Think Small for Big Gains in Natural Gas Stocks

Natural gas prices today have almost doubled from just one year ago. Profits throughout the industry could surge this year if prices remain in the current range or continue to trek higher. So,is this the much-awaited cue to jump into natural gas companies? If it is, you'll have a difficult time sorting through the possibilities: There are more than 300 natural gas utilities and drilling companies to choose from. Good luck.

Perhaps the best way to capitalize on a potential Natural Gas Boom 2.0 is to think small. Really small. I'm talking about proppants: tiny beads that are pumped into a well to keep fractures open and hydrocarbons flowing, thus "propping" the well open. These microscopic marvels can increase a well's productivity and ultimate recovery by up to 30%, thereby enabling an entire industry from behind the scenes. While the competition is fierce, there are only a handful of major players jockeying for partnerships with drillers. If you want big gains in natural gas stocks, then the best investments may require you to think small.

Proppant rundown
There are three major types of proppants for energy companies to choose from:

Source: Schlumberger.

Drillers will choose proppants based on availability, budget, geography, and geology of their reserves, so the advantages and disadvantages I've listed are only part of the equation. For instance, sand may be cheaper, but its non-uniform size and shape can pose a problem in oil-rich wells. Sand is also prone to crushing -- when particles break into smaller, finer particles -- in high-pressure wells, which can lead to severe blockages. Here's how CARBO Ceramics explains the difference between its higher-end ceramic proppants and sand or resin-coated sand:

Source: CARBO Ceramics.

That doesn't make sand or resin-coated sand obsolete. All investors need to do is look at the share prices and payouts of U.S. Silica Holdings and Hi-Crush Partners to see how lucrative a business sand pumping can be. U.S. Silica has soared 86% in the past 12 months on the heels of an improved outlook and a "slight" bump in net income of more than 160%. Despite the run-up, the company sports a P/E under 16.

Hi-Crush has been working its way back from a cliff-diving adventure shares took in November. The master limited partnership went public less than one year ago and deals only in sand proppants. Although there are risks associated with MLPs that are absent of more traditional securities, Hi-Crush generates substantially all of its revenue from long-term contract agreements that run through 2015 and include 1.16 million tons of proppants each year. Translation: The payout seems relatively safe to me.

The P/E for Hi-Crush? A measly 7. That alone could justify an investment in this natural gas stock for some investors, but there is also considerable growth to look forward to when drilling activity picks up.

The growth ahead
At the end of May, the Department of Energy tallied 1,711 total natural gas and oil rig wells. That represents an 11% drop compared to last year. To be fair, improving natural gas prices won't cause drilling activity to pick up overnight, but I believe the trend remains intact despite the slowdown in 2012. It appears I'm not alone.

Analysts are circling these stocks like vultures around roadkill. Keep in mind that the following numbers hinge on drilling activity, which no one can predict years in advance. They're impressive nonetheless.

Source: Yahoo! Finance.

CARBO may be the laggard of the pack, but it faces stiff competition from cheaper sand proppants and cheaper Chinese ceramic products. Analysts are still calling for a major rebound in the next several years, with estimated EPS growing 32% from this year to next. Investors will have to weigh the salivating growth for the company's high-end products with the risks that come with it. For instance, CARBO relied on Schlumberger and Halliburton for 48.9% of sales in 2012. That could make for some uncomfortable turbulence if the energy giants turn elsewhere.

Foolish bottom line

Who knew that sand and ceramic beads could potentially be such great investments? Payouts, growth, and cheap valuations -- the three proppant companies I've discussed have a lot going for them. With such a wide selection of natural gas drillers and utilities to choose from, investors may be better off looking to the smaller collection of proppant manufacturers. The way I look at it, the natural gas industry is virtually dependent on proppants for increasing the economic competitiveness of extracting its massive domestic reserves. I'm not saying drillers don't belong in your portfolio, but proppant manufacturers should be considered for a balanced approach to natural gas stocks.

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The article Think Small for Big Gains in Natural Gas Stocks originally appeared on Fool.com.

Fool contributor Maxx Chatsko has no position in any stocks mentioned. Check out his personal portfolio or his CAPS page, or follow him on Twitter, @BlacknGoldFool, to keep up with his writing on energy, bioprocessing, and emerging technologies.The Motley Fool recommends Halliburton and owns shares of Hi-Crush Partners and U.S. Silica Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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