3 Energy Plays Worth Watching

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

Declines in fuel oil and natural gas offset each other in June. The energy component of the CPI rose 3.4% as gasoline prices jumped 6.3% and natural gas dropped 1%. Meanwhile, the IMF affirmed rising risks for the Chinese economic outlook and the U.S. Federal Reserve Chairman Bernanke reiterated that the timing for tapering was flexible, data dependent. Exploration and Production (E&P) companies are directly exposed to oil and gas prices and utilities production, which are inherently volatile and subject to complex market forces.

Top unconventional liquids-rich plays

Chesapeake Energy (NYSE: CHK) explores, produces, and markets natural gas, oil, and NGLs, contributing about 3.5% of the total U.S. production. Chesapeake is more vertically integrated than most large producers, with leading position among the top unconventional liquids-rich plays, including Eagle Ford, Utica, Granite Wash, Cleveland, Tonkawa, Mississippi Lime, and Niobrara and in the Marcellus, Haynesville/Bossier, and Barnett natural gas shale plays.

The company is particularly vulnerable to fluctuations in the natural gas market with three quarters of its production volume coming from natural gas. Therefore, given the weak natural gas price scenario, Chesapeake plans to move aggressively within its liquids-rich plays as part of a continuing strategy to diversify away from natural gas. Chesapeake announced recently that it had reached an agreement to sell its non-core Eagle Ford and Haynesville assets to EXCO Resources for $1 billion.

The company faces other risks associated with its business model that relies on non-traditional sources of financing to work. Failure to locate buyers for future deals could force the company to issue equity or sell assets at below-market rates to help fund operations. In addition, its dependence on individual well performance, cost overruns on long-term projects, and regulatory changes could ultimately eat into profitability.

Last January, McClendon resigned as CEO after 24 years in the position. His replacement is a petroleum engineer by training, and his appointment has been received well. I would recommend to hold on to Chesapeake’s stock, to see how things progress with new management and the oil and gas prices.

Wide-moat, long-haul pipelines

Williams Companies (NYSE: WMB) is an integrated, large pipeline company that processes roughly 10% of U.S. gas production. The company’s core operations include finding, producing, gathering, processing, and transportation of natural gas. The company operates 15,000 miles of interstate gas pipelines and 1,000 miles of natural gas liquids (NGLs) pipelines.

Its model consists of a combination of a wide-moat, long-haul pipelines, a large midstream gathering and processing business, and investments in downstream petrochemical processing. While Williams has a clear exposure to natural gas prices, this allows the company to collect economic rent from each link of the midstream value chain and to retain a cash flow profile that is fairly insulated from commodity price fluctuations.

Other risks include tax or regulatory changes, changes in regulated pipeline tariffs, and pipeline spills, explosions, or ruptures.

During 2012, the prices of NGLs, specifically ethane and propane, dropped significantly as supply from shale drilling far exceeded demand. The scenario could change in or after 2015, when petrochemical demand for ethane is expected to increase as a result of multiple new ethylene crackers currently under construction.

Net income was up 8% sequentially, but down 44% from last year due to low NGL margins and particularly low ethane prices. Consequently, gas processors opted not to extract ethane from the gas, as extraction and transportation costs exceeded ethane prices. Williams would be benefited from the rebound in industrial activity due to increased natural gas demand. Trading at about 36 times its earnings (7% above the industry average) while offering a moated business, I would recommend shares of Williams as a hold for now.

The largest natural gas pipeline system in North America

Kinder Morgan (NYSE: KMI) is one of the largest midstream energy companies in the U.S. It owns and operates pipelines that transport natural gas, gasoline, crude oil, carbon dioxide, and additional products. It has more than 180 terminals that store petroleum products and chemicals, as well as ethanol, coal, petroleum coke, and steel.

Kinder Morgan intends to increase its exploration and production volumes, expanding the Transmountain and other future projects that would also enhance shareholder value. Last year, Kinder Morgan acquired El Paso, becoming the owner of the largest natural gas pipeline system in North America. Kinder Morgan shareholders own approximately 68% of the combined company, and El Paso shareholders hold the remaining 32%.

However, the company’s move toward natural gas via this acquisition raised concerns amid a sluggish natural gas price environment. Other risks include the possibility of tax or regulatory changes; changes in regulated pipeline tariffs; capital investment risks; and pipeline spills, explosions, or ruptures.

For 2013, management expects a hike of 6% in declared cash distributions per unit compared to last year. Trading at about 37 times its earnings compared to the industry average of 24 times, Kinder Morgan is expected to outperform its peers based on a moated brand and compelling growth prospects.

Bottom line

Chesapeake and Williams do not offer convincing reasons for a buy recommendation due to the risk of a substantial and prolonged drop in oil and gas prices. Nevertheless, Kinder Morgan is expected to deliver strong growth figures in the future and outperform its peers. 

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Victor Selva has no position in any stocks mentioned. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan and has the following options: long January 2014 $20 calls on Chesapeake Energy, long January 2014 $30 calls on Chesapeake Energy, and short January 2014 $15 puts on Chesapeake Energy. 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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