Utility Gas Fund Shifts Into High Gear

NEW YORK ( TheStreet) -- For much of the past decade, shareholders had little reason to cheer the performance of FBR Gas Utility Index ( GASFX).

Annual returns were generally in the middle of Morningstar's group of utilities funds. But lately FBR has caught fire. While the S&P 500 has lost 6.4% this year, FBR has gained 10.1%. During the past three years, the fund has outpaced the S&P by a wide margin and ranked as the top performer in the utilities category.

FBR holds about 60 stocks, including producers of natural gas as well as utilities that have both gas and electric operations. Those stocks typically deliver solid dividends and unexciting total returns. But a number of factors have combined to make gas an outperformer.

Beginning several years ago, companies discovered that they could exploit new gas fields by a using a technique known as hydraulic fracturing, or "fracking," which involves pumping water into underground rock layers. Thanks to fracking, new wells have begun delivering profitable supplies in the Marcellus Shale of Pennsylvania and the Barnett Shale in Texas.

Relying on the new techniques, gas producers increased their sales and profits. In some cases, staid distribution companies found that it was possible to go into the more exciting field of exploration and production. As gas supplies increased, prices declined. But producers compensated by increasing their sales volumes. "We have seen companies increase their production business and double total revenues," says Skip Aylesworth, FBR's portfolio manager.

While gas prices have plummeted, oil prices climbed. That encouraged more demand for gas. In some cases, cheap domestic gas has replaced expensive imported oil. All in all, the long-term future of the gas companies has begun to look brighter. "Many of these gas companies are sitting on large proven reserves of a commodity that is going to play an increasing role in satisfying the energy needs of the country," says Aylesworth.

What could disrupt the rosy outlook? Environmentalists are trying to stop fracking, arguing that the technique can pollute groundwater. The SEC and other regulators are talking about imposing new rules. But few politicians have been willing to disrupt an industry that is creating new jobs in states that need them. Lower gas prices could also pose a threat to profit margins. But so far declining prices have simply created more demand.

If you are intrigued by the gas story, FBR makes a solid choice. The fund pays a 2.5% dividend yield. No matter what happens to gas markets, the fund should deliver decent results because most holdings are regulated utilities that serve captive markets. If demand for gas explodes, the fund could soar.

Another way to play gas is by buying a general utilities fund. Many of these hold gas companies along with power producers and telecoms. A top performer is Wells Fargo Utility and Telecommunications ( EVUAX), which has returned 3.4% annually during the past five years, outdperforming 61% of peers.

The fund currently has about 25% of assets in stocks that benefit from gas. Portfolio manager Timothy O'Brien likes National Fuel Gas ( NFG), which operates gas pipelines and processing facilities. The company owns 700,000 acres in the Marcellus region of New York and Pennsylvania. O'Brien argues that the land is more valuable than the market recognizes. "There have been some transactions in the Marcellus where land has gone for $6,000 to $14,000 an acre," he says. "If you apply that value to the acreage owned by National Fuel Gas, you get a fair value for the stock of $85 , and the stock currently sells for around $57."

O'Brien also likes Sempra Energy ( SRE), which operates San Diego Gas & Electric. He says that the company is investing in gas infrastructure that should help to boost profits.

There are several gas ETFs, but investors should approach them with caution. The funds track the price of gas, which can be volatile. With gas prices sinking lately, the ETFs have recorded losses. This year United States Natural Gas ETF ( UNG) has lost 16.6%.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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