Feeding Off the Natural Gas Glut

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

Natural gas prices have been depressed for a while now.  The commodity has been trading at around $3.50 per thousand cubic feet, but its price used to be $15 per thousand cubic feet. The reason for this depreciation is that there is an oversupply of natural gas so severe that it is being referred to as a natural gas glut. The oversupply is caused by the new-found ability to tap the reserves in shale formations.  So how should investors play this gas gluttony? 

Let's start by looking at the profitable producer Linn Energy (NASDAQ: LINE). The summary of Linn's business is that it takes proven, developed fields and hedges production with contracts to lock in a minimum sale price. This works great if prices stay below the price of the contract, but if prices rise, extra profit is lost. The company does not suffer a loss, but it does not make as much as it could have. That is the cost of playing it safe.

Linn is a master limited partnership, which means there are some complications with owning the stock. When you buy it you technically become a partner, which can make things a bit more complex during tax time. You should consult your accountant, tax attorney, or some other professional to inform you of the consequences of buying into a master limited partnership. I unknowingly bought into one in the past, and though I have no regrets I would spare you the surprise. The benefits might just be worth it.

It also means that Linn does not retain capital. It either spends the cash or distributes it, so do not be concerned with the company's low cash position of under $2 million. Assets on the books have more than doubled in the last two years, making me comfortable with Linn's future ambitions. High dividends plus profitable acquisitions are the makings of a forever stock, though forever is a long time for something as tricky as a fossil fuel.

Linn has had some serious capital appreciation over the years, but I think there is room to grow. The company was trading at $15 a share at the beginning of 2009, and now it is above $40. As time passes and more fields are acquired, more and more expensive contracts can be negotiated to lock in the sale price on the new assets, fattening profits. I think that aspect is critically important. Linn might leave money on the table if the price rises rapidly, but if it makes new acquisitions it can stair-step its contracts and still earn a really nice profit. Additionally, Linn sports a 7.10% dividend yield right now, which is great.

You should also consider companies that could benefit from cheap natural gas prices. Off the top of my head I would think natural gas engine makers, steel producers, and petrochemical makers. That is a fancy way of saying cars, metal, and fertilizer.

Cheap natural gas contrasted with annoyingly expensive gasoline makes me wonder why I do not have a natural gas vehicle. It is a mix of convenience, which is probably why I drive a hybrid. However, I do see all those UPS vehicles saying they are running on natural gas, and there are many initiatives to convert buses into natural gas vehicles. Recently, there have been rumblings that trucks might convert to the cheaper natural gas. Westport Innovations (NASDAQ: WPRT) is probably well suited to capture some this activity.

Recently, the stock has been hit by a poor quarter. The year-to-date return is around -8%, which is quite a cool down from a 3-year return of over 150%. Unless the internal aspects of the company have changed, like all its patents on engine design are worthless, then I think it will be fine. With a current ratio approaching 5, it is not going insolvent any time soon. Cash is almost double total liabilities, which is a good sign. With the move for trucks to start implementing natural gas engines, Westport is well positioned to benefit.

Cheap natural gas prices go beyond use as a fuel for vehicles. United States Steel  (NYSE: X) is one of the last remnants of the once proud United States steel industry. Natural gas is a suitable replacement for coking coal in the steel production process. With gas prices so low, US Steel can boost margins by using natural gas. The inability to compete with the margins of overseas steel producers led to the decline of the steel industry in the US. US Steel is another company to research, though I suspect it has issues that make it a pass, rather than a buy; for example, being exposed to the US and Europe, but not the emerging economies. For now, the -2% revenue growth and over -50% EPS growth have me thoroughly side-lined.

Cheap natural gas helps companies such as The Mosaic Company (NYSE: MOS). Natural gas is a key material in the production of ammonia for fertilizers. The same logic applicable to US Steel applies here; if a key part in the production process is cheap, then margins go up or the cost to the consumer goes down. Fertilizer is an international business. If the US can grab an advantage because of cheap, locally-extracted natural gas it should. Citi upgraded Mosaic to a buy, noting that the drought will not hurt fertilizer demand. Considering the US is an agricultural giant, I think a fertilizer producer is worth looking into.

With a debt-to-equity ratio below 0.1, cash above $3.5B, a 17% profit margin, and a stock price that has been basically flat for the last 3 years I think Mosaic can make some serious gains if it can show improving fundamentals. If it can really leverage the cheap natural gas and any other positive signs it is primed for some capital appreciation. With all those good signs I noted, I am definitely looking further into Mosaic. I would rather not buy at the short-term peak, even if I hold the stock long-term. Despite the durability of fertilizer demand even during the drought, I wonder if the farmers most harshly effected will have the ability to pay top dollar for fertilizer next year. It might place a cap on Mosaics future growth. That is just conjecture based on the trajectory of the drought becoming one of the costliest disasters in recent US history.

Conclusion

Lots of benefits can flow from natural gas. The earlier Wall Street Journal article I linked made mention of producers wanting to export gas to help undo the price decline is very critical for any company relying on natural gas. Definitely an issue to keep an eye on. I would prefer that the fuel be used internally to benefit many different American industries.


TheArchivist has no positions in the stocks mentioned above. The Motley Fool owns shares of Westport Innovations. Motley Fool newsletter services recommend Westport Innovations. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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