When dealing with commodity shares always bear in mind the counter intuitive nature of their valuations. In good times earnings tend to be sky high. As a result conventional valuation metrics like the price-to-earnings ratio might look very cheap. Conversely when times are bad earnings crater and the same metric might look very expensive. The reality is that the complete opposite is very often true (i.e. low P/E ratios are often a sign of a strong bull market). The absolute sweet spot? Low commodity prices and attractive conventional valuation metrics.
This brings me to San Juan Basin Royalty Trust (NYSE: SJT), herein referred to as the Trust. Unlike the stocks I’ve covered so far royalty trusts aren’t strictly businesses in the traditional sense of the word. They simply own the mineral rights to a property or group of properties which hopefully contain large amounts of natural resources (in this case the land covered by the Trust in the San Juan Basin is a prolific source of natural gas). Here’s how the trust describes the relationship between itself and the operator Hilcorp:
Hilcorp, as the owner of most of the working interests and other leasehold interests comprising the Subject Interests, receives revenue monthly from the natural gas purchasers. Hilcorp deducts its production and development costs (including applicable lease operating expenses, capital expenses and taxes) and wires the Trust 75% of the remaining net profits. The Trustee adds investment income, deducts administrative expenses, and then distributes all remaining funds, net of cash reserves.
Basically the Trust gets a big slice of the profit and then passes virtually all of this to its unit holders. The one thing to really bear in mind is that this a profit interest rather than a revenue interest. This leaves the Trust highly sensitive to natural gas prices. In turn the unit price and monthly dividend can be very volatile. For instance in February the Trust declared a monthly distribution of $0.056701 per unit which was more than double the January distribution.
So why do I then refer to this as conservative speculation? Well as it stands natural gas is currently trading at around $2.85 per MMBtu. Judging by past distributions that might result in an annual dividend here of around $0.45 per unit. At the current $4.95 unit price that means we could be looking at a yield of around 9%. As I mentioned above there’s a fair amount of guess work involved though I don’t think the downside drops much below a $0.25-$0.30 per year distribution unless natural gas prices really tank. Even that case would still imply a current yield of around 5%-6%.
The plus side to being highly sensitive to the underlying commodity price is that the upside scenarios can be spectacular. Check out the unit prices in the mid-2000s; they were five to ten times higher than what it is right now. Not only that, but annual distributions would likely repay the current unit price within two two three years (check out the annual dividend between 2003 and 2009 for example). Even if natural gas prices were to average $4/MMBtu then we’d likely get 15%-20% yield on cost (at today’s price) at a minimum.
Now it’s important to understand that eventually the land will stop yielding gas and the Trust will terminate. But this won’t occur for decades (the Trust has already been going since 1980). In the meantime natural gas will surely go through a bull cycle or two. While you wait you can sit back and collect a modest monthly distribution with relatively little long term risk.