Masters Series: How to Make Commodity Investing Nearly Risk-Free

Editor's note: From the beginning of last September through the end of 2014, the Toronto Venture Exchange – the "Dow Jones Industrials" of small resource companies – fell nearly 35%.

That has given investors an incredible opportunity today. Because these stocks are cyclical, they often experience huge booms and massive busts.

The booms can lead you to portfolio-changing winners. The Stansberry Research Top 10 is littered with triple-digit gains in the sector... like Seabridge Gold (up 995%), ATAC Resources (up 597%), and Silver Wheaton (up 345%), for example.

When these stocks head higher, you'll want to be ready to take advantage.

In today's edition of our weekend Masters Series – excerpted from one of our most popular books, Secrets of the Natural Resource Market – Stansberry Research founder Porter Stansberry explains how to greatly reduce your risk and position yourself to profit...

How to Make Commodity Investing Nearly Risk-Free

By Porter Stansberry, founder, Stansberry Research

For most people, investing in commodities is an extremely risky activity.

That's because most people are totally unaware of a way to make investing in commodities almost risk free.

Rather than give you a bunch of theory, I'd rather show you precisely how I put these ideas to work, starting in 2001...

At the time, I was a vehement and frequent critic of "Peak Oil."

Promoters of this idea were the most intellectually dishonest people I have ever met. The true believers were worse. They were criminally stupid. There was no way we were going to run out of oil or any other hydrocarbon, as they claimed. Not any time in the next 100 or more years.

But such arguments did scare people. They sold a lot of books. They raised a lot of money for oil companies, even for idiots who proposed importing natural gas into the American market. (That's like setting up a business to import oil to Saudi Arabia.)

Meanwhile, while the press and the promoters were crowing about Peak Oil and starting a panic, the actual leaders of the oil business in the United States were figuring out how to combine hydraulic fracking and horizontal drilling to produce huge amounts of gas and oil from shale rock.

One of the first was Mitchell Energy, which began producing huge volumes of gas out of the Barnett Shale (north of Dallas) in the early 2000s. Devon Energy bought the company for $3.5 billion in 2001.

Note the date. By 2001, everyone in the oil business knew large increases to domestic onshore production were possible. It took a while, of course, for the industry to figure out how to optimize and economize the strategies that Mitchell pioneered.

But everyone should have known – as I did – that new technology, massive increases to drilling, and rapidly growing production would eventually create a glut. The risk wasn't that we would run out of hydrocarbons. The risk was that too much capital would be invested in the fields and that a glut would develop.

As early as 2006, I began to warn that a huge natural-gas glut was inevitable. From the June 2006 issue of my Investment Advisory...

As more rigs come on-line and consumers use less natural gas because of its high price, guess what is bound to happen? A glut of natural gas, with more and more natural gas in storage. Is that happening? Is there a glut of natural gas developing? Right now, there's 41% more natural gas in storage than average for this time of year. That's how markets work: The price of the commodity goes up, increased production follows, consumer behavior is impacted by higher prices, and, eventually, a surplus leads to lower prices. It's not about Peak Oil. It's simply a regular commodity cycle. Boom precedes bust. And when it comes to natural gas, unlike housing, we can't just sit on the extra capacity. It has to be either stored or liquidated. That's why natural gas prices might go lower than anyone expects, for a long time... Natural gas could fall even further to below $3.

Keep in mind, when I wrote that, I had no idea that the global economy would collapse in 2008. I simply knew that there was far too much capital being put to work in oil and gas fields... that prices were far too high based on inventories... and that marginal producers would continue producing for years, simply to keep cash coming in the door.

As late as 2009, I was still expecting natural gas to fall below $3 per thousand cubic feet (MCF). At a conference that March, I famously told global resource expert and longtime natural gas investor Rick Rule, "If you're long natural gas, you should have your head examined."

I then bet him a case of fine Bordeaux wine that prices would continue falling to below $3. They did. (Rick, being a man of his word, paid up.)

I want you to understand... I wasn't trying to predict the future. I simply knew that all over the U.S., formerly marginal drilling sites were being turned into gushers with new technology that was becoming more and more efficient.

I knew production was soaring. And I knew natural gas consumption was falling because high prices were leading power companies to burn more coal. Supply was soaring. Demand was falling. Inventories were bulging.

And best of all, the public was fully entranced by the nonsense of Peak Oil. There was only one possible outcome: a huge glut of natural gas. This isn't rocket science. It's common sense. You can see what inevitably happened below...

The trick to buying commodities is to wait until there's a bust.

Wait until prices for the commodity have fallen so low that producers can't produce the commodity at a profit. Wait until inventories have surged and rolled over. Wait until prices have reached a nonsensical level. And remember... these trends take a long time to develop.

Natural Gas: Bearish to Bullish

With natural gas, I went from bearish to bullish in the spring of 2012. Here's what I wrote in my April 2012 issue, titled "The Best Opportunities of the Next Two Years"...

I am extremely bullish on natural gas... For most investors, the opportunity unfolding in natural gas will be one of the best investment opportunities of the next decade. Right now, natural gas is so cheap that many companies are simply flaring it off – they're burning it – rather than bothering to pipe it across the country and sell it. Not only that, but right now, you can buy natural gas reserves in the stock market for free. Sooner or later, the price of natural gas will rebound sharply... and not just because it always has in the past. What will propel natural gas prices over the medium term (say, five years) is an economic truism: It's impossible for a surplus of energy to exist for long. As prices fall, more and more uses for natural gas will appear. At some price, natural gas becomes competitive with other forms of energy. In my mind, you ought to buy all the natural gas you can afford because these energy resources will not be cheap forever.

By the spring of 2012, I knew a few things that gave me total confidence that natural gas prices had reached a bottom...

First, I knew that with the spot price under $2 per MCF, it was impossible for any of the independent natural-gas companies (Devon, Chesapeake, Anadarko, Southwestern, Encana, WPX, and Ultra) to make money.

The chart below shows how their operating margins were collapsing as their hedges rolled off and they began transacting at the new, much lower price of gas...

Second, because natural gas is only one form of hydrocarbon energy, I could see that it had reached a comparative price that was simply unthinkable. The real commodity you're buying when you buy natural gas is energy. At some price, all forms of hydrocarbons are relatively interchangeable.

For decades, oil has been about 10 times more expensive than natural gas, on average, on an energy-equivalent basis. But by the spring of 2012, oil was trading for more than 50 times the price of natural gas. There was no way that such a price disparity would last because one form of energy is ultimately interchangeable with another...

By the spring of 2012, we could see that a glut had developed (as we had expected). We could see that prices had collapsed to historic lows. We could see that the marginal producers (the U.S. independents) were going to experience massive operating losses.

But how did we know the time was truly right? Our timing was dictated by significant reductions to both production and inventories.

The next chart shows the natural-gas-rig count maintained by oil-services giant Baker Hughes. It's the number of rigs that were working in the U.S. to produce natural gas from 2004 to mid-2014. You can see that in 2012, the rig count plummeted. That's the producers "taking their ball and going home"...

This move – plus a large and surprising decline in natural-gas inventories in March 2012 – was the final sign I had been waiting to see. The neat thing about commodity markets is that they are purely logical. High prices (during a boom) spur production and cause consumers to reduce consumption.

But at the bottom, the opposite occurs. After gas prices crashed, we saw all kinds of new demand for natural gas emerge because the price was so low. We saw a surge in exports. We saw power companies switch from coal back to natural gas. And we saw global manufacturing relocate to the U.S. to take advantage of the surplus of cheap energy – particularly the petrochemical industry.

Reduce Your Risk by 90% in Commodities

If you go back and look at the best-performing S&P 500 companies over the long term, you'll find that many of them are energy companies. That's because the operating margins and returns on investment in the resource sector (particularly energy) can be huge. Investing in commodity stocks is generally perceived as risky.

But using a small amount of common sense and information that's widely available to all investors... it's not only possible, it's easy to identify safe opportunities to invest in commodities.

The trick is waiting until prices are so low, the entire production industry is failing... and then not 'pulling the trigger' until inventories begin to sharply decline. Also remember that these cycles are long-lived.

You might only get the kind of opportunity we saw in natural gas back in 2012 once or twice every 20 years. You have to watch these markets over the long term and be prepared to make large commitments when the time is right.

There are two more things you should know about investing in commodities... two genuine "inside" secrets that few people will ever explain to you. If you watch the cycle develop like I describe, you can reduce your risk by 90%.

All you have to be is patient. You can't force a commodity-price cycle to change. If you're able to be patient, you can virtually eliminate the remaining risk by only investing in royalty-paying securities. These are companies – like natural gas royalty trust San Juan Royalty Trust (SJT) – that simply own royalty interests in wells or mines.

The cool thing about these trusts is that their payout increases tend to follow commodity-price changes by about six months. If you look at San Juan Royalty Trust, for example, it really began to move higher in 2013, even though natural gas prices bottomed in April 2012.

We call this the "royal" delay. It gives investors a second chance to buy into the bottom of a commodity. That's great for obvious reasons, but the real reason royalty trusts help you eliminate investment risk is because they don't have any debt or any overhead. It's next to impossible for them to go bankrupt.

The other, safer, option than buying the producers is to focus on the "picks and shovels" companies. Take Halliburton, for example. It's one of the leading providers of services to the production companies I listed. Its shares climbed 150% from mid-2012 to mid-2014! That's a far better return than almost all other producers.

The great thing about buying a well-run services company is that you get industry-wide diversification. All production companies use Halliburton's services. Thus, you don't have to try to figure out which fields are the best or which producer is going to strike the biggest wells.

Whoever is doing best will be using Halliburton. You can accomplish much the same by buying low-risk ETFs that hold stakes in all of the producers, like FRAK, for example.

The point is... investing in the commodity-price cycle can be low risk if you buy securities like royalty trusts, service companies, or ETFs that don't have any single-stock risk.

If you combine this approach with buying a few of the highest-quality producers (think EOG in the Eagle Ford Shale, Devon in the Permian Basin, or Continental in the Bakken Shale), you'll be successful.

Most investors think investing in commodity businesses is risky. But if you're willing to time the commodity-price cycle and if you focus on royalty firms and "picks and shovels" plays, these investments can be among the safest you'll ever make.

In the right circumstances, you can produce trades with zero downside risk and huge upside potential. Just remember to wait for historically low prices, collapsing profit margins (in the producers), and suddenly shrinking inventories.

Editor's note: We released Secrets of the Natural Resource Market last year... and it quickly became one of the most popular books Stansberry Research has ever published. As one of the most comprehensive guides to resource investing around, Secrets of the Natural Resource Market features insight from industry experts Matt Badiali, Rick Rule, and Brian Hunt. You'll learn the essential tools needed to make big, safe returns for decades.

Whether you're just starting to invest in resource stocks or looking for ways to increase your returns while lowering your risk, Secrets of the Natural Resource Market is a must-read. Click here to claim your copy today.