A Dangerous Income Trap For Commodity Investors

By Matt Badiali, S&A Resource Report

If you hold a natural gas trust in your portfolio, you might be holding a ticking time bomb.

For years, one of my favorite trades was generating income from beaten-down natural gas. These are companies that own royalties on acreage in older oil and gas fields.

The companies receive a share of production revenues and pass most of it along to shareholders in the form of dividends. It’s a great investment if you buy them when oil and gas prices are low.

And we thought we did. However, things have changed. It’s time to get out before things get worse. Let me explain…

The king of natural gas trusts is San Juan Basin Trust. It owns a royalty interest in acreage in the prolific San Juan Basin of northern New Mexico.

After it covers its share of the lease, operating expenses, and drilling expenses, San Juan Trust receives its royalty income. It then pays that money to shareholders as a dividend… and the divided is about to fall hard.

Today, San Juan Trust has a trailing 12-month dividend of $1.44 per share. It’s trading at $17.28 per share. That works out to roughly an 8.3% yield.

The five-year average yield is 7.5%. So today’s high yield says the market is pricing in bad news… but not nearly enough.

Its latest dividend was $0.09 per share. That was based on the volume of natural gas it pumped in January 2012 and the price it received: $4.07 per thousand cubic feet (mcf). Since then, natural gas prices are down to under $2 per mcf. So we’re likely to see San Juan Trust’s monthly dividend fall steadily as February and March’s data arrives.

How low can it go?

In June 2009, San Juan Trust had its worst month ever. It sold gas for $2.64 per mcf. It generated less than $0.01 per share in dividends. That’s terrible. And I’m concerned it could happen again.

To get an idea of what could happen, we will assume that its production volumes will stay the same. These older fields have stable production, so we won’t be too far off.

If natural gas prices spend the year at $2.95 per mcf, San Juan will generate $0.60 in dividends. Let’s assume the yield returns to its five-year average of 7.5%. In that case, shares would sell for $8. That’s more than 50% below today’s price.

But it could get worse…

At today’s prices – $2 per mcf – San Juan will generate $0.43 in dividends. With a 7.5% yield, shares would fall to $5.75. That’s a 65% total loss.

San Juan isn’t alone. Any energy trust that gets a substantial portion of its revenue from natural gas is in big trouble. That includes names like Mesa Energy Trust, Sabine Royalty Trust, and Permian Basin Royalty Trust.

As I noted, I’ve recommended natural gas royalty stocks in the past. I underestimated the potential decline in natural gas. But conservative exit strategies got my readers out of them with a small loss.

Fortunately, these stocks are not down much in the short term. Some have even rallied modestly in the past few months. But I believe they carry too much risk here.

I still believe in the safety of trading resources at rock-bottom prices. But I don’t believe the worst case is priced in to these stocks yet.

Good investing,

Matt Badiali