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One Inflation Hedge That Isn’t Inflated

July 07, 2009 – by Richard Band

A lot of observers are concerned about the long-term impact of the U.S. government’s bailout policies. Count me among the worriers.

Since last September, the Federal Reserve has virtually doubled the monetary base (consisting of currency in circulation, member bank reserves held at the Fed and vault cash).

As Prof. Arthur Laffer pointed out recently in a Wall Street Journal piece, that’s the largest percentage increase in the past 50 years — by a factor of 10!

Bernanke’s crew promises to reel in this excess cash once the economy picks up. Unless the Fed acts promptly, though, we’ll be battling a serious inflation problem two or three years down the line.

So I’m scouring the markets for inflation hedges. Trouble is, however, many of the traditional hedges are expensive nowadays.

The price of gold bullion has more than tripled since 2001. Ditto for silver. Oil has doubled from last December’s low. Real estate values are improving, but rental yields (so-called “capitalization rates”) for commercial property still haven’t reached knock-your-socks-off levels in most parts of the country.

So, what’s the solution?

Your Best Bet to Hedge Against Inflation

As it happens, one hard asset is remarkably cheap, both in terms of its own history and relative to its nearest rivals. What’s more, it fits perfectly with the Obama administration’s goal to curb emissions of carbon dioxide.

I’m talking about natural gas.

After surging to a record $13.50 per million BTUs a year ago, the clean-burning fuel has plummeted to a little under $4 recently. At the April low, natgas had given up virtually all its gains from the energy boom of the past seven years.

Compared with oil, natural gas is a steal. On a heat-equivalent basis, it should take about 6 MMBTUs of gas to buy a barrel of oil. (In practice, because it takes energy to refine oil, a ratio of about 8:1 is probably more appropriate.)

Over the past few months, however, the oil/gas ratio has taken a moonshot up to the 16:1–19:1 range, the lowest relative price for gas since 1992. Gas is now even trading at a heat-equivalent discount to filthy (and superabundant) coal!

Of course, there are reasons why natgas is so depressed.

In recent years, huge new deposits have been tapped in the western United States and Canada. Producers in the Persian Gulf and elsewhere are shipping increased quantities of liquefied gas to U.S. ports.

It will take time for electric utilities and other major energy consumers to pick up the slack. (You can’t convert a coal-burning power plant, or a city bus fleet, to gas overnight.) But I’m prepared to wait for the inevitable turn of the tide.

The Obama team is far more committed to combating climate change than any previous U.S. administration. Two or three years out, that spells much higher natgas usage — and much higher prices.

Two Ways to Play Natural Gas

You can play the natural-gas story through any number of vehicles.

The most conservative pick is ExxonMobil (XOM), which sits on a massive treasure chest of natgas reserves (the equivalent of about 11 billion barrels of oil, or approximately half the company’s total resource base).

Current yield: 2.5%. Buy XOM at $74 or less.

Want to focus more intently on gas? Then check out, San Juan Basin Royalty Trust(SJT).

This debt-free trust collects royalties on gas produced by wells in New Mexico’s San Juan Basin, one of America’s most prolific gas fields. Eventually, the trust will run dry, but SJT’s wells have pumped for more than 50 years — and Burlington Resources, the trust’s operating partner, is constantly drilling new wells on the acreage. I figure the bounty should last another decade at least.

SJT pays monthly distributions, which fluctuate up or down with the price of gas. Right now, with natgas in the dumps, the trust is yielding only about 3% (based on payouts for the first five months of 2009).

However, if gas prices rise again, as I believe they will, your yield could easily climb back into double digits. Given today’s share price and the average distribution for 2006–2008, you would pull down a fabulous cash yield of 16%.

Buy SJT at $18 or less.