A Stratospheric Yield from a Deep-Down Place
Coming to a prehistoric bog or a modern oil well near you: The next bull move.
It’s tempting to think all the “easy money” has been made in this market already. The S&P 500, after all, is up +64% from its March low. Oil prices have risen at nearly twice that pace during the same period. And many commodities have likewise surged during the past nine months.
For one commodity, however, the recovery has yet to begin. As the current bull markets get long in the tooth, it’s still April for one sector.
And here’s the good news: There’s a way for you as a stock market investor to profit. Here’s the better news: This security pays carriers a dividend yield in excess of 10%.
The commodity? Natural gas.
Natural gas, like oil, was formed from decayed prehistoric life forms. Geologists find natural gas by looking for certain sedimentary rock formations likely to contain it. Drills bore thousands of feet into the earth’s crust to tap into these formations, and, with luck, natural gas rises to the wellhead, where it can be stored or shipped by pipeline to be refined.
Natural gas prices, like those for oil and many other commodities, reached an all time high of about $13 per MMbtu (million British thermal units) in mid-2008. Prices plunged in the financial crisis, falling to less than $3.50 in March and then to $1.84 in September. The recession weighed on demand for natural gas at a time when supplies were increasing due to improvements in exploration technology.
Supplies are still abundant, and the price outlook remains bleak. The oversupply is of bin-busting proportions. The United States has storage capacity of an estimated 4 trillion bcf (billion cubic feet). According to the Energy Information Administration, storage levels were nearly 3.8 trillion bcf at the end of October. And according to Bloomberg, a 14% drop in prices this year ranks gas as the world’s worst performer among major commodities.
What better time to get in on the action?
Any indication of a colder-than-normal winter in North America likely will send natural gas prices above and beyond the current $4.81. Ditto for signs of an economic recovery in the United States and elsewhere. EIA predicts gas prices will average $5.01 in 2010. And at least one major forecaster — JPMorgan Chase — expects that prices next year will average closer to the $6.00 level on the expectation we’re in for a frigid winter.
#-ad_banner-#The way to play this market: Targa Resources Partners LP (Nasdaq: NGLS, $20.26).
Targa is a master limited partnership (MLP) that purchases natural gas and natural gas liquids from producers and then gathers, compresses, processes, and transports the commodities for sale to various marketers and refineries.
Targa is an enticing choice right now for two reasons: 1) The company should benefit significantly from rising natural gas prices and higher demand in a recovery, and, 2) NGLS pays a stratospheric 10.2% yield that should be secure in the meantime.
Targa’s gathering and processing business involves heavy exposure to commodity prices, as the company buys and sells natural gas. About 75% of Targa’s cash flows are tied to commodity prices, and 25% are fee based.
As an MLP, Targa pays no income taxes on income earned and passes the tax savings on to unit holders in the form of high distributions. Higher profits go right from the company’s balance sheet to your pocket. Targa currently pays a $0.5175 quarterly distribution or $2.07 per year for a tremendous 10.2% yield.
But, the company has a track record of increasing distributions. Distributions have steadily increased since Targa’s 2007 IPO. The last payment of $0.5175 represents a 53% increase over the first full distribution of $0.338 in 2007.
How safe is the current distribution?
In the third quarter ended September 30, Targa generated distributable cash flow of $51.5 million, which covered distributions by a comfortable 1.46 times; distributable cash flow also covered the dividend by 1.35 times last quarter.
Targa has been able to easily cover the distribution in an environment in which the average selling price of natural gas for the first nine months of 2009 fell to $3.83 from $9.29 a year earlier. Natural gas liquids (NGL), natural gas liquefied for ease of storage and transport, prices fell to $0.71 per gallon from $1.56 per gallon for the same period.
In addition, Targa has recently taken steps to improve its top line. In late July, the company agreed to acquire the “downstream” natural gas liquids business from its general partner Targa Resources Inc. The acquisition should provide Targa with a more stable cash flow. The newly acquired assets included 75% fee-based contracts, which increased Targa’s overall balance of fee-based cash flows from 2% to about 25%.
The acquisition is expected to add $80-$85 million per year to EBITDA (earnings before interest depreciation and amortization). This will be significant considering EBITDA was $131 million for all of 2008. The agreement also provides for Targa Resources to provide support for Targa’s quarterly distribution of up to $8 million per quarter until the fourth quarter of 2011, which is almost one quarter of the last distribution.
In the longer term, low demand and oversupply of natural gas should correct. In the short term, a recovery and increased use by utilities could drive the price much higher. But, even if natural gas prices stay low for a while, Targa is well equipped to weather the storm and continue to pay a high distribution.
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