demand routes that have limited pipeline capacity can also command a premium for their services. 

Quality of pipeline is also important. A large-diameter long-distance pipeline is generally more lucrative than a gathering system consisting of small pipes connecting a network of wells, even though the gathering system may boast more miles of pipe. Looking at a company's growth plans to see what projects it has in the works is also important, as it gives clues into how well the company may fare in the future. But be aware that big infrastructure projects like these are faced with numerous logistical hurdles and regulatory challenges, not to mention potential opposition from people who live near the project sites. 

Investors should also take a look at what percentage of a midstream company's income is reliable, either from fee-based contracts or regulated assets. The higher the percentage of reliable income, the less likely it is that the company will experience an unexpected cash flow problem. 

Because midstream companies are infrastructure companies, they often have high debt levels, thanks to the upfront investments required to build long pipelines and large terminals before those assets begin generating revenue. Investors should expect debt levels of multiple times EBITDA -- Earnings Before Interest, Taxes, Depreciation, and Amortization. However, a debt level of more than four times EBITDA is starting to look high, even for a midstream company. Checking the company's debt rating from one of the major ratings agencies like Moody's or Fitch Ratings can help give you an idea of how well the company is managing its debt load.

A pair of large pipes in a trench.

The midstream gas industry has been growing as high production requires more transportation options. Image source: Getty Images.

Midstream MLPs: a different beast

Many midstream companies are organized as master limited partnerships (MLPs). While investing in an MLP is very similar to investing in a regular corporation, investors in MLPs own "units" not "stock shares," and the partnerships pay "distributions" rather than "dividends." More importantly for investors, MLPs are given certain tax advantages in exchange for paying out most of their cash flow as distributions to their unitholders. 

What to look for in a midstream MLP

Investors buying MLPs are usually looking for high distribution yields, and most midstream MLPs are happy to oblige. However, it's important to make sure that an MLP has sufficient coverage for its distribution. In general, a coverage ratio of 1.2 times -- that is, distributable cash flow that equals 1.2 times the total distribution payout or more -- is considered safe.

If an MLP (or any company, for that matter) falls below a coverage ratio of 1.0, it is paying out more in distributions than it is generating in cash, and it will have to make up the difference by taking on additional debt, selling assets, issuing new units, or cutting its payout. For MLPs with already-high debt loads, this can be a tricky situation to navigate, and rarely ends well for unitholders. It's important to look at an MLP's record of distribution increases and cuts: the best ones will have long (multi-year) track records of quarterly or annual increases and no cuts. 

One final note about MLPs: because of their unique tax structure, they often require investors to file additional paperwork at taxtime. In some cases, they may not be compatible with certain types of accounts, particularly tax-advantaged retirement accounts like Roth IRAs. Be sure to brush up on how MLP ownership may affect your situation before buying in. 

Downstream (refining and marketing)

Downstream oil companies refine petroleum into gasoline or petrochemicals, and sell it either to consumers or -- in the case of petrochemicals -- to industrial customers. The bulk of refining activities in the energy sector is the refining of crude oil, although some petrochemicals are refined from NGLs. Most gas processing, including fractionation and purification, is handled by midstream companies. Because we're talking gas and not oil, we're not going to spend much time discussing this oil-dominated subsector, although there are plenty of integrated oil and gas companies that operate in this space in their oil businesses. 

Speaking of integrated companies...

Integrated companies

An integrated oil and gas company is a company that operates in multiple streams. Usually, such companies operate in all three streams. These include the five oil majors -- so-called "Big Oil" -- ExxonMobil, Royal Dutch Shell, BP (NYSE:BP)Chevron (NYSE:CVX), and Total (NYSE:TOT). This also includes the lone major integrated gas company that doesn't deal with oil at all, the Russian gas giant Gazprom

Some smaller gas companies operate in multiple streams as well. Producers that also transport and export gas include the up-and-coming Tellurian, which is focused on exporting LNG. 

When evaluating an integrated company, you need to look at the whole company's operations: upstream, midstream, and downstream (whichever apply). Often, these companies fare better than non-integrated companies, especially in times of low gas and oil prices, because their refining and marketing arms -- which are less susceptible to price swings -- can offset struggling production arms. Likewise, a company with midstream operations that generate plenty of reliable cash can use that cash to cover its dividend payouts even when times are tough.

Other types of gas companies

Oilfield services companies

Usually thought of as part of the oil industry, oilfield services companies like Schlumberger and Halliburton provide what's often referred to as "picks and shovels" for oil and gas production companies. Today, though, those "picks and shovels" are more likely to take the form of drill bits and logistics software. Because most oil wells also produce some gas -- and vice-versa -- oilfield services companies can also be considered part of the gas industry.

One major subset of services companies that deals exclusively with the gas industry are frac sand providers. When a company engages in hydraulic fracturing, an injection of high-quality sand is required to keep the fissures in the rock open to allow gas and liquid through. Both Schlumberger and Halliburton sell frac sand as part of their offerings, but there are numerous small independent frac sand providers as well. 

Utilities

Once processed natural gas makes its way through a midstream pipeline, it's often picked up by a local utility, which distributes it to customers. These utilities are usually referred to by investors as "utilities" rather than "gas companies," although many customers might refer to Duke Energy or Southern Company as "the gas company." Both also distribute electricity, as do most gas utilities. 

The vast majority of gas utilities are large, regulated, and slow-growing, so one of the most important factors in an investment decision is the size and reliability of the company's dividend. 

Delivery companies

Propane delivery companies are the odd ducks of the gas industry. These companies store and distribute propane and propane cylinders to consumers for gas grills in the summer and heating in the winter. Because they don't fractionate the propane, but just deliver it, they are largely immune from fluctuations in gas prices: they get paid for the deliveries. 

A spate of warmer winters has taken its toll on the propane delivery industry, which consists primarily of MLPs, including Suburban Propane Partners (NYSE:SPH). With weather on a warming trend, this niche probably isn't going to be of much interest to gas investors. 

Gas lamps hang on an antique porch

The first use of natural gas in the U.S. was in lighting. Image source: Getty Images.

A brief history of the U.S. gas industry

Natural gas has been used in the U.S. since 1816, when imported gas extracted from coal was used to power streetlights in Baltimore. The first U.S. gas well was drilled in 1821, and with the invention of the Bunsen burner in 1885, gas became far more practical to use. Over the next century, more wells and a pipeline network were built, and according to 2017 census data, piped natural gas is the primary home heating fuel in the country, used in 48% of homes, with another 4.7% using kerosene heat or other forms of gas.  

The biggest recent advance in the natural gas industry is hydraulic fracturing, or "fracking," which injects high-pressure liquid into a well to crack the surrounding rock, releasing trapped gas and liquid hydrocarbons. Sand is then injected into the hole to hold the cracks open and allow gas to continue to flow. Although fracking has been around since the 1940s, it wasn't widely used in shale formations until the late 1990s. Now, however, the technique has been extensively used in shale formations across the U.S., turning them into major natural gas producers and fueling the U.S.'s natural gas boom. 

That boom has been extraordinary. According to the U.S. Energy Information Administration (EIA), in 2005, the U.S. produced 18.9 trillion Mcf of natural gas. In 2018, it produced 32.8 trillion Mcf. The U.S. has been the top natural gas producer in the world since 2009. In fact, we're now awash in so much gas that many companies are racing to construct LNG export terminals to export that gas overseas. The U.S. exported no LNG by ship in 2013, and in 2014 was only sending about 13.3 billion cubic feet to Japan. By 2018, however, the U.S. was exporting 1.1 trillion cubic feet of LNG to 32 different countries. 

Where is natural gas produced and processed?

The EIA hasn't done a survey of the largest gas fields in the U.S. since 2013. At the time, the Marcellus Shale in the Pennsylvania -West Virginia-Ohio Appalachian region was the largest in terms of estimated production. Today, the Marcellus Shale is often lumped together with the neighboring Utica Shale formation.

Other major gas fields in 2013 that are still important today are the Barnett and Eagle Ford Shales of Texas, the Woodford Shale of Oklahoma, the Haynesville Shale in Texas-Louisiana, the Antrim Shale in Michigan-Indiana-Ohio, the Niobrara-DJ Basin of Wyoming, and the San Juan Basin of New Mexico. However, in recent years, the Permian Basin of West Texas -- a longtime oil haven -- has become a major producer of shale gas. 

Some gas is also produced offshore in the Gulf of Mexico, but only about 5% of total U.S. production. Offshore drilling is more focused on oil production. However, 51% of natural gas processing facilities are located on the Gulf Coast, which is also a major hub for oil refining. The remaining gas processing facilities tend to be located near major gas fields. Gas pipelines crisscross the country from coast to coast, getting raw and processed gas where it needs to go. 

What affects gas prices?

In 1938 the U.S. government passed the Natural Gas Act, regulating the industry. However, after widespread shortages and pricing issues in the 1970s and 1980s, the government gradually began a process of deregulation, which resulted in increased production and cheaper prices. Today, gas prices fluctuate on the open market. 

The primary factor affecting the price of natural gas is supply and demand. Despite the massive increase in natural gas supply over the last ten years, prices have not fallen as much as you might expect. The standard price quoted for natural gas is the Henry Hub spot price, which is measured in dollars per British thermal units (BTUs).

The Henry Hub is the world's largest gas distribution hub, built on a major pipeline in Erath, Louisiana. The site was chosen because of its accessibility to many major gas markets. It's the official delivery location for gas futures contracts on the New York Mercantile Exchange. Here's how the Henry Hub spot price has changed over the last ten years:

Henry Hub Natural Gas Spot Price Chart

Henry Hub Natural Gas Spot Price data by YCharts

Natural gas spot prices fell in 2014 along with oil prices during the oil price downturn of 2014-2017. In fact, because oil and gas are so often produced together, oil and gas prices -- sometimes lumped together as "energy prices" -- often move in tandem:

Henry Hub Natural Gas Spot Price Chart

Henry Hub Natural Gas Spot Price data by YCharts

However, the Henry Hub price isn't the only gas price in the U.S. Different local hubs -- designated delivery sites that have pipeline and storage infrastructure to move and transfer gas quickly -- offer different prices that may exceed or lag the Henry Hub price, again primarily determined by local supply and demand. 

There are more than 100 local gas hubs in the U.S. and prices can vary quite widely among them. For example, in the Permian Basin in April 2019, pipeline bottlenecks combined with record production levels actually caused spot prices at the Waha Hub to turn negative, meaning that "sellers" were actually paying "buyers" to take their gas away. 

Gas production companies can turn such price disparities to their advantage, however. By producing in a less-expensive hub and shipping the gas to a more-expensive hub for sale, producers can improve their margins, assuming that the price difference isn't eaten up in shipping costs. It's a complex web of supply, demand, and pipeline capacity. 

How to invest in gas stocks

There are many ways to invest in gas stocks. By far the most straightforward is to buy shares in a gas company -- or units in a gas MLP -- outright, through a traditional or online broker. Most gas stocks are traded on the two big U.S. exchanges, the NYSE or the NASDAQ, even major foreign companies like Royal Dutch Shell or the French company Total.

Some foreign gas stocks may not offer shares on U.S. exchanges: these would need to be purchased "over the counter." Many will offer American Depository Receipt shares (ADRs). These are usually denoted by a five-letter ticker symbol ending in Y, and mean that the company is offering its shares to U.S. investors, and are executed in the U.S.

An alternate type of share is an "F share," which usually has a five-letter ticker symbol ending in F. These shares are requested by U.S. brokers to allow their clients to trade directly in foreign companies, and are executed on foreign exchanges. Sometimes there can be multiple ADRs or F shares, or a combination of both, for a single company. For example, Russian gas giant Gazprom offers two ADR tickers: OGZRY and OGZPY. Be sure you understand the risks before investing in a foreign company that isn't traded on a U.S. exchange. 

If you prefer to invest in the sector as a whole as opposed to in individual stocks, you might consider buying shares in an exchange-traded fund or ETF. An ETF is a fund that owns a number of stocks in a particular sector, so buying shares in the fund gives you broad exposure to the sector. Many energy sector ETFs combine oil and gas investments, and most focus on upstream companies.

So, for example, the iShares U.S. Oil & Gas Exploration and Production ETF seeks to track the performance of upstream oil and gas companies as a whole, while the First Trust Natural Gas ETF tries to mimic only the performance of upstream gas companies. Other ETFs are even more specific: the VanEck Vectors Unconventional Oil & Gas ETF only tracks "unconventional" oil and gas production, such as coal bed methane, shale gas, or oil from oil sands.

Meanwhile, many indexes contain oil and gas stocks, so buying shares of an ETF -- or investing in an index fund -- will often provide some gas exposure. For example, a purchase of the Vanguard 500 Index Fund would get you exposure to the gas companies in the S&P 500, including oil major Chevron, driller Apache Corporation (NYSE:APA), and gas pipeline operator Kinder Morgan. 

Much more to learn about gas stocks

Now that you understand a bit more about gas stocks, you should have no problem delving more deeply into individual companies' financials, news releases, and reports to learn more about them. But the sector has seen big changes in recent years, and is likely to continue changing quickly. Still, with so many companies involved, there's a wealth of opportunity for investors in gas.