A 7%-Yielder in an Energy Sector You Aren’t Hearing About

Right now it’s a booming component of the energy sector, but I’d guess that you’ve probably never heard about it.

It’s certainly not covered day-in and day-out by the major media outlets.

#-ad_banner-#But just because this story isn’t making front-page headlines, don’t think it’s gone unnoticed.

In fact, the change you’re not hearing about has major companies such as Dow Chemical (NYSE: DOW) rushing to expand their operations in order to capitalize on this revolution.

But before I tell you what it is, let me ask you: What do plastic cups, clothing constructed from man-made fibers, premium synthetic oil, propane, and anti-freeze all have in common?

Simple answer, they’re all made from natural gas liquids, or NGLs.

Natural gas liquids are naturally occurring elements found as a byproduct of natural gas. You’ve heard of them by their more specific names such as ethane, propane and butane. NGLs are valuable as separate products, making it profitable to remove them from the natural gas itself.

So why are they seeing an investment boom?

Well, to understand this opportunity, it’s important to understand how NGLs are priced.

You see, while U.S. natural gas prices are languishing from oversupply and weak demand, natural gas liquid prices are booming. That’s because NGL prices are tied to oil prices, not gas prices.

A barrel of NGL is typically worth about 60% of the value of a barrel of West Texas Intermediate crude oil. As of mid-August, the exact figure was 62.3%.

In other words, when oil prices are unusually high relative to natural gas prices, profit margins on NGLs are unusually fat. And right now that margin is historically large.

According to the U.S. Energy Information Agency (EIA), crude oil will average just over $94 a barrel for this year and next. Meanwhile, natural gas will fetch a little more than $4 per thousand cubic feet.

At those price levels, oil is trading at a ratio of about 23 times natural gas prices. The historical average is less than half that, at about 10 times.
What’s causing such a large disparity?

In short, it’s all due to a recent technological development called hydraulic fracturing. Hydraulic fracturing is a production technique whereby oil companies pump sand and water into oil wells, fracturing the formation and making it more porous. This development has allowed oil companies to recover natural gas from formations that were otherwise thought of as impermeable.

Starting in about 2005, hydraulic fracturing tapped large pools of previously inaccessible shale gas.

As a result, U.S. gas production has increased about 20% since then. Increased production has joined up with tepid demand — in part created by the Great Recession — to keep gas prices low.

Oil, however, is currently in a rough supply and demand balance. The International Energy Agency projects that worldwide production will be 90.7 million barrels a day in 2012 and that demand will be 89.3 million barrels a day. Even with reduced worldwide economic growth, oil prices are expected to be stable.

And as long as the oil-to-gas price ratio stays in the current vicinity, NGL producers should continue to prosper.

But the producers aren’t the only ones that will profit from this new trend in energy. Natural gas liquids are also a booming business for the entities that transport them.

These businesses benefit from increasing fee-based volumes as they connect the producers with end-users, whether they be petrochemical plants, refineries or propane distributors.

That’s good news for master limited partnerships (MLPs) like Targa Resources Partners (NYSE: NGLS). Targa Resources Partners owns pipelines that oil and gas companies use to transport NGLs around the country. Since their business is not directly affected by the price of commodities (they only own and operate the transportation infrastructure), they are less exposed to commodity risk as well.

Now, natural gas MLPs are a dime a dozen, but few have an established and fully integrated NGL footprint.

That’s what makes Targa Resources Partners so appealing. With more than 800 miles of NGL pipelines and 385,000 barrels a day of fractionation capacity (the quantity of NGLs that can be broken down into their base components daily), Targa is one of the largest NGL plays in the United States.

And right now, Targa looks cheap. As it stands, the units are trading at just six times cash flow. That’s a deep discount when you consider that the average of its pipeline peers is 12 times.

Consequently, Targa Resources Partners is currently offering a 6.8% yield. That’s well above the industry average of 4.8%. So buying now not only locks in a nice yield, Targa also gets the benefit of having a big upside potential as well.

Risks to Consider: A double-dip recession could lead to a sharp decline in oil prices. Natural gas prices would also weaken but oil prices could decline more dramatically, reducing the value of NGLs.

Action to Take –>That being said, as long as we avoid a recession I think this opportunity looks promising. Only a handful of MLPs provide an entrenched NGL footprint. And since that footprint is expensive to replicate — high-yield MLPs focused on natural gas liquids are protected by significant barriers to entry and should prosper as long as oil stays high relative to natural gas.