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Can investors use passives to play US shale gas market revolution?

Can investors use passives to play US shale gas market revolution?

Much has been written about the resurgent US energy sector, but can investors play the shale gas revolution through passives?

Michael John Lytle, chief development officer at exchange traded product (ETP) provider Source, believes passive investments can enable investors to access the theme of rising production in the US.

He points to a survey by oilfield service firm Halliburton, which puts US energy sector recoverable reserves at between 500 trillion to 1,000 trillion cubic feet.

‘Within the next five years, the US is expected to hike its production to around 10 million barrels per day [from 7.5 million currently], and that gives us plenty of hope,’ says Lytle.

In May, Source launched its first exchange traded fund (ETF) linked to master limited partnerships (MLPs) in the US energy infrastructure sector. These are designed for investors looking for exposure to around 40 companies working in this specialist field, such as Enterprise Product Partners and Kinder Morgan Energy Partners.

The midstream MLPs own and operate many of the US’s core infrastructure assets, such as pipelines and storage facilities. They avoid the double tax bite associated with investing directly in the US due to their structure.

‘Through partial structural monopolies, MLPs typically generate excellent inflation-protected long-term returns and relatively high free cash flow generation. They can attract both investors seeking income and growth as they need future investments,’ Lytle explains.

Source’s ETF currently has $116.4 million (£74.43 million) assets.

Though Ben Seager-Scott, a senior research analyst at BestInvest, believes MLPs ‘could do fairly well for themselves’ because they are less dependent on commodity prices and are well positioned given the demand for infrastructure, he says issues remain.

‘For a start, these investments, due to their structure, are high yield assets, which could make them more sensitive to changes in interest rates than traditional equity investments. Also, as the US looks to tighten its fiscal belt, tax-advantaged MLPs could run a risk of losing this status in any tax reform.’

Lytle acknowledges markets are worried about interest rates exposure in the sector, but says: ‘We don’t think it is as critical an issue because the existing debt is typically long-duration and fixed rate and around 25% of cash flows are indexed at PPI+2.5%, providing an inflation hedge.’

Alan Miller founding partner of SCM Private, is negative on a sector he describes as ‘already more than fully priced into any stock playing the shale gas card’. He believes shale gas production is not as economically viable as many people believe.

‘The current gas price is close to $3.40 and many think at least $4.50 to $5 is required to break even, taking into account the cost of the original field licences,’ he says. ‘Eventually the law of economics will apply. If US production is uneconomic, it must lead to dramatic falls in production until the price rises to above break-even.’

Seager-Scott recommends the actively managed GAM Star Gamco US Equity fund for more diversified US equity exposure. He notes it is overweight industrials, which he says will benefit from cheaper gas.

He advises investors to steer clear of traditional gas producers which would have their margins squeezed by gas prices falling towards their marginal cost of production.

‘As a result, you could consider the shale gas revolution as feeding in to the wider “re-industrialisation” of the US theme that a lot of people are talking about at the moment,’ he says. He also believes investors should be wary of investing too heavily in a very niche part of the investment market through single-play strategies.

Meanwhile, Miller is avoiding any specialist active or passive investments in this area, and says thematic funds are ‘dangerous’.

He recommends a broad passive investment approach through natural gas contract positions.

‘There are plenty of natural gas ETFs, but these are extremely volatile and tend to suffer from extreme contango, whereby the future gas price is at a significant premium to the spot price,’ he says.

‘This effectively means that unless the price really spikes up, you don’t make any money.’

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