How Utilities Are Boosting Natural Gas Prospects

The recent mild winter and the unparalleled potential in new shale gas production have combined to result in a depressed pricing market for natural gas.

The rise in demand for everything from electricity to petrochemical feeder stock, liquefied natural gas (LNG) exports and even usage in vehicle fuels, will start driving that price up over the next two years.

You already know that, of course.

We've talked about it many times before.

But now there's something else on the horizon that is likely to provide a boost to investor prospects even sooner.

Utilities, one of the main beneficiaries of the gas boom, are moving to capitalize on the accelerating transition in power generation.

And in the process, two important trends are emerging that will be of interest to retail investors.

First, the low current prices and the prospect of rapid increases in extraction rates, if the market warrants, are allowing electricity managers the opportunity to plan for multiyear cost projections.

That, in turn, is propelling the intensified replacement of aging capacity with new gas-fueled plants.

As Pacific Gas & Electric Co. (NYSE:PCG) CEO Tony Earley noted this week, infrastructure investment becomes a priority when projected fuel prices are low. The system has to be upgraded and replaced in any event, as large segments of it reach the point of "retirement."

Earley also has advanced the idea that the power industry needs to speak with one voice in its dealings with regulators and policy makers.

This need for solidarity has been reflected in comments from other leaders in the power industry as well.

As policymakers increase capital expenditure in infrastructure replacement and expansion, we are also likely to see a renewed interest in developing a consensus on where the next "generation of generators" is going to be moving.

And one of the pushes coming upon the scene moves right into familiar—and profitable -territory, at least for us.

The MLP Structure Takes Hold in a New Market

When we think of a vertically integrated company in the energy sector, we need to understand the various stages of the supply chain.

Vertical integration of crude oil and natural gas requires the ownership of facilities from the upstream (field production), through midstream (gathering, processing, storage, transit) to downstream markets (refining and wholesale/retail distribution).

Now, vertical integration is beginning to make an appearance in the production of electricity.

Already, indications are that utilities are taking a new approach to their supply chains.

While there have been examples of fuel producers, like natural gas extractors, or major end-users, such as aluminum manufacturers, acquiring generating capacity, the next wrinkle involves the utilities themselves moving into master limited partnerships (MLPs) and their equivalents.

This is territory we have come to know well.

MLPs usually are created to control pipelines and other midstream assets. The structure provides the advantage of moving all profits directly to the partners, eliminating a corporate tax liability.

When an MLP decides to spin off an equity issue, that portion of the profits is usually reflected in a hefty dividend.

Given the depressed gas price, some utilities are beginning to experiment with cutting their supply costs even more by controlling a portion of the midstream process.

And they are doing that by moving into the MLPs controlling such activity or, conversely, acquiring the midstream assets themselves and forming separate partnerships to control them.

Such an approach is on the radar of utilities across a gamut of fuel types—natural gas, renewables and even coal. Controlling the movement of raw materials from the source of extraction to the location where utilities produce electricity give them a primary cost reduction advantage.

This is especially the case with a primary midstream function—storage.

As in most industries, storage costs for excess (or reserve) supply are rising.

In the case of natural gas, it is now common for most of the pipeline capacity in a number of regions to be use as storage and not just transport.

Much of this capacity is controlled by MLPs or similar limited partnerships.

And that's the beauty of it: The partnership ends up receiving revenue whether the gas is transported or stored.

With profit margins in the utility sector already under some pressure, and returns subdued, cutting overhead (or moving it under a utility's greater control) becomes a primary way of improving profit margins.

Especially in the current environment of cheap gas and coal.

Prospects for a continuing short-term low price for both are strong. That translates into a major opportunity for the generators to acquire and control fuel supply at discount, keeping their own midstream expenditures to third parties down in the process.

Further, as expansion in gas demand kicks in all the areas mentioned earlier, so too do additional potential revenue streams.

Midstream applications benefit from all of these outlets.

Coming to control them, therefore, will provide utilities with a portion of developing fuel markets well beyond the power sector. . .without having to do anything about setting up new expensive infrastructures in other energy systems.

A utility benefits from the diversification of gas needs merely by overseeing access to the fuel, something that also is one of its own primary objectives. By owning the midstream process, the generator guarantees its own supply at lower price and participates in every other fuel application.

The transition of utilities into MLPS and like structures will change the fuel supply chain. . .the functions of power producers…

. . .And our ability to make rising investment returns from them.

Sincerely, Kent

Kent Moors, Money Morning

[Editor's Note: We are going through the greatest technological transition in the history of the energy markets. But few politicians, reporters, or analysts really understand where we're headed.

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