New to the Stock Market? 3 Common Mistakes to Avoid as an Energy Investor
The energy sector can offer attractive total returns provided you know where to look.
Natural gas is one of the oldest power sources in the United States, first used in 1816 to power Baltimore’s streetlights. Like crude oil and coal, natural gas is a hydrocarbon-based fossil fuel found in underground deposits. Today, thanks in part to hydraulic fracturing (“fracking”) and horizontal drilling technology, piped natural gas is the primary home heating fuel in the country, used in almost half of all homes. If you have a gas stove or gas furnace, you’re using natural gas.
In the meantime, investors have made billions -- if not trillions -- of dollars investing in natural gas stocks. The coronavirus pandemic, though, hit the industry hard. If you’re thinking of buying into this industry while prices are low, consider these natural gas companies to help you get started.
The natural gas industry is rapidly changing in the current economic climate. Check out the recent articles at the bottom of this page for the latest.
Of all the so-called “big oil” companies, Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) has made the biggest bet on natural gas. Its management team believes that the natural gas market -- particularly liquefied natural gas (LNG) -- will grow even faster than the oil market in the coming years. That’s why Shell shelled out big money during the oil price downturn of 2014-2017 to buy major gas exploration and production company BG Group on the cheap.
Shell’s major natural gas investments have helped it outperform its peers in the past. When oil prices have been low but natural gas prices relatively high, Shell has benefited. It also benefits from economies of scale, a solid balance sheet, and a strong, shareholder-friendly management team that regularly earns better returns on capital employed than its peers.
Unfortunately, in light of the oil price crash of March 2020 and the COVID-19 pandemic, Shell cut its once-best-in-class dividend by two-thirds, which prompted a big drop in share price. While it’s unlikely to cut its dividend again unless industry conditions deteriorate even further, investors should be aware that the thesis for buying Shell has changed.
Even though the energy sector can be a volatile place, Royal Dutch Shell should be a comparatively stable pick in the future, in part thanks to its investments in natural gas.
Plenty of natural gas companies don’t produce the stuff. Some, like midstream company Kinder Morgan (NYSE:KMI), operate the pipelines and terminals that move gas from the shale basins where it’s produced to the communities where it’s used.
Kinder Morgan has the largest natural gas pipeline network in North America, as measured by miles of pipeline. Importantly, Kinder Morgan’s network includes many large pipelines connecting major production centers to key hubs. These include the 11,750-mile Tennessee Gas Pipeline system, which connects the Gulf Coast to New York City, and the 10,140-mile El Paso Natural Gas Pipeline system, which transports gas from Texas’ Permian Basin to the Phoenix and Los Angeles areas. With urban populations on the rise and “not in my backyard” resistance to new pipeline construction a continuing concern, key systems like these ensure a steady stream of income for Kinder Morgan.
Midstream pipeline operators seldom buy or sell natural gas themselves. Instead they often use a “tollbooth” model, charging gas production companies a fee based on how much gas they ship through the pipeline. Many of these fee-based arrangements are backed up by long-term contracts that assign a set amount of capacity per customer, meaning that even if the customer doesn’t use all of its capacity, Kinder Morgan still gets paid. Other contracts are regulated at fixed rates.
Kinder Morgan routinely generates more than 85% of its revenue from these kinds of reliable sources, and it churns out strong cash flow from its operations, which it uses to pay dividends and to invest in new pipeline projects that further its growth. While the COVID-19 pandemic disrupted the industry, causing Kinder to delay some expansion projects and slow down its dividend increases, the company’s reliable business model still makes it a solid long-term play in the gas sector.
Another major U.S. midstream pipeline operator is master limited partnership (MLP) Enterprise Products Partners (NYSE:EPD). While Enterprise’s business model is similar to Kinder Morgan’s, and it boasts a similar percentage of reliable income, there are some key differences between the two companies.
For one thing, Enterprise focuses on NGLs like propane and hexane as opposed to dry gas, shipping them through long-haul pipelines from various shale basins to be processed on the Gulf Coast. It then sends the refined products through another series of long-haul pipelines to major markets including Chicago, Minneapolis, Cincinnati, and Philadelphia. But the real difference between Enterprise and Kinder Morgan is the way each is structured.
Because Enterprise is an MLP, it gets tax-advantaged status in exchange for paying out almost all of its operating cash flow as distributions to its unitholders, much as a standard C corporation pays dividends to shareholders. The pandemic caused Enterprise to pause its long history of upping its payout every quarter, but its yield remains quite healthy.
Because of the unique tax status of MLPs, owning shares of Enterprise may require some extra work around tax time, and it may not be a good choice for certain tax-advantaged accounts, especially retirement accounts.
Enterprise has a top-notch management team and a very shareholder-friendly history. Dividend investors will love the regular payout increases, backed up by the big cash-generating business model of pipeline operation. Although the COVID-19 pandemic caused Enterprise to slow down its growth plans, it still looks like one of the strongest MLPs in the sector.
Natural gas is a global commodity, particularly as a heating fuel. As the world’s population grows, global demand continues to rise. There’s an abundant supply of gas to meet that demand, but it’s produced only in key regions. In the U.S., the top natural gas producer in the world, that’s mostly shale formations in Appalachia or the West.
Natural gas can travel by train or truck, but it usually follows a network of pipelines and storage terminals, with separate infrastructure for “dry gas” (gas in its gaseous form) and natural gas liquids (NGLs) like propane. It can also be converted into liquefied natural gas (LNG) and shipped overseas.
International transportation issues can make natural gas prices particularly susceptible to geopolitical tensions, but exploiting the chronic shortage of transportation infrastructure relative to demand can pay off for natural gas companies. The companies that handle natural gas transportation and storage are often referred to as “midstream” companies.
Gas prices tend to be cyclical, and in the U.S. they’re usually measured by the Henry Hub spot price: the cost of a million BTUs of natural gas at the Henry Hub on Louisiana’s Gulf Coast. This makes gas stocks somewhat resilient to oil price volatility.
However, the gas industry has still been affected by the COVID-19 pandemic and global efforts to reduce fossil fuel consumption. Because oil and natural gas are often found together, most natural gas production companies are also oil producers. Many such companies have been forced to cut back production of both oil and gas because of lower demand resulting from the pandemic. It’s still too early to tell whether this will be a temporary or a permanent change.
Natural gas is abundant and cheap, which is a concern for natural gas production companies. However, the combination of a growing global population and high energy infrastructure costs presents a big opportunity for long-term value creation -- often in the form of dividends -- for top companies in the sector. That said, we can expect a lot of turmoil in the industry because of fallout from the pandemic and growing interest in renewable energy, so investors should make sure they understand the risks before buying.
The energy sector can offer attractive total returns provided you know where to look.
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