San Juan Basin's Plunge To Historic Lows Is An Opportunity For The Patient

Jun.11.12 | About: San Juan (SJT)

In several past pieces on natural gas this year (for example, "Exports Of Liquefied Natural Gas Add To Evidence Of Bottoming Natural Gas Prices"), I have offered San Juan Basin Royalty Trust (NYSE:SJT) as one alternative to the United States Natural Gas ETF (NYSEARCA:UNG) for playing a bottoming in natural gas prices. While noting the technical price risks in SJT, I did not have a 22% drop in five days (May 29th to June 4th) on my radar. That loss exceeded UNG's loss of 7% over the same period. (SJT's loss for 2012 of 45% is now below UNG's year-to-date loss of 38%). I wondered whether any other factors beyond weakening macroeconomic conditions are impacting SJT's performance. I read through the last financial report and 10Ks (annual reports) from 2011 and 2008 in search of clues. I did not find anything of particular alarm, but I do want to highlight some key information to consider going forward. I begin with this peek at SJT bears who have increased their pessimistic bets in a timely fashion.

The overall short interest in SJT is a very small 3.3% of float as of May 15. This short interest has swung widely. From July, 2011 to September, 2011, shares short doubled. They doubled again in another 3 1/2 months. Shares short doubled yet again over another two months to a peak of 1.8M shares. Short interest has since settled down a bit to 1.5M shares. The chart below shows shares short with an overlay of SJT's stock price. (The stock price is presented in arithmetic, not log, form given display limitations in Excel).

Click for a larger view..

Shorts have ramped against San Juan Basin Royalty Trust in a short amount of time

Shorts have ramped against San Juan Basin Royalty Trust in a short amount of time

Source: Short interest from NASDAQ, stock price from

Although relative short interest remains small, it is clear that a few traders have sniffed out opportunity in SJT's price decline. I am guessing the swift pace of the trading action reflects the trades of a small number of traders, perhaps related, but that is pure speculation on my part. Regardless, this chart motivated me further to dig deeper: good short sellers can flag issues that do not become obvious until it is almost too late to act.

In SJT's last earnings report, the company reported a 3.5% year-over-year decline in royalty income; distributable income was essentially flat at $14.6M. Average natural gas prices over the respective quarters remained flat but capital expenditures soared 62%. Capital expenditures can vary widely depending upon natural gas prices, regulatory actions, and specific characteristics of well-drilling activities. Burlington Resources Oil & Gas Company LP (BROG), the owner of the oil and gas leasehold and royalty interests, estimates that actual capital expenditures for 2012 will range from as little as $5M to $35M. More importantly, the income distributions steadily declined each month of the quarter from $.118906 to $.086028. The current yield on SJT is 6.6%. This is very attractive although in the past I tended to only start buying SJT once the yield reached around 9%. That rule would have served me very well this round.

Starting in 2009, distributions per unit have hit their lowest point since the early 2000s. In fact, these distributions are in general decline since hitting a peak in 2005:

San Juan Royalty Trust Distribution Per Unit 2001-2011Click to enlarge

San Juan Royalty Trust Distribution Per Unit 2001-2011

Source: San Juan Basin Royalty Trust website

While distributions have fluctuated widely, production over at least the last five years has declined very slowly. Production in 2011 was 11% below production in 2007 when the economy was at its peak.

San Juan Basin Royalty Trust Annual Gas Production 2007-2011Click to enlarge

San Juan Basin Royalty Trust Annual Gas Production 2007-2011

Source: SJT Annual Report and 10K for 2011

Probably most important for thinking through an investment in SJT is the estimated life of the natural gas assets (I have ignored the oil assets give they are extremely small - for example, responsible for only 3.4% of gross proceeds last quarter). In the 2011 10K, SJT estimated a production index (remaining reserves divided by current production) of 8.9 years. This index may not equal the remaining life expectancy of the trust given potential revisions in reserves. For example, if prices increase then more gas is economically available for extraction…and of course production may go up as well if demand is driving up prices. Using the estimates of independent petroleum engineers, SJT estimates as of today (conservatively) that the trust can run another 10-15 years (see FAQ). Proved reserves have dropped 30% since 2007 (so faster than the drop in production) and now sit at 135,941 Mcf (million cubic feet).

Proved Reserves of Natural Gas from 2007 - 2011Click to enlarge

Proved Reserves of Natural Gas from 2007 - 2011

While proved reserves have steadily declined, SJT's estimates for future net revenue (along with present value at a 10% discount) has fluctuated more widely. Over the last two years, this valuation has stabilized. SJT's model takes into account natural gas prices and production costs known at the time of the estimate.

Estimated Value of Proved Reserves 2006-2011Click to enlarge

Estimated Value of Proved Reserves 2006-2011

In the 2011 10K, SJT warns that these valuations "should not be considered the market values of such oil and gas reserves or the costs that would be incurred to acquire equivalent reserves." So, I decided to examine whether any relationship exists between the price investors are willing to pay for SJT and these estimates. Until the last three years, there has been little to no relationship between the stock price and these estimates even when looking at multiple perspectives. The annual reports cover the period from November of the prior year to October of the reporting year. I calculated the average, mean, minimum, and maximum stock price in each of these years and created a ratio with the total estimated future net revenue per proved unit. The chart below shows that the only consistent relationship from year-to-year has been in the last three years between the median price and SJT's estimates.

Ratio of Estimated Future Net Revenue Proved Per Unit and Various Stock Price Categories 2006-2011Click to enlarge

Ratio of Estimated Future Net Revenue Proved Per Unit and Various Stock Price Categories 2006-2011

It almost appears that all these valuations are converging but confirmation would take another two years or so of data and/or more granular data. Regardless, it is at least reassuring that the ratio using the median and average annual stock prices are not trending higher or lower over recent history.

The final place I looked for trouble was in litigation. Under Item 3, "legal proceedings", SJT reviews a series of legal issues going back as far as 2008. Again, I did not find anything particularly alarming. In March, 2008, SJT had to reduce distributions by $4.9M to pay a settlement for underpayment of royalties. BROG paid SJT $2.6M in May, 2010 in a settlement over compliance issues. There is an outstanding legal proceeding involving the Department of the Interior (DOI) and the Jicarilla Apache Nation. SJT provides no estimates of potential liabilities but the case has been churning since 1998 and seems to involve the years 1984-1988. SJT is the plaintiff in a case seeking payment for royalties. While a May, 2011 verdict awarded them $13M, the case is not yet settled. SJT also indicated it cannot determine whether the final settlement will be material to SJT's distributions.

So, overall, for now, I think it is sufficient to think of SJT in terms of the prospects for natural gas prices to bottom. With rig counts in decline and drillers feeling the pain of a supply gut, it seems that overall production is finally beginning to decline (for more details see "Dirt Cheap Natural Gas Is Tearing Up The Very Industry That's Producing It"). At some point then, sooner than later, natural gas prices should bottom. While interest in LNG exports out of the U.S. is increasing (the U.S. could rival fourth largest exporter Australia in future years), this outlet for supply could get caught up in political wrangling. Given the amount of capital and years of investment required to get LNG exports up and running, such uncertainty could push out exports for many more years to come.

SJT is now a breath away from its historic 2009 lows which in turn represented prices unseen since 2002. This seems far too cheap to me, but I realize I am talking into the market's headwind given the vicious downtrend. A break of these levels could take SJT very quickly to the 9% yields I prefer on the stock. I will consider adding to positions if the stock reaches that point.

SJTClick to enlarge

SJT's historic plunge is only rivaled by the one in 2009 and is worse than 2001's 50% haircut


Be careful out there!

Disclosure: I am long SJT.