How to Prepare for Natural Gas Overtaking Coal in the U.S. Utility Sector

The U.S. Energy Information Administration projects that natural gas will overtake coal as the most dominant fuel source in the U.S. utility sector by 2040. However, it doesn't see natural-gas prices rocketing higher, which means you'll need to be selective in how you invest in this trend.

Cheap gas
The combination of horizontal drilling and hydraulic fracturing has led to a material increase in the supply of natural gas in the United States. There isn't enough demand to sop it all up, so the commodity's price has plumbed new lows. That's a mixed blessing.

Source: EIA

On the one hand, some drillers have had a hard time making a profit. On the other hand, low prices have led to an increase in the use of natural gas for everything from electricity to trains. And that trend should continue since the EIA expects natural-gas prices to remain relatively low through 2040.

Still, that's good news for natural-gas adoption but bad news for companies that drill for the fuel. That's why investors should focus on drillers that have very low operating costs, like Ultra Petroleum and Chesapeake Energy .

Chesapeake is probably the better known company -- though that's not necessarily a good thing. Under former management, Chesapeake got caught up in the land grab when natural-gas prices were high. When gas prices fell, Chesapeake was heavily indebted and owned assets that were worth less than what it paid.

And then things got interesting because activist investor Carl Icahn stepped in. He essentially replaced the old CEO with one focused on drilling. And while the company still has notable operational and debt issues to work through, so far the new leaders are doing a good job. And Chesapeake happens to be one of the lowest-cost drillers in the industry.

That said, Ultra Petroleum is even more frugal than Chesapeake when it comes to drilling costs. That makes this lesser-known rival fairly compelling, too. You should overlook the huge loss in 2012, however, because that was largely the result of a non-cash writedown of reserves.

While that means Ultra overpaid for its land based on recent natural-gas prices, Chesapeake shows that it is wasn't alone. Ultra, meanwhile, was solidly profitable in each of the first three quarters of 2013. While the same is true of Chesapeake, being the industry's cheapest driller will offer significant advantages to Ultra if gas prices remain low.

Moving it
For those not willing to take on the risks of drilling for a historically volatile commodity, owning toll-taker businesses like pipeline operators Enterprise Products Partners or American Midstream Partners would be a better bet.

Fifty eight billion dollar market cap Enterprise is one of the largest industry players, offering instant exposure to multiple regions and aspects of the midstream business. It has increased its dividend for 37 consecutive quarters. That said, the company's success is no secret and the shares yield a modest 4.4% or so. If you want more income, American Midstream's yield of nearly 7% might be more enticing.

American Midstream, however, sports just a $100 million market cap, has just a few assets relative to Enterprise, and only increased its distribution for the first time in November. There's been some management changes at the company, too, but American Midstream appears to have decent growth prospects if you are willing to take on more risk for a higher yield.

Two sides
If more natural gas is available and more is used, the United States is set for some specific changes. For drillers, low gas prices will give cheapskates like Ultra and Chesapeake a leg up. More gas, however, also means a need for more infrastructure, a boon for mid-stream players like Enterprise and American Midstream. At the end of the day, this quartet is a good place to start if you are looking for a way to play the natural-gas space.

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Reuben Brewer has positions in American Midstream Partners and Enterprise Products Partners. The Motley Fool recommends Enterprise Products Partners L.P. and Ultra Petroleum. The Motley Fool owns shares of Ultra Petroleum and has the following options: long January 2014 $30 calls on Ultra Petroleum, long January 2014 $40 calls on Ultra Petroleum, and long January 2014 $50 calls on Ultra Petroleum. 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.

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