San Juan Basin Royalty Trust: Time to Jump the Gun

Sep.30.09 | About: San Juan (SJT)

We recommend current purchase of the units of natural gas income stock San Juan Basin Royalty Trust (NYSE:SJT) for unlevered appreciation potential of 38% to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of $21 a share. Investors looking for a stock that has not participated much in the market recovery need look no further than SJT, which trades at the lowest ratio, 0.85, to its 200-day average of any stock in our coverage. The overwhelming factor influencing the stock price of SJT is the price of natural gas, which is under acute short-term pressure ahead of the winter heating season that begins on November 1. Record short interest seems to anticipate a price decline climax in the next several weeks. We think it is time to “jump the gun” because if the climax occurs, the price recovery could be sharp. The main risk is that depressed conditions take longer to be alleviated.

SJT Almost Always Offers Attractive Income
Our current estimates anticipate a distribution of $1.08 a unit for the next twelve months ended September 30, 2010. That implies a distribution yield of 7% a year. Buyers can usually figure that the distribution yield will be in the high single digits because the stock price tends to adjust for distribution expectations. In that case, the risk becomes the prospect for changes in expectations, which in turn depend mostly on the outlook for natural gas price. Alternatively, if an investor has a view on natural gas price, then SJT is a pure play vehicle to invest in that view.

NPV Tied to Long-Term Natural Gas Price of $8 a Million Btu
Our view on natural gas price is that $8 a million btu is reasonable for the long-term before adjustment for inflation. That appears to be a bullish position compared to the average of futures prices for the next 72 months, or six years, at $6.33 for the September 3 settlement. In any case we use the $8 price to calculate NPV in a discounted cash flow format. Change the long-term price to $6 and NPV becomes $15, a percentage change about the same as the percentage change in price.
Among other estimates we project capital expenditures that keep volume decline modest. Projected volume would accumulate to 20 times initial volume or about twice the proven reserves estimated by the trust’s independent engineer. Proven reserves of a high quality resource can underestimate actual future production by a wide margin. The U.S. Energy Information Administration reports that reserves in the San Juan Basin, the largest natural gas field in the U.S. at the end of 2007, have grown to some 13 trillion cubic feet (tcf) from 10 tcf in 1980, the year the trust was created. That is an increase after 27 years of production. The U.S. Geological Survey estimates 50 tcf of resources remaining to be discovered in the basin. Thus, while our estimate of production looks high relative to proven reserves, it looks low relative to historical performance.
The recent technological advances that make production from shale formations economic contributed to our reduction in long-term price from $10 to $8 two months ago in July. Now industry volume is declining as not even new shale drilling is enough to keep production at the current level. The shale gas development is analogous to the coal seam gas development that contributed to extra reserve increases in the San Juan Basin twenty years ago. The extra supply contributed to weak price for awhile before an upward trend resumed.

Originally published on September 4, 2009.