HOW TO PLAY IT: Natural gas falls near 10-year low

A pipe and pressure gauge are seen at a Ukrainian gas compressor station and storage facility in the village of Mryn, about 130 km (81 miles) northeast of Kiev December 16, 2008.

NEW YORK (Reuters) - Call it a case of too much of a good thing.

Fracking, a controversial new drilling method, makes it possible to extract natural gas in the United States in quantities once thought unimaginable. At the same time, an unusually warm early winter in the Northeast has lowered demand for gas for heating.

The result: a glut in the market that has sent natural gas prices down 20 percent this year, near a 10-year low. Cheaper natural gas is already hurting big companies like Chesapeake Energy Corp, which has seen its share price fall nearly 40 percent over the last six months.

But investors can take advantage of overabundance in the marketplace. How to play the natural gas industry's unexpected woes.

BE A TOLL COLLECTOR

Sometimes it pays to be the middle man.

Jay Wong, co-manager of the $80 million Payden Value Leaders fund (PYVLX), insulates his portfolio from falling natural gas prices by buying master limited partnerships. The partnerships, similar to real estate investment trusts, typically own infrastructure like pipelines and storage facilities. They generally offer high dividend yields and stable cash flows.

"Gas prices don't need to be high for these companies to make money," he said. "As long as the gas is moving, they'll do well because they're just toll-takers."

One pick: Williams Partners LP, which owns approximately 13,900 miles of pipeline in the Rocky Mountains and along the East Coast. It pays a yield of 4.7 percent. Even after a 40 percent gain over the last year, the company remains moderately priced at a price to earnings ratio of 19, compared with the nearly 14 earnings multiple of the broad Standard & Poor's 500 index.

A few competitors are slightly cheaper. Spectra Energy trades at a P/E of 17, but yields a lower 3.6 percent. El Paso Pipeline Partners trades at a P/E of 17 and yields 5.6 percent.

For a broader bet on the pipeline business a fund like the JPMorgan Alerian MLP Index (AMJ) is an exchange-traded note that holds master limited partnerships that transport both oil and natural gas. Exchanged-traded notes are like exchange-traded funds, but may not have the same tax efficiency for all investors. AMJ yields 4.9 percent and charges 85 cents for every $100 invested.

The JPMorgan ETN may be a tactical holding for investors seeking consistent income, noted Abraham Bailin. "The operating income from the transportation of fuels tends to be much less volatile than the prices of commodities themselves," he wrote in a recent report.

INVEST IN THE BUILD-OUT

Companies have continued to start new drills despite the low gas prices, in part to maintain their leases. That is benefiting the companies that provide the equipment necessary for fracking, a process that essentially injects water and chemicals into cracks in deep rock formations to extract natural gas.

Environmentalists have criticized the practice, raising concerns ranging from contaminating drinking water to creating earthquakes.

"It's the arms producers who are going to do well now," said Joseph Doyle, co-portfolio manager at Malvern, Pennsylvania-based Morris Capital Advisers.

Doyle owns National Oilwell Varco, a services company that works with both natural gas wells and offshore oil rigs. The company is up nearly 12 percent so far in 2012 and trades at a price-to-earnings ratio of 17.2 per share. It yields 0.6 percent.

Large energy service companies have fallen recently along with natural gas prices. That could yield some value opportunities, investors said.

Fred Labatt, director of equity research at South Texas Money Management, a San Antonio firm with $2 billion in assets under management, believes investors are discounting the overseas revenue of big oil service companies. Labatt has a position in Baker Hughes Inc, which has fallen 38 percent over the last six months and trades at a P/E of 12.1.

"The valuations are so low that if you've got a year horizon then it's a pretty good entry point," he said.

Halliburton Co is another value play. The company trades at a P/E of 12.2 and yields 1 percent.

BUY THE BENEFICIARIES

The drop in the price of natural gas may cut into energy company profits, but it is a benefit for their customers.

Investors can play the natural gas glut by buying chemical companies that are watching their margins expand as their costs decrease, said Kent Croft, co-manager of the $306 million Croft Value Fund.

"These companies are doing everything they can to take advantage of the low price," he said.

Dow Chemical Co, for instance, depends on natural gas to manufacture plastics used in everything from toys to artificial turf to diapers. The company is expanding its capacity in the United States to produce ethylene, a key plastics component that is derived from natural gas.

Dow Chemical may be something of a momentum play. It is up 14.6 percent so far in January, and trades at a P/E of 13.5. It yields 3 percent.

Companies like DuPont, meanwhile, will likely see costs for producing fertilizer, plastics and other products decrease, said Doyle from Morris Capital Advisers. Natural gas is a component of ammonia, which is used in fertilizer production.

That will likely help them both at home and overseas. Demand for fertilizer alone, part of the $700 billion chemical industry, is expected to grow by 3 percent worldwide in 2012, according to the International Fertilizer Industry. The chemical industry is one of the top U.S. exporters, according to Zacks Investment Research.

DuPont is up 14 percent this month. It trades at a P/E of 13.4 and yields 3.3 percent.

The $673 million Fidelity Select Chemicals Fund is one actively managed option for investors looking to own the category. Its top holdings include Monsanto Co, DuPont and Dow Chemical. The fund, which gained 8.5 percent over the last 12 months, charges 89 cents per every $100 invested.

Index investors can turn to the iShares Dow Jones US Basic Materials ETF (IYM), which charges 47 cents per every $100 invested. DuPont and Dow are two of its top holdings.

(Reporting By David Randall; Editing by Jennifer Merritt and Matthew Lewis)