Profit From Panic With Businesses Like Fairfax, Linn

Safety in Natural Gas

Like food, natural gas is essential to our society. And with natural gas prices down nearly 50%, natural gas companies have been selling off as if we no longer need the stuff. Even more, several high-quality natural gas companies are now being valued at fractions of their asset values.

Even further, natural gas master limited partnerships (MLPs) have been thrown out with the bath water for fear that their debt burdens are too onerous in this market. Yet the stable nature of natural gas sales -- even at these prices -- should adequately cover the interest obligation and still leave room for a nice dividend payout. One of my favorites continues to be Linn Energy (LINE Quote). I thought it was a good bet a few months back at $19; at $14 a unit, I think it's a steal. And the dividend yield is a whopping 16.7%, which appears to be cash in the bank for investors.

I recently outlined the case for Linn based on asset values. But many couldn't get past the "huge losses" that Linn was reporting. These losses were simply unrealized losses based on long-term put options on energy prices.

Because of its MLP structure, Linn hedges its sales prices to maintain stable cash flows to pay out an attractive dividend. So think about the economics of a put trade. If you enter a put contract on assets you own, you are effectively putting a floor on your price. But what happens if the asset price goes up? Your put option declines in value, but you still sell your asset at your intended put price. So for example, if Linn sold puts to sell natural gas at $10/tcf, but natural gas goes to $13/tcf, the value of the put declines, but they still sell their gas at a great price.

Today, natural gas has come down rapidly. These puts are now heavily in the money, and you should expect many MLPs to report "large gains" similar to the losses taken earlier. A solid company like Linn will easily cover its dividend during these tough periods of credit. If natural gas stays low, the hedges remain in the money and Linn does well. If natural gas prices go up, Linn still makes money, you get the dividend and the value of the assets to potential buyers goes up.

Believe or not, if you're patient, you can profit from the panic.

This was originally published on RealMoney on Oct. 7, 2008. For more information about subscribing to RealMoney, please click here.