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My Two Favorite Ways to Play the Natural Gas Decline (Part 1)

By now, every investor is aware of the precipitous decline in natural gas. (Prices are down about 40% since last summer.)

In turn, natural gas is easily the most hated commodity in the world.

I have to admit, though, that has the contrarian in me salivating! And here’s why…

Look Out Below

Don’t worry. Just because I’m a contrarian, doesn’t mean I’m stupid. So I’m not about to recommend you try to catch the proverbial “falling knife.” Heck no!

Thanks to an unseasonably warm winter and ever-increasing supplies – the U.S. Energy Information Administration recently reported that U.S. storage facilities now hold 3.3 trillion cubic feet of gas, up 20% from last year’s record high levels – natural gas prices are likely to remain depressed for quite some time.

I’m not the only one that thinks so, either.

Major natural gas producers like Chesapeake Energy (NYSE: CHK), recently announced sizeable – and immediate – production cuts.

As Chesapeake’s CEO, Aubrey K. McClendon, said, “We have committed to cut our dry gas drilling to bare minimum levels.”

Obviously such bearish comments and actions aren’t a promising sign for natural gas prices in the short to intermediate term.

Accordingly, I’d avoid investing in natural gas exploration and production companies. That includes even the ultra low-cost producers like Range Resources (NYSE: RRC).

Instead, I’d consider going with a royalty trust like San Juan Basin Royalty (NYSE: SJT).

Get Paid to Wait for a Rebound

San Juan is one of the largest energy sector royalty trusts in the United States. It has no true employees. It does zero exploration and production.

Instead, it owns a 75% net profit interest in natural gas properties in the San Juan Basin of New Mexico. Over 90% of its royalties come from natural gas.

Burlington Resources Oil & Gas Company LP, a subsidiary of ConocoPhillips (NYSE: COP), operates the properties and worries about maximizing profits. San Juan just sits back, collects the royalties and pays monthly distributions to owners. That’s it.

Given such a setup, it’s no surprise that San Juan’s price has been falling with natural gas prices.

Being levered to the price of the underlying commodity is actually good news for us right now. It pushes up the yield on San Juan. At current prices, the royalty trust yields an estimated 7.2%.

It’s also good news for us in the future. When natural gas prices finally do rise, so should San Juan’s distributions to unit holders

In the end, San Juan represents a lower-risk and income-producing way to play the decline in natural gas prices. But it’s not my absolute favorite.

If we revisit McClendon’s comments above, you’ll notice he didn’t say the company was cutting all of its drilling to a bare minimum. And therein lies the real opportunity, in my opinion.

I’ll explain exactly what I mean in tomorrow’s column. So stay tuned.

Ahead of the tape,

Louis Basenese