Unlike corporations or master limited partnerships, oil and gas
royalty trusts aren't operating businesses, usually have no
employees, and can't make acquisitions, take on additional
commodity price hedges or invest in new growth projects. The
sponsor contributes all of a trust's assets, from oil- and
gas-producing acreage to hedges against fluctuating commodity
prices. These investment vehicles also have a finite lifespan and
will liquidate their assets at a predetermined point in the
Investing in a publicly traded royaltytrust is akin to buying an
interest in a series of oil and/or natural gas wells; you will
receive a share of the proceeds from the hydrocarbons produced from
these wells throughout the trust's life. The best royalty trusts
offer double-digit yields and the potential for near-term growth in
But be forewarned that every trust has a unique structure: You
shouldn't focus on
alone when making your investment decision. Some trusts have
outsized exposure to depressed natural gas prices; other
high-yielders are slated to terminate in a few years and are
suffering from declining production and distributions.
Investors should consider several factors when evaluating an oil
and gas royalty trust, including the potential for near-term output
growth, the trust's production mix, the amount of time remaining in
its life span and the quality of its underlying assets.
Furthermore, the buy target on every royalty trust I track reflects
the results of a valuation model that I run after these holdings
report quarterly results.
My strategy for profiting from oil and gas royalty trusts
remains unchanged: Buy the stocks when they trade below my buy
target to lock in an above average yield; and take profits when the
unit price appreciates to frothy levels-usually when commodity
prices are on the rise.
Now marks another buying opportunity to buy strong royalty
trusts, especially names that will benefit from a potential
increase in oil prices in the back half of 2012 and early 2013.
With this strategy in mind, here's a review of one of my
favorite oil and gas trusts.
SandRidge Permian Trust
(NYSE: [[PER]]) will pay a quarterly distribution of $0.574232 per
unit on Aug. 29, 2012, tounit holders of record on Aug. 14, 2012.
This disbursement represents investors' share of the proceeds from
the trust's production in March, April and May; the distribution
covering June, July and August will be paid on Nov. 30, 2012.
Bloomberg, SandRidge Permian Trust S-1
SandRidge Permian Trust has exceeded the target distributions
laid out in its
S-1 registration statement
with the Securities and Exchange Commission in every quarter since
going public. In the most recent quarter, the trust exceeded this
target by 4 percent, largely because higher-than-expected
production offset lower-than-expected commodity prices.
At the time of SandRidge Permian Trust's initial public offering
(IPO), the S-1 estimated that the underlying wells would produce
351,000 barrels of oil equivalent per day in the three months ended
June 30, 2012. In actuality, these wells flowed 386,000 barrels of
oil equivalent per day-10 percent greater than the target level.
Oil output exceeded expectations by 8 percent, while the trust's
sponsor lifted 30 percent more natural gas and 19 percent more
natural gas liquids
)) than outlined in the S-1 form.
This upside stemmed from SandRidge Energy (NYSE: [[SD]])
drilling the trust's developmental wells at a faster rate than
initially planned. As of March 31, 2011, the area of mutual
interest (AMI) included 509 producing wells on 16,800 gross acres
of land in the Permian Basin. SandRidge Energy, the trust's
sponsor, had committed to drill an additional 888 developmental
wells in the AMI by March 31, 2016, at the latest. In the S-1
registration statement, management estimated that the parent
company would fulfill this obligation by March 31, 2015, implying a
drilling schedule of 18 wells per month.
But between March 31, 2011 and May 31, 2012, SandRidge Energy
had drilled 300.9 developmental wells, receiving fractional credit
for some wells depending on its ownership interest and certain
technical specifications. In other words, the trust's sponsor has
drilled an average of 21.5 developmental wells per month. In the
three months ended May 31, 2012, the firm drilled and completed an
average of 27 wells per month.
Lower-than-expected commodity prices offset this accelerated
drilling program, though the trust's oil-heavy production mix
provided a degree of protection against these challenges. In the
three months ended May 31, 2012, crude oil represented almost 86
percent of output attributable to the trust, with NGLs accounting
for 9.8 percent and natural gas making up the balance.
More important, oil accounted for 94 percent of the trust's
total revenue over this period. Despite dramatic declines in the
price of NGLs and natural gas, these headwinds had a negligible
impact on the trust's revenue and quarterly distribution.
Although the price of West Texas Intermediate ((
)) crude oil tumbled precipitously over this three-month period,
the trust hedged 88 percent of its production at an average price
of $102.20 per barrel, ensuring that its price realizations fell
short of expectations by only 1 percent.
These hedges should likewise cushion the trust's revenue and
distribution against recent weakness in the price of WTI, which has
averaged $87.25 per barrel since June 1. In its S-1 registration
statement, the trust had targeted a distribution of $0.58 per unit
for the three months ended Aug. 31. This forecast assumes an oil
price of $101.50 per barrel, about 15 percent above the average
price of WTI since June 1. Investors shouldn't fret about weak oil
prices eating into the trust's distribution: Management estimates
that WTI prices that are 15 percent lower than the forecast
outlined in the prospectus would reduce the payout by less than
$0.01 per unit.
Meanwhile, NGL prices have rebounded sharply since late June,
and natural gas prices have recovered to $2.82 per million British
thermal units from less than $2 per million British thermal units
at the end of April 2012.
I expect SandRidge energy to continue drilling wells at an
accelerated pace in the short term, a strategy which should ensure
that quarterly output exceeds management's production targets. At
the end of May, the trust had more than 18 developmental wells that
were awaiting completion.
Higher production should more than offset any shortfall in
commodity prices. At the time of the trust's IPO, management
estimated that a 10 percent increase in production relative to the
targets laid out in the prospectus would add $0.05 to $0.06 per
unit to the quarterly distribution.
The trust doesn't foot the bill for drilling or completion but
does bear its share of post-production expenses, including the cost
of gathering and transporting gas. These expenses exceeded
management's forecast, largely because higher-than-expected output
entails additional post-production costs.
I expect SandRidge Permian Trust's distributions in coming
quarters to surpass the targets set out in the prospectus by about
5 percent, implying a payout of $2.50 to $2.63 per unit over the
next 12 months. Moreover, I remain bullish on oil prices over the
long term; when the trust's hedges expire on March 31, 2015,
higher-than-forecast oil prices could result in quarterly
disbursements that exceed estimates outlined in the prospectus.
I use a variation of the dividend discount model ((
)) for valuing royalty trusts. Based on SandRidge Permian Trust's
recent results, I've updated my valuation model to reflect eight
quarters of distributions that are 5 percent higher than targeted
levels and 10 percent above target from mid-2015 through trust
termination date in 2031. Accordingly, SandRidge Permian Trust
remains one of
my top oil and gas investments
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
The Kind Of Stock You Don't Need To Buy