NATURAL GAS: A Stock Investor's Guide To The Most Controversial Commodity In The World

natural gasNatural gas compressor station

Photo: Sergei Grits / AP Images

Natural gas has been the most beat up commodity in the world.  Professor Mark Perry of the Carpe Diem blog recently noted that adjusted for inflation, the commodity was priced at multi-decade lows.Relative to oil prices, the price drop appears even more dramatic.

And it’s no surprise. The unseasonably warm winter caused demand to collapse.  And with all of the new drilling activity, supplies are bloated.

But increasingly, big names are jumping on the natural gas bandwagon.  It’s currently the favourite investment idea of investment legend Jeffrey Gundlach.

So, how do you play it?  Not all of us are savvy enough to trade futures contracts.  And there’s something unsettling about investing in an exchange-traded note that tries to track natural gas prices.

One easy alternative is to invest in the companies that are exposed to natural gas.

Morgan Stanley recently published its Diversified Natural Gas Investing Playbook, which guides investors through the current issues facing the commodity.

What follows are six stock picks and key highlights from the 63-page report.

Natural gas prices are still on their way down.

The analysts recently revised their 2012 forecast to $2.40/mmBtu, down from $2.70/mmBtu. The downward revision stems largely from continued warmer-than-normal weather. Low prices could result in industrial firms accelerating substitutions of coal for gas.

Source: Morgan Stanley

Companies with the greatest direct exposure to natgas have suffered as a result of falling prices.

National Fuel Gas Corp. (NFG), EQT Corporation (EQT) and CenterPoint Energy Inc. (CNP) have seen negative YTD stock performance. Companies who haven't branched out into utilities like MDU Resources Group Inc. (MDU) and Questar Corp. (STR) have also seen losses.

Source: Morgan Stanley

Mergers and acquisitions will continue for the foreseeable future.

For now, the majority of M&A activity is likely to take place at the asset level. Many midstream assets (i.e. transportation, treatment and wholesale marketing companies) remain undervalued, and everyone is shifting focus to liquids.

Source: Morgan Stanley

Dividend paying stocks will outperform.

Conglomerates will be valued at a discount as a result of lumpily performing subsidiaries. Stocks with cash-flow growth and increasing dividend yield will perform better.

Source: Morgan Stanley

Corporate structure matters.

The market has rewarded companies that have created master limited partnership subsidiaries. MLPs enjoy lower cost of equity capital, less burdensome corporate taxes and dedicated investor appetite for yield and growth. As a result, assets within MLP structures will trade at higher valuations. Owning a general partner who's created an MLP will also pay off.

Source: Morgan Stanley

Location, location, location.

The analysts regard shale-driven infrastructure growth as 'a secular theme with room to run.' Companies with existing asset positions and producer relationships in key regions are likely to benefit most.

Source: Morgan Stanley

Expect volatility in liquids prices to continue.

The analysts say the Conway / Mt. Belvieu and West Texas Intermediate/Brent spreads will be key trends to
watch in the second half of 2012.

Source: Morgan Stanley

Morgan Stanley's analysts offer ratings on 12 stocks. They consider 6 of them to be top picks

What follows are the 6 Top Picks in the natural gas sector.

ONEOK Inc.

Sunoco Inc.

Targa Resources Corp.

Williams Companies Inc.

Crosstex Energy Inc.

Spectra

Ticker: SE

Price Target: $35

Location: Houston, TX

Specialty: Gathering and processing, transmission and storage, and distribution

Comments: 'Stable fee-based revenues (~80% of portfolio) that have little exposure to commodity prices, but more limited room to surprise to the upside.'

Source: Morgan Stanley

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