Natural gas's abundant supplies and low prices are having a dramatic effect on how we generate electricity. The biggest price drop in over a year, coupled with the prospect of stringent pollution legislation, has eroded the market for coal and caused natural gas to move up the energy food chain. The Department of Energy estimates that gas-fired electricity will climb nearly 31% in 2010 - up from five years ago, while coal usage will fall 6.5%. This fundamental shift in energy production can mean big profits for longer-term investors.

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The Big Switch

The lowest natural gas prices in over 11 months, combined with an unfavorable regulatory outlook toward coal, has prompted many utilities to defer new coal projects and construct plants that burn the cleaner choice. According to the U.S. Energy Information Administration, coal-fired plants are expected to fall to just 10% of total new capacity in the United States by 2013, down from 18% in 2009. Natural gas, however, is expected to climb to 82% of new capacity in 2013. Executives at utility Duke Energy (NYSE: DUK) predict that as long as natural gas prices hover between $4 and $7, there will be a continued shift toward natural gas-fired plants.

Other power generators are following suit. Xcel Energy (NYSE: XEL) recently announced that it wants to convert a Denver plant to burn natural gas instead of coal. The utility expects to save $225 million converting to gas rather than installing pollution equipment on the coal units. Progress Energy (NYSE: PGN) has plans to close four coal-burning plants and replace two of them with natural gas by 2017.

More and more utilities continue to shift away from coal toward natural gas. These new and converted plants will help create a floor for natural gas prices and ultimately benefit natural gas producers in the long run.

A Gas-Fired Portfolio

Coal is still the leading fuel in power, accounting for about 47% of electricity generation. Investors shouldn't abandon the Market Vectors Coal ETF (NYSE: KOL) just yet. However, over the longer term, this shift toward natural gas could be one of the better investment themes. Investors may want to position themselves accordingly to profit.

Several of the major integrated oil companies have signaled their natural gas ambitions; for example, Exxon Mobil (NYSE: XOM) with its recent purchase of XTO Energy. Both the First Trust ISE-Revere Natural Gas (NYSE: FCG) and Energy Select Sector SPDR (NYSE: XLE) count some of the largest oil and gas firms as their holdings. These firms will most likely be the long-term winners as more natural gas is used to generate electricity.

Inversely, investors may want to stay away from the small fries as new fracking legislation could price many of these smaller firms out of their lucrative shale formations. Investors may want to avoid the Jefferies TR/J CRB Wildcatters E&P (Nasdaq: WCAT), which focuses on small cap natural gas firms.

Finally, betting on natural gas prices via vehicles such as United States Natural Gas (NYSE: UNG) has been mediocre at best. A better way is to invest in natural gas infrastructure via the UBS E-TRACS Alerian Natural Gas MLP Index ETN (NYSE: MLPG). The ETN focuses its attention on storage and pipeline opportunities in the sector.

Bottom Line

With its low prices and pending legislation affecting its major competitor, natural gas is once again seeing its star rise. More and more utilities are beginning the shift away from coal-fired plants to those that use clean natural gas. As this shift continues, companies involved in its production will benefit. Long-term investors can profit from this by placing their bets now while prices are still low. (For related reading, see Mine For Profits With Natural Resource Sector Funds.)

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