The shale gas revolution: the winners to buy and the losers to avoid

Shale gas extraction is a game-changer. But along with the winners, there will be losers. Matthew Partridge looks at what to buy and what to avoid.

We've heard a lot about the shale oil and gas energy revolution' and how it's a game-changer. We're very excited about it ourselves.

But amid all the hype, it's worth remembering that revolutions have losers as well as winners.

The invention and spread of railways in Britain slashed transport costs and saw towns spring up along the routes, but it bankrupted canal owners. The internet had a similarly disruptive impact on retailers and the entertainment industry.

Shale is no different. The revolution is one-sided, for a start the US is benefiting, but hopes for cheap gas elsewhere so far look overdone. That gives America a competitive advantage over many other nations. And even in the US, some businesses will be hurt by the rise of shale.

Here's what to buy and what to avoid

Fracking is harder than it looks

New technology has enabled us to access shale gas. But it's still not that easy to extract.

It's easy to laugh at German fears that the side-effects of hydraulic fracturing' might ruin their country's beer. However, while concerns about the environmental impact of fracking may be overdone by some, extraction industries by their very nature are not pleasant things to be living alongside.

So it's not surprising that fracking has taken off in the rolling plains of North Dakota in the US. Until the recent boom brought swathes of new jobs to the area, very few people lived there.

In more densely populated areas, fracking has met massive opposition. So even if there is a big push, it seems likely that the amount extracted in Europe and the UK for that matter will always be much smaller than in the US.

Of course, public opinion is not an issue in China. They also have large reserves and a pressing need to cut the use of coal, which is literally choking the country. The problem there however, as Nancy Cardin of Close Brothers Asset Management points out, is that you also need a lot of water to inject into the ground. And China already has too little water to go around.

Even in Australia which has plenty of wide open, sparsely-populated areas the latest estimates are that it will take years to develop a shale gas industry, and it will cost about double that of the US.

There are also cases where estimates of reserves have proven overly optimistic. The repeated failure of exploration in Poland is an important example. Even in the US, areas such as Ohio have taken longer to develop than expected.

This doesn't mean that drillers will stop trying - the economics of shale are just too attractive. However, a repeat of the rock bottom natural gas prices that the US briefly experienced isn't on the cards elsewhere.

US industry will profit at the expense of Europe

It's clear from this that the big winners will be those energy-intensive industrial firms who are able to access cheap gas. Most of these firms are, and will continue to be, in America. Accountancy group PricewaterhouseCoopers estimates that US chemicals firms have already grown capacity by a third.

Meanwhile, things are getting harder for their European rivals. German industrial giant BASF is finding it hard to compete. Although it does have some operations in the US, its main plant is in Germany, which has to pay between four and five times more for gas. While BASF thinks that it can partly compensate by becoming more efficient, it has admitted that it has already had to leave certain price-sensitive markets.

Cardin also believes that fracking will push oil prices a little lower but not by much. Shale oil isn't the most expensive source of oil, but it's nowhere near Middle East levels overall it costs about $70 a barrel to produce.

So while most big oil producers would see their profit margins fall if the price of oil takes a hit, the most pain would be felt by high-cost producers, such as those in North Africa.

By contrast, the Gulf states, who can extract oil for next to nothing, will be much better protected from the impact. However, oil cartel Opec will still find it harder to push oil prices up for political reasons, which should reduce the element of political risk priced into crude.

What to invest in

The easiest way to profit from America's lead in the shale gas business is to invest in one of the US petrochemical companies, which are blowing away their European competition. Dow Chemical (NYSE: DOW) has seen its net income rise by a third and earnings per share grow by 13.1% since last year. It trades on a forward price/earnings ratio of 14, but offers a juicy dividend of 3.8%.

Another option is to invest in one of the companies that transports shale oil and gas around the US. The best example is Kinder Morgan (NYSE: KMI). The company owns 180 terminals and 37,000 miles of pipelines, so is perfectly placed to profit from the energy boom. At the most recent results, quarterly profits were up by 80% on a year ago, which makes the forward p/e of 30 look a little less unreasonable. More importantly, it is paying a dividend of 4% as it returns cash to shareholders.

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