News Analysis date published New: 
Friday, January 18, 2013 - 10:00
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Friday, January 18, 2013 - 10:00
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Friday, January 18, 2013 - 10:00

One of the Safest Ways to Cash in on the Natural Gas Revolution

Friday, January 18, 2013 - 10:00am

Did you know the United States is projected to be the world's top oil producer within the next five to seven years? At least that's what the International Energy Agency has projected. This means the United States is on pace to beat Russia and Saudi Arabia in daily crude output.

How could this happen?

One word: shale. Shales are fine-grained sedimentary rocks formed by the accumulation of sediments at the Earth's surface and within bodies of water. Petroleum and natural gas get trapped within the rock formations, so shales are rich resources of these two energy sources.

Oil and natural gas are extracted from these shales through hydraulic fracking -- the method of forcing a high-pressure mixture of water, sand and lubricants sideways into small cracks in the shale. This opens up a natural pipeline for the natural gas to escape into the vertical well to be captured.

[See also "My Top 2 Stocks for America's Energy Independence"]

During the past decade, the combination of horizontal drilling and hydraulic fracturing has allowed access to large volumes of shale gas that were previously uneconomical to produce. But thanks to fracking, the production of shale gas has rejuvenated the natural gas industry in the United States.

That's why my colleague Andy Obermueller, chief strategist of Game-Changing Stocks, says the United States "will run on natural gas" in the next few decades. (He's actually putting the finishing touches on a special report on this topic right now, including the names and ticker symbols of the companies that are set to profit from this trend.)

Consulting firm Woods Mackenzie has projected that U.S. shale formations are expected to yield 4.2 million barrels of oil per day by 2020. Today, this number is roughly 1.6 million barrels, so you can see the amazing growth opportunity in shale gas.

Trying to cash in on the "shale revolution" can be a high-stakes battle. Many of the publicly-traded exploration companies are risky at best. Even some of the larger, more established companies such as Chesapeake Energy (NSYE: CHK), Devon Energy (NYSE: DVN), and Kinder Morgan Energy Partners (NYSE: KMP) have seen their share prices take a beating in the past 12 months, largely due to the oversupply and subsequent drop in price of the commodity.

But as I look at opportunities in shale, one company that stands out is Sunoco Logistics (NYSE: SXL), a master-limited partnership (MLP) spun off from integrated oil company Sunoco (NYSE: SUN).

Sunoco's logistics business has actively pursued growth opportunities in burgeoning shale oil and gas for the past few years. The partnership owns 5,400 miles of crude oil pipelines in Texas, Oklahoma, and the Gulf coast and 42 terminals that provide temporary storage for refined products. It is now focused on growth opportunities that include pipelines being developed in the Marcellus and Utica shale plays. Last September, it announced a successful open season for Mariner East, a pipeline projected to deliver propane and ethane from the liquid-rich Marcellus Shale areas in Western Pennsylvania to Sunoco's facility in Marcus Hook, Pennsylvania, where it will be processed, stored and distributed globally.

Sunoco Logistics' core pipeline business is attractive and generates healthy cash flow each year. But crude oil and natural gas liquids production in shale formations provide Sunoco with opportunities to extend its pipeline network and collect attractive fee-based cash flows.

Acquisitions of additional pipeline properties should also add to this cash flow. Additionally, its marketing segment helps Sunoco Logistics increase returns by locking in margin opportunities. What I like best about Sunoco is its potential for higher growth with new projects and optimization of its existing assets. Sunoco's core assets are liquids pipelines that receive inflation-protected annual rate adjustments.

Impressive balance sheet
Sunoco Logistics Partners' latest quarterly results were quite impressive as it delivered a 25% gain in adjusted year-over-year EBITDA to $188 million from $149 million. Sunoco's main driver was its oil pipelines segment, which increased EBITDA by 48% to $71 million. In addition, its terminals and lease marketing segments each delivered impressive 20% gains. Sunoco also posted an impressive 37% increase in distributable cash flow, which provided a 25% year-over-year increase in per-unit distributions. The stock yields almost 4% and has a history of consistently increasing distribution.

From a financial standpoint, Sunoco Logistics looks stable. It faces modest debt maturities of $175 million in 2014 and 2016. This is not a concern, however, as it continues to maintain a very strong balance sheet along with high levels of distribution coverage. This mainly comes from excess cash flows from the crude-oil leasehold business. Its current debt/EBITDA ratio is around 2.7 times, with the potential ability to cover interest payments by four-to-five times during the next five years.

Risks to Consider: Because partnerships pay out a large percentage of their cash flow, Sunoco Logistics is forced to use external funding for growth and acquisitions. It also generates significant revenue from crude-oil marketing. This is a lower-margin business that has cash-flow volatility due to the sensitivity of commodity prices. In addition, because Sunoco Logistics is an MLP, investors in the partnership's common units are responsible for their share of the partnership's tax bill, which could increase tax-filing complexity. However, given all these risks, I still like the diversified approach at Sunoco Logistics and its dedication and commitment to shale opportunities.

Action to Take --> Buy Sunoco up to $60 a share. It is currently trading around $55 and my price target is $66, representing a potential 20% gain in the next six to 12 months. If you are looking for a safer way to get onboard with the shale revolution, then this stock is definitely worth a closer look.

Jay Peroni does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of KMP, DVN, CHK in one or more of its “real money” portfolios.