I first uncovered this
years ago, when I started my
advisory in 2004. In October of that year, I added one of these
securities to my portfolio at $41.33. I sold it for $64.51 about
two years later. Along with $9.93 in distributions, my total
returns were a little more than 80%.
Another one of these rare investments has also done well for
subscribers. I added it to my portfolio in late October 2010. I've
received $4.28 per unit in distributions and the price has soared.
So far, total returns are more than 50% in just 16 months.
I like to return to investment ideas that have done well for me. So
it comes as no surprise that I'm again looking into one of the
highest-yielding, yet rarest, income investments on the
-- royalty trusts.
These trusts are designed for one thing: to pay out royalties, or a
share of production revenue, from a field of existing oil and
natural gas wells.
The first trust debuted in 1979. Amazingly, even after more than 30
years, there are still only about two dozen publicly traded oil and
gas royalty trusts. And between 1999 and 2007, no new royalty
trusts were created.
But in the past year, there has been a small renaissance in royalty
trusts. I count four new trusts that have come to market in the
past two years alone.
For income investors, the sudden surge of interest is good news.
Routinely providing yields of about 10% or more, royalty trusts can
seem too good to be true. Why, then, are oil and gas companies
spinning off properties into publicly traded trusts?
Trusts allow the
to get full value for their reserves while also raising money,
without diluting their common
or going further into debt.
But there is one potential hang-up. By definition, these new trusts
don't have an established track record of generating
from their reserves. Instead, you must rely on the company's
production projections and price assumptions, as stated in the
That's the downside. But it's offset by at least two benefits.
First, recent trusts are being formed for a set life or "term" of
20 years. For example,
SandRidge Permian Trust (NYSE:
was formed on May 12, 2011, and will dissolve by March 31, 2031.
The parent company or sponsor endows the trust with proven reserves
that have high-probability development opportunities to ensure the
term is fulfilled.
In contrast, many older trusts formed in the early 1980s have
consumed much of their original reserves. Although new production
technologies have allowed them, in some cases, to draw more
production from their reserves than originally anticipated, they
still have a much shorter remaining reserve life. The average
reserve life for older royalty trusts is about 8.3 years, compared
with 20 years for some of the newer trusts.
Once the reserves are used up, a trust expires and any remaining
assets are distributed to unitholders. It can't issue equity or
debt to acquire new reserves.
A second benefit is some new trusts have created "subordinated
shares are called units.) These units, which are held by the
trust's sponsor, support the distribution rate to common
They work like this. When SandRidge Permian was created, sponsor
SandRidge Energy (NYSE:
set aside 25% of the outstanding units for itself as subordinated
units. These units are also entitled to receive distributions...
with a catch.
The trust forecasts target distributions for several years in
advance, based on projections of production volumes,
prices, the effect of hedges, expenses and taxes.
Then a subordination threshold is also established. For the
SandRidge Permian Trust, the threshold is 20% below the target
distribution. If the distribution ends up being less than the
subordination threshold, then the sponsor will make up the
difference by reducing or foregoing the distribution on
subordinated units. This way, there is some assurance that
distributions will reach a predetermined level should commodity
In return, if the distribution is substantially higher than the
target, then the subordinated shares will receive an extra share of
These subordinated shares don't last forever. The parent company
retains these subordinated shares until new wells that the trust is
also required to drill are completed. Then, a year later, the
subordinated shares convert to common shares.
Risks to Consider:
Now before you dive into any trust, there is plenty more to
know. Taxes are a little trickier than with a common stock, and
trusts will perform differently based on their
programs and their production mix of oil and natural gas (I detail
all of this in my March issue of
Action to Take -->
But if you're looking for a place to still capture high yields when
interest rates are near zero, this sector may be small, but also
holds plenty of promise.
-- Carla Pasternak
Carla Pasternak does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.
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