How to Make a Portfolio of Natural Gas Stocks

By Markets Fool.com

Over the past few years, natural gas has gone from being a seasonal commodity to a megatrend in North America. That's largely due to the fact that a combination of hydraulic fracturing and horizontal drilling unlocked vast quantities of shale gas in the U.S. and Canada. This megatrend is yielding strong supply growth for natural gas producers, which is increasingly being sopped up by new demand for natural gas that is expected to lead to another 40% surge in production over the next decade, as we see on the following slide.

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Source: Kinder Morgan Investor Presentation.

With so much growth potential, and therefore profit potential, investors are being drawn to the sector and are looking to put together a portfolio of natural gas stocks. Here's a simple way to build your own natural gas stock portfolio to profit from this megatrend.

Step 1: Invest in a pure-play producer
One of the obvious ways to profit from the natural gas megatrend is to buy stock in a pure-play natural gas producer. There are a lot to choose from, and the slide below notes the nearly three dozen top natural gas producers in the lower 48 states.

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Source: Southwestern Energy Company Investor Presentation.

Not all of the names on that list are pure-play gas producers; many are focused on oil and produce gas only as a byproduct. So, if the idea of this portfolio is to focus on natural gas, then an investor would want at least half of a company's production to be that commodity.

Two pure-play names that stand out among the top five are Chesapeake Energy , which is the nation's second largest gas producer, and Southwestern Energy , which, as the chart shows, has shot up the rankings and is now No. 4. Both companies are not only top producers now, but both have a vast portfolio of future well locations to drill in the years ahead.

Step 2: Put some money on the pipelines
Once a pure-play producer is chosen, investors should take a look at a natural gas pipeline company to help balance out the risk. Unlike producers, these companies aren't exposed to volatile natural gas prices. Instead, they charge producers a fee to pipe natural gas from production basins to end users. This fee-based business model tends to be very stable, as producers typically sign long-term capacity contracts. This enables pipeline companies to pay very generous dividends to investors.

A top name here is Kinder Morgan , which owns North America's largest natural gas network consisting of 67,000 miles of natural gas pipeline. The company operates in all of the key supply basins as well as on the demand side, bringing gas to end users, and overall, it transports a third of the nation's natural gas. To top it off, Kinder Morgan pays a very compelling dividend that currently yields 4.2%.

Two other names worth noting are MLPs Energy Transfer Partners and Williams Partners . Energy Transfer is the nation's second largest transporter of natural gas; it transports 22% of the country's production. It is also the third largest NGL producer and third largest gathering and processing company. Rivaling it in size is Williams; a third of the country's natural gas volumes touches its systems. The pair pay very generous distributions, yielding 7.3% and 7%, respectively.

Step 3: Drive some dollars into demand
The last type of stock an investor would want to own in a natural gas portfolio is one that will profit from the increased demand for natural gas in the U.S. and abroad. Investors really have a range of options here, including natural gas exporters like Cheniere Energy as well as companies driving change so that natural gas will become a key transportation fuel, like natural gas engine designer Westport Innovation or natural gas fuel station builder Clean Energy Fuels .

In addition to these ideas, investors can also take a look at other heavy natural gas users. The opportunities are really endless, as fertilizer makers, petrochemical manufacturers, and utilities that are converting coal to natural gas all stand to benefit.

Likewise, companies that make natural gas turbines or other products that either consume natural gas or lead to its consumption, such as natural gas equipment maker Chart Industries , all stand to benefit from increased natural gas demand and can help hedge against lower natural gas prices that would impact a producer.

Investor takeaway
In just three steps, any investor can build a small portfolio of natural gas stocks to profit from the megatrend. An ideal portfolio would be diversified to reduce some risk, yet still focused. That should enable an investor to earn strong natural gas-fueled returns without overloading just on gas producers, which would really ramp up the risk without meaningfully increasing the reward potential.

The article How to Make a Portfolio of Natural Gas Stocks originally appeared on Fool.com.

Matt DiLallo owns shares of Chart Industries andhas the following options: short January 2016 $32.5 puts on Kinder Morgan and long January 2016 $32.5 calls on Kinder Morgan. The Motley Fool recommends Chart Industries, Clean Energy Fuels, Kinder Morgan, and Westport Innovations. The Motley Fool owns shares of Chart Industries, Kinder Morgan, and Westport Innovations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.