2 Strong Plays In A Struggling Natural Gas Market

By: Adam Fischbaum of Street Authority

Once heralded as the bridge to an oil-free energy future, natural gas seems to have been relegated to stepchild status in the hierarchy of carbon fuels. Why?

It's cheap, clean, efficient and plentiful. That's part of the problem. The Energy Information Administration (EIA), estimate that there are 388.8 trillion (yes… trillion) cubic feet of proven natural gas reserves in the United States. That's a lot of product to be pumped along with the 20+ trillion cubic feet of dry natural gas we pump annually.

And we keep discovering more. Take a peek at a 20-year study of the spot price.

After a couple of flirts with ridiculous prices, we're pretty much back to where we started when I still had hair and wore size 32 jeans.

The other challenge is lack of industry consolidation. The top 10 U.S. natural gas producers control 31% of the market. That's a decent number. But compare that to the top 10 petroleum producers who tap 52% of the market. Thin margins due to low prices don't get companies excited about acquisitions.

So with prices in the toilet and lack of merger activity, can investors make any money with natural gas? The answer is "yes". I've found two companies that are thriving despite challenging sector fundamentals.

Spectra Energy Corp. (NYSE:SE) -- Spectra is weathering the energy meltdown thanks to its diversified portfolio of gas related assets. Although the company is primarily known as a midstream company (processing, storage, transportation and marketing), it also operates a regulated transmission and distribution business that currently serves 1.4 million customers in Ontario, Canada. The relative safety of the transmission and distribution operations work to offset the inherent risks associated with the disruption of lower commodity prices that can affect traditional midstream operations.

The company's natural gas pipeline system consists of 21,000 miles of natural gas transmission pipelines and around 295 billion cubic feet of storage capacity in both the United States and Canada. And despite the brutal repricing of natural gas as a commodity, the company was able to actually invest over $2 billion in growth projects last year. These projects were launched based on secured, long term contracts with investment grade customers rather than speculation on a rise in commodity prices.

This enabled Spectra to grow distributable cash flow by 7% and to raise its annual dividend by 9.5% to $1.62 per share. Analysts are confident that SE can continue to generate distributable cash flow for shareholders. Currently, the stock trades around $30.80 with a 5.3% dividend yield.

The Williams Companies, Inc. (NYSE:WMB) -- After spinning off its midstream and exploration business to shareholders in 2012, WMB has become an energy infrastructure company focusing on North America. In the natural gas world, the company operates 13,600 miles of pipeline across the United States. Again, like Spectra, Williams transports product for producers resulting in tangible, stable, regulated, long term contracts that support consistent cash flow. But the real story is the company's proposed merger with Energy Transfer Equity (NYSE:ETE).

Last summer, Williams received an unsolicited offer to be purchased by Energy Transfer for $64 a share. At the time, Spectra was also a prospective suitor. However, as energy prices deteriorated, so did the chances of the merger being completed. ETE would have to take on a mountain of unmanageable debt to pull off the $32.6 billion deal. Williams has filed a lawsuit contending that ETE had conducted a private preferred stock offering to raise money for the deal, which violated the terms of the merger agreement. Williams management has not directly spoken out against the merger but it would appear that this move would encourage shareholders to reject the plan.

Although the proposed merger would create the largest natural gas pipeline in North America, it would seem that the company is better off on its own. Like Spectra, Williams has a balanced mix of fixed return, regulated businesses versus the higher risk gas gathering and processing business. This enables the company to generate over a $1 billion in annual cash flow resulting in a 10-year track record of growing the dividend by 60% on a compounded annual basis.

Termination of the merger should remove uncertainty from the stock and allow the company to do what it does best: move natural gas from point A to point B. Shares trade around $18 with a 14% dividend yield.

Risks To Consider: Due to earnings pressure from the tumultuous energy environment, these stocks trade at forward P/E's that are a little higher than those I typically work with. However, the whole sector is such a mess I can't expect earnings NOT to be adjusted downward in this environment.

Also, long term debt to capitalization percentages for these companies are a bit higher than I typically recommend. Again, not to make excuses, but pressure on stock prices are the primary culprit. Granted, they're fundamentally driven, but on a macro level. Both companies are extremely well run, have diversified business portfolios and generate the necessary cash flow required for debt service and shareholder distributions.

Action To Take: On average, both stocks are trading at a 45% discount to their 52-week highs (WMB is responsible for the lion's share at 71%) and, yielding a blended 9.8%. For investors who are mentally ready to tiptoe back into natural gas, this combo is a good place to start for attractive income and upside potential.

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Article source: http://www.streetauthority.com/node/30670356