Oil and Natural Gas: Driving the New Industrial Revolution

By Mark Morelli - August 15, 2012 | Tickers: C, DPM, EEP, EPD, XOM, NUE | 0 Comments

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Citigroup, Inc. (NYSE: C) recently published a report, "North America, the New Middle East?" which suggests that there is a transformation taking place and that a "re-industrialization" of the United States is underway.

What is driving the budding industrial revolution? It is none other than oil and natural gas. Increased domestic production of fossil fuels has the potential not only to reduce dependence on foreign energy sources and reduce the trade deficit, but also to become a key driver for economic and jobs growth in this country over the next decade. This should be good news as the unemployment rate is unacceptably high right now and GDP growth has been anemic following the financial crisis of 2008.

Technological advances in drilling over the last decade or so have resulted in an increase in supply; some say there is a glut in gas, and a decrease in prices. Natural gas futures are near an all-time low and are a lot lower than in the rest of the world.

I have written in the past about how innovation, if implemented correctly, can provide a payoff (please see my July 25, 2012 blog "Does Innovation Really Pay?"). It appears that the hydraulic fracturing technique for drilling is one innovation that has great potential. Those companies leveraging off it have a great chance to prosper and those investing in those companies may soon benefit.

The new industrial revolution will create several investment opportunities. Energy transportation and storage, steel and petrochemical processing are industries that should be investigated. Also, companies developing natural gas powered commercial vehicles and some utilities may benefit down the road. The use of natural gas in electricity production has doubled over the last 20 years and that of coal has declined. The trend should continue as long as prices remain subdued as gas-fired plants are cheaper to operate than coal-fired plants. A side benefit is that it is cleaner as well.

In the energy transportation and storage business, you may want to consider Enbridge Energy Partners LP (NYSE: EEP). Enbridge is well positioned and is currently benefiting from lower prices. A caveat for Enbridge is that it is a master limited partnership (MLP), which in general, results in some complications when preparing income tax returns. One way around that is to invest in exchange traded funds (ETFs) that track MLP indexes. They are a lot less complicated, tax-wise. A positive is that most of the partnerships have good yields. For example, Enbridge currently yields about 7.5%. Another MLP, Enterprise Product Partners LP (NYSE: EPD), yields 4.8%. Keep in mind, these partnerships may not be right for everyone's portfolio as there are some downside risks, even in a robust market.

Nucor Corp. (NYSE: NUE) is building a new iron-processing plant in Louisiana that will run on natural gas. Expect their production costs to go down and margins up if prices remain relatively low. A risk is that slowing economic growth will dampen demand for their products and negate the gas benefit, at least in the short term.

The petrochemical processing industry uses natural gas as a feedstock in production and may see increased margins in their operations as the result of lower gas prices. You may want to consider DCP Midstream Partners (NYSE: DPM), which provides natural gas to petrochemical companies. It is also involved in other types of pipeline projects. DCP has a 6.2% yield.

There will also be a trickle-down effect as firms building new plants and suppliers will also see increased revenue. So a look at the construction and building trades industries may be warranted.

The big players, like Exxon Mobil, are also well positioned to take advantage. 

So far the benefits have been realized only in certain parts of the country but this is expected to change and other states will prosper in the future. Currently the drilling boom in the Bakken shale has contributed to a mass influx of jobs to North Dakota, which now has the lowest unemployment rate in the U.S. It has become the number 2 oil producing state today. Louisiana has observed a big increase in investment. Ascension Parish, the area where the new Nucor plant is being built, will see a doubling of investment this year due to lower gas prices. Texas is another state that has benefited.

If the gas boom expands in the Marcellus shale in the eastern U.S., states like Pennsylvania, Ohio, West Virginia and perhaps New York may see an uptick in investment and increased economic activity.

However, there are some downside risks to the scenario. 

There is the political aspect. Most environmental groups are opposed to any increase in fossil fuel drilling and usage and are heavily lobbying against it. The decision by the U.S. Department of State to deny permits for building the Keystone XL pipeline resulted in a shift in the plan to build a pipeline from the Alberta tar sands to British Columbia instead of transporting the extracted oil to refineries on the U.S. Gulf Coast. U.S. companies probably will lose out if this trend continues. Things may become a little clearer after the presidential election in November. A Romney Administration will likely be a lot more friendly to oil and gas projects.

Increased natural gas consumption outside of the U.S. may result in price inflation. Some estimates indicate that usage in China alone will increase by an average of 2.7% per year over the next five years. Also, domestic companies could decrease production and as a result prices could go higher later. 

So if the present trend continues, at a minimum the economy should improve, more people will work and society will benefit. 

If you have a fairly long time horizon (as it probably will take some time for the benefits to fully work through the system), can tolerate some risk (or at least wait until the risks are mitigated) and are willing to do lots of research to find the right investment in this space, you may want to consider getting in on the boom. 

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