New Energy For Your Portfolio

OCEAN CITY — In 2012, the U.S. saw the largest expansion in domestic oil and gas production in the more than 150 years since it began drilling commercial wells. Improved technology that can unleash oil and gas from shale rock formations helped domestic oil output grow last year by a record 853,000 barrels a day, to the highest level in 17 years, according to the U.S. Energy Information Administration. And for natural gas, whereas the amount extracted from shale represented just 2% of the U.S. natural gas supply in 2000, it was 37% in 2012.

This U.S. energy boom comes largely thanks to the technology of "fracking," or hydraulic fracturing, coupled with horizontal drilling methods that allow for much faster, more efficient extraction of oil and natural gas. Fracking is controversial, with opponents noting that its methods — pumping a mixture of water, sand and chemicals under high pressure into source rock to crack it open, allowing gas and oil to flow — may result in groundwater pollution and other problems. But energy companies have continued to invest aggressively in this technology. And as processes have improved, natural gas production has become far more predictable.

"We’ve gone from a high-risk, high-return market, with huge price volatility and swings in success of drilling rates, to a more stable current market that’s largely about manufacturing," says Francisco Blanch, managing director and head of Global Commodity Research at BofA Merrill Lynch Global Research.

Although the prospect of what Blanch calls a "shale revolution" might suggest investment opportunities in producers of natural gas, he also notes that the bottomed-out prices in the U.S. may actually be adversely affecting these businesses, which include large energy companies that maintain significant natural gas operations as well as firms that focus exclusively on the fuel. Many stocks in this sector have, however, historically provided solid dividend income, and low valuations now could translate into long-term opportunities.

In the meantime, Blanch suggests several indirect approaches that might help tap the current U.S. energy boom.

Invest in energy-intensive U.S. businesses. Domestic manufacturers, particularly makers of steel, aluminum and automobiles, may benefit significantly from falling energy prices, which could reduce operating expenses, increase profitability and free up capital to invest in expansion and new employees. Domestic companies also are poised to save on transportation costs as many of them (particularly automakers) move factories back to this country. Rising labor costs in many parts of the world have made emerging markets less competitive.

Another area to look at may be the U.S. petrochemical industry, which has largely switched from oil to natural gas for feedstock used to make chemicals such as ammonia, a vital ingredient of fertilizer. Those cheaper chemicals serve as economical raw materials for everything from auto manufacturing to farming and household goods, and can now be exported at globally competitive prices.

Consider providers of consumer goods and services. According to the U.S. Energy Department, natural gas home-heating prices have fallen 21% in New England and 25% in the mid-Atlantic during the past five years. Those savings leave consumers with more discretionary income, and as they spend less on utilities, they’re able to spend more at restaurants and on electronics, travel, and a host of other products and services.

Look at transportation companies and retailers that manage large fleets of delivery trucks. Such businesses are exploring options for converting from diesel fuel to liquefied and compressed natural gas. Meanwhile, railroad companies are experimenting with gas-powered locomotives.

Think beyond stocks. Master limited partnerships, or MLPs, can help investors diversify within the energy sector, and they bring potential tax advantages (and risks) as well. Energy MLPs are typically offered by pipeline operators whose profits are based more on the volume of natural gas transported than on the price of the gas itself.

Today’s investing landscape could shift if the U.S. eases restrictions on selling surplus natural gas overseas. A Department of Energy study released last December suggested that increased exports could provide a broad boost to the economy. But it would likely raise U.S. prices for the fuel, and that worries groups such as America’s Energy Advantage, a coalition of energy-dependent companies.

If such concerns keep natural gas production and prices at current levels, "that would be a negative for U.S. gas-producing companies but a plus for gas-consuming companies and consumers," Blanch says. "North America has become natural gas-independent, and that’s a big net positive for the economy on all sides." That makes this an ideal time to consider which investments might benefit most from these factors during the next five years.

(A Merrill Lynch senior financial advisor, who can be reached at 410-213-8520.)