Dar & Company

Investing in U.S. Natural Gas: The Commodity Versus the Business
(First published on www.SeekingAlpha.com on April 29, 2009)

Natural gas attracts 3 kinds of investors: speculators, flight to safety inflation hedgers and traditional investors (that is, people whose time horizon is years, not months; especially the retail investor).

Speculative traders, of course, care about natural gas as the commodity symbol on the screen (the digital natural gas), not natural gas the business. They trade the price attributes - direction and volatility - and in many, cases hardly understand or find it relevant to study the business of natural gas. They certainly deeply ponder the financial engineering aspects of gas, however. A subset of these are the specialized hard asset anchored crack spread traders who trade the gas/oil, gas/liquids, gas/electric price spreads using physical positions in gas conversion assets to back their financial positions. Trading provides a good living but spectacular multi-billion dollar failures do occur, taking entire trading companies down with them.

Given the depth, liquidity, trading platforms, detailed data sets, trading algorithms and “greek” instruments, trading natural gas can be done at almost any financial level. Thousands of individual investors like to trade the price attributes. Some do it full time from home and it can provide a decent living. Companies who provide support services to these individual traders have a profitable niche.

Inflation hedgers are keen on physical natural gas. They want rights to the molecules themselves as a store of value. In the US, fractional ownership of reserves and security of physical delivery are so well developed that secure ownership of gas in the ground (unproduced, proven and probable reserves or produced gas in underground storage) is within the reach of even a moderately prosperous and well informed individual. Some hedgers prefer to own a portfolio of prospects and a bank of proprietary geophysical data rather than proven developed and undeveloped reserves. The dollar can be stretched much further but there is, obviously, a significant increase in volumetric and E&P cost risks. This hedge is for people who deeply understand a basin or a few basins, have worked in the industry and have well developed relationships with independent E&P companies.

For traditional investors in stocks and bonds, the U.S. natural gas industry (the business of natural gas) offers something for almost all appetites for scale and risk. It is big, geographically diversified, price and ROE-unregulated, quasi-regulated, regulated (depending on the business), fragmented horizontally and vertically (the industry is a set of value chain stacks, including value chains within value chain stacks) well researched and populated with companies ranging from tiny to very large indeed. It has pure plays and mixed plays. It has companies focused on just one niche to companies with substantial internal diversification.

For investors with an aggressive risk/return profile, the Upstream (E&P) stack is attractive. Beyond the majors and mini majors (US natural gas is too small a part of their global investments to offer material direct exposure to the domestically focused investor) and very large independents (there are about 20 of these, with considerable positions in US and Canadian natural gas E&P plus international operations), there are well over 200 publicly traded independent E&P companies in the US on which research is readily available and several thousand (hundreds of which are, nominally, publicly traded or private with multiple investors) more that are not followed by analysts and many royalty trust companies. Independents produce about 80% of US natural gas, so there are many points of investment entry in the upstream stack. As might be expected, there is substantial entry/exit, M&A, private placement and new business formation at this level. There are also several rungs in the capital ladder ranging from VPPs (volumetric production payments---last resort financing) and mezzanine debt to convertible preferreds and common equity.

Wall Street knows almost nothing about these small/medium independent E&P companies, which is why they have been a favorite, for many years, amongst retail investors and small institutional, endowment and family trust or family investment company investors. However, investors must rely mostly on themselves for research and analysis and be familiar to very familiar with E&P at the state or county level, other local investors, company managements, company financing and deciphering E&P balance sheets. This is old fashioned personal (friends and family plus friends of friends) investing. There is fraud certainly and it is not rare to lose all one’s money but the prospect of a 10 to 1 or even 100 to 1 win every few years keeps investors coming back. It is also entertaining. Scores of millions of Americans live within a comfortable drive to a natural gas E&P operation, so it is not difficult to get a visceral knowledge of this business.

Field Services constitutes the next stack in the value chain. This stack includes gathering, processing, treatment and administrative services for producers. Once highly fragmented, this sub-industry has consolidated greatly and has been largely absorbed by the large pipelines or by E&P companies. Still, there are still scores of small field service companies, dozens of which are affiliates of small E&P companies, several of which are publicly traded. The gas processing business can have very volatile margins unless it is conducted as a toll processing business. The other functions are fee based and depend on volume, fixed fee or now, less commonly, percentage of well head or FOB pipeline price. This stack has attracted some new entry recently. It has long been popular with many of the people who engage in personal investing.

Midstream operations are the next major value stack. It is called the Big Pipes stack, consisting of intrastate and interstate pipelines moving gas scores to hundreds of miles, connecting sources of supply to major points of demand (industrial, chemical, fertilizer, crude refining/petrochemical, power generation and local distribution companies). Attached to these Big Pipes are compressors, storage facilities, hubs (gas switching stations that are also trading, pricing and liquidity points), gathering/processing systems and LNG regasification terminals.

This stack has consolidated over the years but, nonetheless, there are still several companies to choose from. These pipelines are classified as interstate, Hinshaw and intrastate; the latter two subject to state and the first category to FERC regulation. Pipeline holding companies are volumetric plays, largely insulated from commodity price volatility, since they are long term contract, capacity and delivery fee-based, businesses. They do well even during hard times.

Investors, retail and institutional, who seek dividend growth with capital preservation are attracted to these companies. The cash profile lends itself unusually well to MLPs. There is very extensive brokerage research and public information available. The companies are well covered by analysts.

Each interstate and intrastate pipeline is a separately regulated legal entity and must keep its own set of books, even when owned by a holding company. There are about 50 major interstate pipelines, several dozen minor interstate pipelines, about 20 predominantly offshore pipelines and less than 10 LNG import terminals regulated by FERC. There are dozens of state regulated intrastate pipelines.

The final major stack is called Downstream, also called Little Pipes. It consists of local gas distribution companies (LDCs). This stack, too, is very fragmented but much less so than electricity distribution. There are no more independent large gas utilities. These have been bought by combination gas-electric utility holding companies, US and European, or by combination pipeline/LDC holding companies. There are a few medium/small independent, publicly traded, gas utilities. This limits pure play gas LDC investment opportunities to a few small geographies.

Valuations in this stack have been surprisingly volatile and the dividend stream is not nearly as secure as it used to be. Footprint specific economics and demographics, interest rates, legacy employee health and pension costs, old coal-gas plant clean up costs and regulator hostility are important risk factors.

There are niche or emerging value stacks as well but they are inaccessible to the typical retail or institutional investor. They include conversion/fueling of NG vehicles, standalone storage, innovative gas use technologies, GTL (gas to liquids) plants. There is also the new shallow- deep play, which is E&P in shallow US Gulf waters where the field services/midstream infrastructure is well developed but the drilling requires going deep into the ground under the shallow water. This the familiar onshore deep drilling technique applied to shallow waters.

Investment Themes

Traditional investors have a choice of themes. Some examples follow. The stack specific theme is for investors who are interested in a specific stack of the value chain. It is a common way to invest for a large number of people and easy to execute.

The virtual value chain theme, where the investor creates a customized value chain by taking positions in several companies across all the industry stacks and so constructs national, superregional or regional synthetic value chains. This is more difficult to execute and requires substantial analysis and portfolio balancing but investors like it.

The protected income theme is for investors who buy and hold 5 to 10 of the safest, reliable dividend paying companies. In practice this means investing in the Midstream and Downstream stacks or in private MLPs.

The proven resource-specific theme is for people who have particular interest and insight in a certain kind of resource such as deep onshore gas, coal bed methane, Barnett shale.

The treasure hunting theme is for people who are looking for very high risk/very high payoff investments. These are confined to small E&P companies and require very active, knowledge intensive, effort. The competitive edge is access to technical information and relationships that very few can possess. It is a bet on a specific combination of small management team (or an individual) and specific exploration idea backed by just enough money to potentially succeed.

The emerging basin theme is for those who like frontier plays with frontier risk /return profiles such as the Bakken, Haynesville and Fayetteville shale formations. The investment vehicle is a small, perhaps newly created, E&P company. Again, only a very few investors have access to or qualifications for investing this way.

Finally, there is the backyard investment theme available to thousands of investors who live in oil and gas counties and engage in high due diligence (or high trust, but this is usually an error) personal investing in local opportunities.