[Last time], I outlined why natural gas prices were moving up.

Today, let’s talk about how investors can make some money off this.

As gas prices inch toward $4 per 1,000 cubic feet (or million BTUs) on the NYMEX futures market, we need to remember that this is not going to be either an accelerated rise or one that will be without volatility.

[ad#Google Adsense 336×280-IA]For reasons mentioned [earlier], gas prices will likely cap out in the mid-$4 range by the time we reach midsummer.

That means there are not going to be any across-the-board influences raising the entire sector.

This is going to require some patience and selective investing.

So how does one structure an approach to this?

Three overarching considerations must be addressed upfront.

First, the strategy requires some patience.

This rebound is not happening overnight.

Second, unlike in other energy categories, there is limited advantage here in the use of exchange-traded funds (ETFs). With natural gas, it’s all about cherry-picking stocks, not playing the broad environment of providers.

Third, be prepared to redirect investment.

Staying with selected companies through low periods may work in other sectors, but with gas there is considerable extractable volume to bring to market at any time. While demand is going to be rising in the categories discussed on Saturday, the potential on the supply side will make a “lifting of all boats” impossible.

Therefore, adopt an approach utilizing trailing stops. Select a loss level you can live with (25% or 30% is what I usually use), and sell shares when they reach that level.

These are trailing stops. The stops kick in once the decline has reached the percentage from the share’s highest value while part of your holdings. That allows you to retain some profits or at least minimize the overall loss, if the stock has benefited from an improvement.

So, as the natural gas rebound continues, what opportunities should you target?

A Winning Natural Gas Strategy

Here, there are four areas of primary interest. Each requires that you apply the following considerations in selecting investments.

  • First, the companies need to have a particular emphasis in the overall upstream-to-downstream sequence (from wellhead to consumer distribution).
  • Second, each selection should have a track record of successful business in an area of specialty – the shale gas “revolution” has brought in a number of players, but the current pricing dynamics will shake many of them out.
  • Third, there is the further need to have sufficient liquidity in the shares selected to allow an entrance and exit on your terms. This is provided by a combination of market cap and daily trading volume.
  • Finally, selected investments should exhibit some diversification. Do not invest in only one sector of the industry. Obviously, as I will mention in a moment, there will be certain elements likely to benefit more than others.

But over-weighting investments in a narrow range of the sector means you either have several investments performing at about the same improvement…or at the same loss. As market indicators change, you have no place to go.

There’s Always Money in the Midstream

Where to move first is the main question. As the gas market opens up, two initial plays are warranted. The first is in midstreams – the companies providing gathering, initial processing, transit, storage, and fractionating.

We have discussed midstreams on several occasions. Many of these are actually equity issuances from master limited partnerships (MLPs). These afford the average investor with an opportunity to participate in the increase in gas movement from field to distributor and usually provide a dividend higher than market averages.

This results from the way MLPs are structured for tax purposes. As with “S” corporations (now the structure of more small businesses in the U.S. than any other), MLPs do not incur corporate taxes. Instead, all profits move directly to the personal tax returns of partners in proportion to ownership.

The percentage of an MLP spun off as stock, therefore, corresponds to a percentage of profits. And all of that moves to the equity holders as dividends.

But not all MLPs are created equal when it comes to returns. When the approach emerged, it was a way to control pipeline systems, long regarded as the backbone of midstreams. That initially resulted in major gains. As the rise in shale gas volume took place, however, the dual advantages of MLPs began to decline.

MLPs had the advantage of gaining fees for transport across pipelines and making money from operators having to use pipelines as storage for gas coming out of the ground with no immediate market end user. The very weight of the new volume increased the portion held in storage, reaching pipeline capacity from such storage not from transport, and reduced the prices for the gas.

The combination of elements producing a declining gas price (until recently) depressed MLP profits by increasing the operating expenses of assets and reducing the fees paid by operators. That finally led to a cut in production (actually, a cut in the increase in production) and a slow reduction in the excess supply in storage.

MLPs are now likely to see a return to rising profitability as the new balance among operators kicks in. Yet this will not result in the same return for all.

In this category, pick the basin comprising the primary service region for an MLP, not the producing companies. Some basins are providing cheaper per well extraction costs than others. These are the ones that will recover first, and provide the MLPs involved in providing pipeline services to those basins with the initial profit.

Two basins are in focus here: Marcellus and Niobrara. Target your initial MLP buys there.

Mergers and Acquisitions Are Heating Up

The second play is going to emerge from a new wave of mergers and acquisitions (M&A). The days are gone when most oil or gas companies will be driving to become vertically integrated – controlling all aspects of the process from the field to retail distribution.

But that does not prevent focused integration and combination of what used to be functions run by separate companies. The vertical moves today are emerging in the area between pipelines and retail sales. These include processing, terminals, wholesale distribution, and especially movement of volume for specialized petrochemical uses.

The objective here is not a new one. These new holdings can utilize transfer pricing rather than market pricing when moving from one particular service to the next. By controlling more than one stage in the process and controlling all the moving parts in between, the vertical can limit costs and increase profit margins.

What has been learned from the first go round in vertical integration – the one that created huge international majors – is the increasing costs and inefficiency flowing from owning too many assets in too many segmented portions of the sector.

Bigger is not always better.

Related modular expansion, however, is the next wave. And that addresses components in the same market neighborhood.

Notice I have not said anything about the operating companies themselves, those drilling and extracting the gas. That’s because there is still too much competition, and another form of M&A must occur there first before profit margins are significantly improved.

That will happen.

But the two areas identified today are more likely to generate a nice return before then.

We’ll talk a bit more about these basins as this rebound continues into the summer.

— Dr. Kent Moors

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Source: Money Morning