The Mitchell Effect

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

One of the world's greatest innovators died recently. No, he wasn't from the high tech industry. He didn't invent the latest iDevice. George Mitchell, the founder of the former Mitchell Energy and Development Corp., was widely credited with the pioneering work that combined horizontal drilling and hydraulic fracturing in the Eagle Ford shale rock formation in Texas. He was 94.

His methods led to the unlocking of vast deposits of energy supplies and to one of the great economic and business success stories and opportunities of a generation. As the result, within a few years, the United States will become the world's biggest energy producer and become less reliant on other countries.

Over the long term a diverse group of businesses and the overall economy will prosper. Investors with a long horizon can also benefit from the "Mitchell Effect."

Upstream

Dozens of oil (and gas) field service providers have sprung up to assist the major integrated oil and gas companies in the extraction process. They provide raw materials, transportation, management, engineering, technical assistance and perform various other tasks.

One of them, Halliburton (NYSE: HAL), has been innovative too. Improvements in its fracking process is lowering the cost to drill a typical well by hundreds of thousands of dollars. Halliburton is even using natural gas to power well-drilling equipment. That's added profit to all the companies involved.

Halliburton needs that extra profit in the short term to overcome some headwinds it is experiencing. They include falling natural gas prices and legal expenses related to the Deepwater Horizon well disaster in the Gulf several years ago that was in part caused by the company. These factors affected the bottom line in the first half of the year.

However, looking ahead, Halliburton fortunes will improve as the energy boom continues and its fracking innovations continue to pay off.

Operating income, which has been declining, will reverse course as the number of rigs that the company services increases by 4% per year and the amount of revenue per rig doubles as expected over the next few years.This will occur even if EBITDA margins flatten out. 

Halliburton mains a long term play because of its application of George Mitchell's techniques and the company own historical performance.

Midstream

In the midstream space, companies that own and operate energy pipelines and storage facilities will continue to profit from increased production, even if gas prices remain subdued. These businesses, called master limited partnerships, are by law required to pay out most of their windfall in the form of distributions to investors. The payouts are typically quite generous, usually resulting in yields over 5%.

A MLP to consider is Enbridge Energy Partners, LP (NYSE: EEP). It pays a hefty distribution of $2.71 per share annually and yields 7.11%. The company moves about 13% of the crude oil imported into the U.S. and about 15% of the natural gas produced in Texas. It possesses 19 million barrels of crude oil storage capability in Oklahoma and Kansas, key junctions in the energy transportation network.

Due to consistent cash flow obtained from long term contracts it has with energy companies things look bright for Enbridge for the foreseeable future. Expect those juicy distributions to keep flowing.

An alternative play in the midstream space is the railroad industry which is picking up the slack now that the pipeline system is at capacity; and due to the long lead times in getting new ones built that situation will continue. In addition, railroads can also move drilling supplies, such as frac sand, to the fields so it can serve both ends of the production process.

A railroad to consider is CSX Corp. (NYSE: CSX) which is poised to increase rail car capacity (and subsequently its revenues) to serve the ever-growing Marcellus shale region of Pennsylvania, Ohio, West Virginia and Virginia. CSX needs the extra cash flow in order to overcome recent sluggishness in its coal hauling business.

The stock of the railroad giant, which operates mainly in the eastern part of the country, is relatively cheap with a trailing P/E of about 14, well below its long term average. Growth rates and margins are modest but the company pays a dividend of around 60 cents a share and has been growing it at a robust 18% annual rate. Since the payout ratio is low at 31% there is plenty of room to keep bumping up the dividend. Expect CSX to overcome the decline in coal revenues, and benefit over the long term because of what George Mitchell has accomplished.

Downstream

In the downstream space, instead of considering the refiners or retailers, a better play might be to look at end-users. Companies whose operations greatly depend on the use of natural gas will see better margins and higher profits. They include steel makers and the petrochemical manufacturers.

A business to consider is Nucor (NYSE: NUE), the biggest domestic steel producer in the U.S. It melts scrap steel, primarily from automobiles, using natural gas powered electric arc furnaces and turns it into dozens of different types of products. Nucor has made a profit every year since 1967 except for the recession year of 2009. It is trying to overcome depressed steel prices and get back into a growth mode. The company is attempting to boost its margins and reduce production expenses by entering into long term agreements with natural gas drillers to ensure a reliable, low-cost supply.

Nucor has a lot going for it in addition to the long term benefits from lower manufacturing costs. It has relatively low debt. The long term debt to equity ratio is 0.45. It pays a $1.47 per share dividend, resulting in a 3.2% yield. A caveat is a high payout ratio of 112% although that hasn't stopped the company from increasing the dividend in each of the last 25 years. Nucor will benefit from the Mitchell shale boom and it should be a solid long term investment.

Conclusion

After the passing of an icon of the energy business, it is a good time to reflect on the benefits he has created. George Mitchell's innovation, the pairing of horizontal drilling with hydraulic fracturing, is probably one of the great accomplishments of the late 20th century.

Several companies, Halliburton, CSX Corp., Enbridge Energy Partners, LP and Nucor, are poised to profit from his success. Individual investors, with an eye out for the long term, can profit along with them.


Mark Morelli has no position in any stocks mentioned. The Motley Fool recommends Halliburton and Nucor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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