While oil seems to grab all the headlines, natural gas is the world’s fastest-growing major source of energy. According to the Energy Information Administration (EIA), global natural gas consumption stood at about 90 trillion cubic feet in 2001 and is projected to reach more than 150 trillion cubic feet by 2025.

The developing world will see the fastest growth in demand, but the US, too, will increasingly rely on natural gas for electricity generation. Already the globe’s largest gas consumer, using about 20 trillion cubic feet of gas in 2001, the US, according to the EIA, is expected to consume nearly double that amount by 2025.

This massive jump in consumption presents a number of problems. The first issue is finding new reserves of gas to fulfill demand. As the chart below shows, US domestic production has been woefully inadequate to meet demand since the late 1980s–the gap between demand and production has been and will continue to be filled by imports.

Right now, the US imports most of its needs from Canada; in the future, liquefied natural gas (LNG) will account for an ever-larger share of consumption demand. For more on the best plays in LNG, check out the March 29 issue of The Energy Strategist.

^{Source: BP Statistical Review}

The second problem is transportation. Domestically produced natural gas must be moved from wells to consumers. To make matters more difficult, many of the most productive wells are located deep underwater in the Gulf of Mexico or in remote land sites in the Rocky Mountains. And most wells located near major population centers have already been depleted–gas often has to move hundreds, even thousands, of miles from the well to consumers.

And then there’s imported gas. LNG may come into US ports by tanker ships, but when it’s re-gasified it must be transported over land for hundreds or thousands of miles.

Almost all of that natural gas consumed in the US is transported by pipeline. The US pipeline system has become increasingly complex in recent years to satisfy the need to carry gas from more distant regions to population centers.

Booming demand for gas transportation is great news for investors. Third-party companies, other than those companies that explore for and produce gas, often own pipeline networks. Pipeline assets are extremely profitable and throw off tremendous amounts of free cash flow. And increased demand for natural gas spells continued growth for the best in the pipeline business.

Better still, pipeline operators usually receive a fixed fee for transporting a given quantity of gas. That means that these companies are insulated from the sometimes wild price swings of natural gas–even relatively large shifts in commodity prices aren’t likely to materially affect cash flows. Bottom line: The best in the business offer an opportunity to earn relatively safe, stable yields.

Many pipeline companies in the US are organized as master limited partnerships (MLPs). MLPs pay out substantially all of their earnings to unitholders (the equivalent of shareholders for MLPs), so many are currently yielding in excess of 6 percent. MLPs are simple to buy, trading right on the New York Stock Exchange just like a stock. But the securities have special tax advantages and considerations–we are preparing a special report on these issues.

The best play on the pipeline business is Enterprise Products Partners (NYSE: EPD); I’m adding the company to the Proven Reserves Portfolio. Enterprise Products owns more than 17,000 miles of natural gas pipelines and more than 13,000 miles of pipelines designed to carry natural gas liquids (NGLs), a valuable by-product of natural gas processing.

Even better, these pipelines connect to some of the most promising gas and oil producing regions of the US–these are regions where gas production is actually growing, spelling more demand for pipeline services.

And the company is far more than a simple pipeline play. Enterprise Products also owns a series of floating production platforms in the Gulf of Mexico, natural gas storage facilities and gas processing plants. To top it all off, the stock offers a yield of nearly 5.9 percent.

I’m also adding another MLP to the Proven Reserves Portfolio, Penn Virginia Resource Partners (NYSE: PVR) with its 4.8 percent yield. Penn Virginia does own some natural gas assets, but its main focus is high-grade coal. Penn owns coal-producing properties in the eastern US, leasing these properties out to mining companies for production.

Unlike Enterprise, Penn Virginia is somewhat vulnerable to swings in commodity pricing–in this case, coal pricing. But coal will remain America’s single most important source of electricity for years to come. And the stock has already seen a correction this year in response to a pullback in coal prices.

Before delving into a detailed discussion of Enterprise and Penn Virginia, let’s take a look at exactly how natural gas is processed and transported around the US. Enterprise Products is involved in several different steps of gas production and transport; it’s important to understand where and how the company fits in.

The Gas Business

Once a natural gas well is drilled, engineers will test the well to see if it has economic quantities of natural gas. If the well looks economical, a valve known as a Christmas tree is simply installed on the top of the well to control the production of gas from the well. Underground gas is usually under considerable pressure and wells rarely need special equipment to lift the gas to the surface of the well.

Gas from wells enters a network of small diameter pipes called the gathering system. A gathering system may collect gas from hundreds or thousands of individual wells. These are low-pressure pipes that transport gas either under natural reservoir pressure or assisted by small compressor stations that increase the pressure. The gathering system network then transports the gas to a processing center. The gathering system can include many hundreds of miles of smaller pipes.

Not all gas wells are alike, and neither is the gas produced from the wells. Gas can exist in wells alone or mixed with oil and other liquid hydrocarbons. When gas is produced alongside crude oil or actually dissolved in crude oil itself it’s known as associated gas. In such cases, the gas is either flared off as a by-product of crude consumption (still typical in remote offshore wells) or is separated from the crude and processed separately.

Gas can also be found with condensate, a valuable hydrocarbon. It’s a gas under pressure deep in the reservoir, but becomes a liquid when pressure drops near the surface–gas containing such condensate is known as wet gas. Condensate is sometimes called natural gasoline because it is so similar to gasoline in composition. Condensate is usually separated from the gas stream and sold separately to be mixed with crude oil. It usually trades at a price roughly equivalent to oil.

No matter what sort of well natural gas comes from, once it’s separated from crude oil and the condensate is removed, it’s still raw natural gas. Just as you don’t power your car with crude oil, raw natural gas isn’t burned in power plants or by your gas stove and appliances. The gas must be processed before it enters the national pipeline grid.

The largest component of natural gas is methane, a colorless, odorless gas that burns extremely cleanly. Methane is the primary fuel used by power plants and in home gas appliances–this is the natural gas that’s piped to consumers. Methane can make up anywhere from 70 to 98 percent of the gas produced from a particular well–raw gas composition varies from site to site.

In addition, raw natural gas usually includes several other compounds. Ethane, propane and butane often naturally occur with methane. These are all hydrocarbons with unique properties; they are more valuable when removed from methane and sold separately. Together, condensate and these hydrocarbons are called natural gas liquids (NGLs).

There are also several impurities associated with natural gas. Some, like helium, nitrogen and carbon dioxide, are relatively harmless but have to be separated before the gas enters an interstate pipeline. Hydrogen sulphide is one of the more dangerous impurities. This highly poisonous and corrosive gas must be removed or it can corrode pipelines or even kill humans. Gas with high sulphur content is known as sour gas.

Once the raw gas is processed, the remaining gas is almost pure methane and contains very few NGLs and impurities–this is called dry gas. Once it meets certain purity standards it’s suitable for transport on the pipeline system.

The interstate pipeline system consists of larger-diameter pipes designed to pipe dry gas over extremely long distances and all over the country. These pipelines are owned by private companies but are regulated by the Federal Energy Regulatory Commission (FERC) as to the prices they can charge for transporting gas. The pipelines do not actually own the gas that’s transported over their networks. They simply charge a regulated fee for transporting the gas.

An additional complication is added when fields are located offshore. Deepwater fields are usually produced from what’s known as subsea completions–the Christmas trees are installed directly on the sea floor. Production from many such wells is usually tied back–connected by undersea pipes–to a single production platform, usually some sort of floating hub. To get an idea what these hubs look like, check out the photo below.

^{Source: Royal Dutch Shell}

^{Shell’s Auger tension-leg plaform located in the Gulf of Mexico.}

Floating hubs are extremely expensive to build, costing as much as half a billion dollars. It would be too expensive for these platforms to handle production from just a single company’s wells so they normally produce fields owned by several different companies. The hubs are, in turn, connected to pipelines, which can transport gas back to shore for further processing and use.

Gas processing and transport companies are collectively called midstream businesses. There are two primary considerations when looking at midstream companies: the location of their assets and sensitivity to commodity prices.

Location, Location, Location

Pipeline companies get paid based on the volume of gas (or oil) pumped through their pipes. Therefore, it’s better to own stocks with gathering and interstate pipelines located in regions with growing production.

There are three main growth areas I see in the US gas market. The first is the deepwater Gulf of Mexico. Many of the largest oil and gas discoveries of the past two decades have occurred in very deep water. This region will account for a rising percentage of domestic production, and gas (and crude) from the region needs to be piped back onshore.

Second, non-conventional reserves are growing quickly. For an explanation of non-conventional reserves, please see my special report. The two most important non-conventional plays are the shales of Texas (particularly the Barnett Shale play) and the Rockies tight sands.

Third, imported gas and LNG are growing rapidly. Companies located near major LNG facilities will see rising supplies of imported liquefied gas over the next few years that need to be transported. What’s more, because most LNG is extremely rich wet gas, it’ll require added processing before use.

Commodity Vulnerability

As most of the midstream players are MLPs, the primary consideration is their ability to maintain cash flows and, therefore, distributions to unitholders. The more stable their revenue stream, the easier that task.

The era of low energy prices is over. That means that oil prices are likely to average above $45 for the next few years. And I also believe that natural gas prices will trend well above levels seen in the late 1990s. That said, as I’ve explained in prior issues of The Energy Strategist, natural gas and oil inventories continue to run at high levels–I see scope for a temporary pullback in pricing this year.

To ensure solid, dependable distributions, look for companies that aren’t dependant on high commodity pricing for their distributions. The processing business is largely unregulated and there are several types of contracts employed between producers and processors. Some contracts involve the processors actually taking ownership of the gas or NGLs they process. Other contracts specify a simple fee per volume of gas processed. And there are even combination contracts–percent of liquids contracts–that split the ownership of NGLs. Companies that take ownership of the gas are far more at risk if gas prices pull back slightly.

Remember, none of these companies are totally insulated from the gas market. If demand for gas drops so does demand for transport and processing. But a real year-over-year drop in gas demand is unlikely. The best midstream players offer dividend distributions insulated from the worst of commodity pricing volatility.

How to Play It

Enterprise Products Partners (NYSE: EPD) covers all these bases. The company’s largest business is NGL processing and transport, accounting for a little over half the company’s annual revenues.

Enterprise Products owns a total of 26 natural gas processing facilities. Some are so-called “straddle facilities” that perform additional processing on gas already in major pipeline systems. Other plants are designed to process raw gas directly from the gathering system.

The company has 11 plants located in Louisiana and Mississippi that process gas from the deepwater Gulf of Mexico. And Enterprise also processed gas from pipelines and gathering systems in the Rockies and East Texas shale plays. According to the company, gas from the Gulf requires particularly heavy processing–the gas contains as much as 4 gallons of NGLs per million cubic feet of gas compared to just 1 or 1.5 from average gas produced onshore.

In 2003, the company ran into big trouble because it was overexposed to commodity pricing volatility through its processing facilities. The reason is that the company had a lot of keep-whole contracts. These contracts involved Enterprise actually taking ownership of the NGLs in the gas stream. These contracts have been largely renegotiated.

Enterprise is now normally compensated, based simply on the amount of gas processed. It doesn’t take full ownership of the NGLs or gas itself. Alternatively, the company has some percent of liquids contracts that give it some exposure to NGL pricing, but not as much as under the keep-whole arrangements.

The company also has over 13,000 miles of NGL pipes in service. Some of these are regulated meaning they charge regulated fees for transporting the NGLs. Most of this business is fee-based–Enterprise earns a fee for transporting NGLs with no direct commodity price risk.

The company’s second most important business is onshore pipelines, worth roughly 26 percent of revenues. This segment includes both interstate and intrastate pipelines and gathering systems; some of these systems are regulated and others, including most of the gathering systems, aren’t. But in most cases, the company’s pipeline revenues are fee-based–Enterprise receives a fee based on volume transported.

This segment is particularly attractive given the location of the pipelines. The Texas Intrastate Pipeline pulls gas from the Gulf and regions such as the Barnett Shale play. And in a recent conference call Enterprise reported that some gas from LNG regasification facilities along the Texas Gulf Coast are already on its network.

And the San Juan gathering system collects gas from New Mexico and Colorado, states with fast-growing unconventional gas plays.

Finally–perhaps the most exciting aspect–is Enterprise Products’ offshore business. This business accounts for only 12 percent of revenues right now, but there’s significant room for growth. Enterprise owns a network of oil and gas pipelines in the Gulf of Mexico, as well as seven production platforms designed to gather gas and oil from offshore wells.

Enterprise has also recently begun building an eight platform, the Independence Hub, to serve the deepwater Gulf. The floating semisubmersible platform (the platform will be partly sunk for stability) will be located in over 8,000 feet of water, the deepest such platform installed to date.

The hub will be completed in late 2006 and is scheduled to start producing in 2007. The maximum daily production from the hub is about 850 million cubic feet per day and Enterprise has already signed up a number of companies to long-term, fee-based agreements to send gas through the hub.

Because its strong portfolio of assets and low commodity vulnerability support continued growth in annual payouts to unitholders, Enterprise Products Partners is added to the Proven Reserves Portfolio.

Black Gold

Your editor lives a stone’s throw from a coal-fired power plant owned by Mirant. While I’ve never had any complaints about pollution, coal dust or offensive odors, the plant (see photo below), located in Alexandria, Virginia, just seems to attract controversy.

Perhaps it’s just a gut reaction by some to the piles of coal lying in storage yards behind the plant. Or perhaps it’s simply the contrast with the leafy, tree-lined streets of the rest of the city’s historic district. But as controversial as it may be, my local plant, and thousands more nation wide, are an absolutely crucial part of the nation’s electricity grid.



^{Source: Elliott H. Gue}

^{Mirant’s coal-fired power plant in Alexandria, Virginia.}

Coal-fired plants do emit some harmful pollutants. Major pollutants released by coal-fired power plants include sulphur dioxide, a chemical that’s been linked to respiratory illness and acid rain.

And mercury is a particularly dangerous pollutant released from coal plants. When mercury combines with water it can accumulate in fish and other marine life; eating such fish has been linked to birth defects and other developmental problems.

New pollution control measures and so-called “low-sulphur” coal can help to mitigate some of these problems. And, as is often the case for my local plant, the environmental impact of modern coal plants can be exaggerated. But it’s not likely coal will ever be as clean as natural gas or nuclear power.

Nevertheless, coal isn’t dead as an energy source. While it may be dirtier than gas, it also has several major advantages. For one, it’s far cheaper to produce power from coal than in natural gas turbines. And the US is home to some of the world’s largest and highest-grade coal deposits–US power plants can satisfy their demands from domestic resources. Unlike oil or gas, the US is not dependant on massive coal imports.

Practically speaking, coal accounts for more than half of US electricity generation. Gas and renewables could be more important supplies of electricity, but they can never replace coal. That is why the EIA actually predicts coal’s share of electricity generation to increase slightly between now and 2025. Total annual US coal consumption is projected to rise from about 1,100 million tons today to nearly 1,600 in 2025. Companies with reserves of coal will see continued demand for their product for at least the next two decades.

Penn Virginia is an MLP that holds reserves of coal. The company doesn’t actually mine and produce the coal; rather, it leases properties to third-party mine operators under relatively long-term contracts. The operators pay Penn Virginia for the coal they recover from the properties–the more coal they mine, the more they pay.

And the price paid is dependant on the price of coal. Therefore, Penn Virginia’s profits are directly dependant on coal pricing.

Penn Virginia has about 50 mining properties located in Virginia, West Virginia and Kentucky. Total reserves are around 588 million tons of mainly extremely high-grade, low-sulphur bituminous coal. This type of coal is the least polluting, most efficient grade around and is in the highest demand of all. I see solid long-term pricing for this type of coal.

Penn Virginia has also been good at replacing reserves. The company’s reserve replacement ratio stood at over 150 percent last year as it bought properties aggressively to replace reserves that had been mined.

In addition, Penn Virginia has branched out into natural gas midstream businesses, pipelines and processing. This will offer some diversification of revenue in future. I’m adding Penn Virginia to the Proven Reserves Portfolio.

Pair Trade Review

My recommendation to buy General Maritime (NYSE: GMR) and short OMI Corporation (NYSE: OMM) in equal dollar amounts stands. For a detailed analysis of recent activity in the sector and my take on several stocks in the industry, please click here.

Upgrades

I’d like to announce an important addition to The Energy Strategist that will be included in the June 29 issue, a “How They Rate” table which will include stocks not recommended in the Proven Reserves or Wildcatters Portfolios. This list of stocks will include updated “Buy,” “Sell” or “Hold” advice in each issue. While I won’t change the way the current portfolios are run, the new table will offer a more comprehensive comprehensive guide to the industry.