2 Timely Shale Plays

01/11/2013 8:00 am EST

Focus: INCOME

Peter Staas

Managing Editor, Capitalist Times and Energy & Income Advisor

The way to go if you're looking to take advantage of the great shale plays in the US is to look to the natural gas liquids (NGLs) stocks and select midstream players in that sector observes Peter Staas of Energy and Income Advisor.

Gregg Early:  We're here with Peter Staas, managing editor of Energy and Income Advisor, and Peter, I wanted to ask you, there was just something that came out earlier this week regarding the fact that last year was the lowest amount of energy imports in the past 25 years for the country and I know some of that has been due to the economic quagmire that we've been in but part of it is also domestic energy production. And I know you're quite involved in this sector, so I was hoping we could discuss some of the more interesting opportunities that  might be available this year within the domestic energy sector.

Peter Staas:  Of course, Gregg, and that's what investors should be focusing on.  This trend has been in play now for about two years.  US oil production has ran for the first time in decades and the US overtook Russia a few years ago as the world's leading producer of natural gas.

Most of this production is coming from unconventional resource plays specifically shale oil and gas plays such as the Eagle Ford in South Texas, the Bakken Shale in North Dakota and a lot of this has come about because of two factors.

One, you've had elevated oil prices, which has incentivized higher cost production but the main thing is that you've had the development of two technologies: hydraulic fracturing, which is pumping huge volumes of water and chemicals and sand and so forth into shale formations, which are formations that have low permeability; and also horizontal drilling.

That's really changed the domestic energy picture and not only has production been growing but a lot of this has occurred in areas that traditionally haven't produced oil and gas, so there's been a huge infrastructure shortage, which is a big opportunity for the master limited partnership space, which traditionally has owned a great deal of mid-stream assets like pipelines, gas processing, and fractionation.

One of the big opportunities that we see in these states is, and again, most of the focus has been on production thus far and I think part of it has just been such a big story because the more you increase domestic production the lower imports.  Obviously, that's something that's going to play well on the news and people are going to focus on but I think that investors would, should, really be paying attention to gas at this point.

I say that because in the US, the demand side of things, especially one of the reasons that natural gas production has remained so robust is because of an associated product. It's a group called Natural Gas Liquids or NGLs and they're a heavier set of hydrocarbons such as propane, ethane, butane, isobutane, and condensate that occur in these formations and they tend to command a higher value than natural gas.

Gregg Early:  What are they used in? Basic chemical processes for developing plastics and other materials, right?

Peter Staas:  That's right, especially propane and ethane, which account for about 70% of NGL production in the US. What the petrochemical industry does is they have these facilities called "crackers" and they use steam to heat ethane and propane, which then, through that process, they transform into propylene and ethylene, which are the basic building blocks for most plastics; synthetic materials; and the domestic petrochemical industry.

2008, 2009 were really, really difficult years for the domestic petrochemical industry mainly, I mean, you had a huge drop-off in demand and you also had really elevated feed stock prices.

Actually, one of our favorite names, LyondellBasell Industries (LYB), actually declared bankruptcy.  They were under so much pressure then.

They've emerged much stronger.  They spun off a lot of losing assets and they're a huge beneficiary of growing NGL production in the US.  We've seen ethane inventory is up 43.6% year over year in November.

There is a huge glut of ethane and that's likely to continue over the next two to three years.  That's pushed ethane prices down to a five year low of $22 per gallon in December and that's kind of the point at which ethane rejection occurs, which is where processing plants that remove NGLs from the natural gas stream start to reject ethane.

That is, it's no longer economic for them to remove it, so NGL prices are very, very low right now, which is a huge, huge advantage for domestic petrochemical companies and LyondellBasell Industries (LYB) has a number of ethane crackers on the Gulf Coast and they also have plans for low-cost plants to bring on additional capacity over the next two years.

The company has paid out a substantial special dividend in each of the past two years, which gives this stock a yield of about 7.5%.  The company has stated that it will change the schedule for paying out this distribution, this special dividend.

They're more likely to do more frequent lower distributions rather than a big lump sum at the end of the year, which should incentivize people to hold longer timeframes but we really like the stock even though it has hit a 52-week high with the significant more upside there.

|pagebreak|

We like it as a pairs trade with Targa Resources Partner LP (NGLS), which is a master limited partnership (MLP). MLPs have a reputation as holding toll road-like assets where they collect the fee; a lot of pipe line assets where the collect disabled fee.

Targa Resources Partner LP (NGLS) has a bit more commodity price exposure than a lot of other ones.  I think about 55% to 60% of their distributable cash flow is fee based so you've got 45% to 40% that has exposure to commodity prices especially NGL prices.

The company does hedge some of its NGL exposure; about 55% in 2013. But hedging NGL, like exposure to ethane and propane, is very challenging because it's not a very liquid market but we like the company for a number a reasons.

First, continues to grow its fractionation, which is the part of the midstream process that separates the NGLs into ethane, propane, and so forth and there still is a huge, huge demand for that.  We expect that business to be very strong.

The other thing we really like is they own one of two propane export terminals in the US and actually they just announced that they acquired more land in that area so they are going to continue to expand that capacity.

Propane exports have increased 10 times over the past like three or four years, which is huge, so they have exposure to that. And in the third quarter they covered their distribution by about 1x time and they're aiming for 1.2x over the long term. 

We see the opportunity for the MLP to grow its distribution about 10% to 12% this year and a lot of that is coming from just new projects that they're going to have.  Yes, there is commodity price exposure but we think it is more conservatively run than some of the other names that are out there and in terms of names that have exposure to the NGL side of things, especially concentrated exposure, Targa Resources Partner LP (NGLS) is our favorite. 

We think Targa is a good pair trade with LyondellBasell.

We would also definitely steer clear of a lot of MLP IPOs that are smaller names that have exposure to this business and they just don't have the diversity of assets or the scale. They're really going to take a hard hit over the next few years. 

One of those is American Midstream (AMID).  I think that's definitely a name to avoid.  Their distribution is going to come under pressure in coming quarters.

Related Reading:

MGM Wins Its Bet on Macau

2 Picks from a Fund Guru

One Refiner MLP Ready to Go

Related Articles on INCOME