Which MLPs Will Benefit From Higher Natural Gas Prices?

The shale gas boom of 2008 went away every bit as quickly as it came, and the domestic natural gas industry has been decidedly sleepy ever since. Shale gas production has receded to only its core, such as low-cost plays in the Marcellus and parts of the Barnett.

But the price of domestic dry gas seems to be on the upswing right now. And if dry gas prices recover to, say, $5 per thousand cubic feet, many companies will see big windfalls. It is tempting to look at big shale gas producers such as Cabot Oil & Gas (NYSE: COG). Cabot, for its part, has among the lowest shale gas production costs and among the best long-term production growth prospects. This is because Cabot has a huge position in the unrivaled Marcellus shale.

But to concentrate on only the shale is to overlook opportunities in the more traditional conventional gas formations. Conventional gas may not have the impressive growth rate that the shale does, but as America's traditional source of natural gas its cost basis is often a lot lower than that of the shale. Why? In short, because conventional gas is easier to reach, and is in regions where infrastructure has been long laid out.

Income investors will want to concentrate on both conventional gas and shale gas because that is where the best income opportunities are. Upstream master limited partnerships, or MLPs, often provide the highest yields in the energy space because, like a normal partnership, these entities do not pay a corporate tax. There are a few good upstream MLPs whose production is mostly natural gas. Most of these names have a portfolio of both conventional gas and shale gas. These partnerships provide a high yield and have good upside if dry gas keeps going higher.

The contrarian MLP
Vanguard Natural Resources (NASDAQ: VNR) is perhaps the biggest gas-centric upstream MLP. It should be among the first gas investments that income investors look at. Over the last couple years, Vanguard's strategy has been to buy the gassier properties that other operators were happy to get rid of at a low price. Its most recent acquisitions have been in the Permian, western Arkansas and the Piceance in Wyoming. All three of these transactions yield profitable production in low-price environments. Some of that acreage is shale gas, some of it is conventional gas. Best of all, if gas prices go modestly higher, roughly $5 or more, Vanguard will have substantially more acreage it can profitably drill. In this sense, Vanguard is a leveraged bet on higher natural gas prices.

Vanguard's distribution coverage is about in the middle of the spectrum, with distributable cash flow at 1.05 times 2013 distributions. There are MLPs out there with better coverage ratios. As of last week, Vanguard was trading at just over 10 times distributable cash flow. While I do like Vanguard as an MLP, and think its acquisition strategy is terrific, there are better values out there.

A captive partnership
Let's look at Memorial Production Partners (NASDAQ: MEMP) instead. At just below an 11% yield, Memorial yields about 2 percentage points more than does Vanguard. But let's dig a bit deeper. Unlike Vanguard, Memorial has a parent company, Natural Gas Partners. Also unlike Vanguard, Memorial sticks mostly to conventional gas. The advantage this brings is in Memorial's rock-bottom cost of production. Literally no other partnership can produce gas as cheaply as Memorial can, as the graphic below shows.

Courtesy of Memorial's RBC Presentation

And despite this partnership's amazingly low cost, Memorial is actually trading at a discount. At only 9.4 times distributable cash flow, Memorial is one of the cheapest upstream MLPs. Why is Memorial priced at such a discount? I believe it is because this partnership is still young, only three years old. But it also has a sustainable yield covered by cash flow at 1.05 times, just like Vanguard. Memorial is among the best values in the upstream MLP space right now. Like Vanguard, Memorial also has big upside to higher dry gas prices.

Bottom line
If dry gas prices are going to rise, these two MLPs stand to benefit the most. It also helps that these names provide a high, sustainable yield. So before income investors look at the bigger, gas-producing corporations, they should first look at these higher-yielding partnerships.

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The article Which MLPs Will Benefit From Higher Natural Gas Prices? originally appeared on Fool.com.

Casey Hoerth owns shares of Vanguard Natural Resources. The Motley Fool has no position in any of the stocks mentioned. 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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