Can We Trust These High Yields?
Everyone loves collecting large cash payouts, especially with short-term interest rates near zero.
Well, royalty trusts are one corner of the market that offers what can still be considered high yields.
These energy trusts own oil- and natural gas-producing properties (or mineral rights) along with the associated wells. Investors can own a portion of the trust, which entitles them to a share of the cash flows. Trusts provide investors with 7% to 15% yields with this simple investment idea.
But, as we’ve shown in the past with mortgage real estate investment trusts, high yields can come with unacceptable risks.
So let’s take a look and see if these trusts are suitable for our portfolios…
Oil royalty trusts have no physical operations, management, or employees; nor do they own the equipment that extracts the oil. This allows for high payouts to trust unitholders.
The trust units trade like stocks, and the payouts are similar to dividends.
Royalty trusts enjoy two special tax benefits – they aren’t taxed at the corporate level, and investors can reduce their taxable income by utilizing the oil depletion allowance.
Here are the major risk factors:
- Oil trusts are depleting assets, which means they have a finite life. Once the oil or gas from a trust’s field is exhausted, the trust ceases to exist. Obviously, the share price drops to zero once this occurs. In some cases, new wells can be brought online to replenish lost output.
- Fluctuations in commodity prices will affect trust income and therefore share prices. Many trusts hedge their exposure to oil and gas prices to smooth out their royalty payments.
- Some trusts have “automatic cost acceleration” provisions, which means the payouts will decline over time unless the price of oil rises sufficiently.
Because of these risk factors, we must be selective as to which trusts we own.
We want to ensure a remaining productive life of 10 years minimum.
The trust filings, such as the 10-K, can provide estimated levels of proven oil and natural gas reserves, as well as other trust specifics.
Here are three energy royalty trusts that meet this minimum remaining life requirement and that I consider to be attractive right now.
- BP Prudhoe Bay Royalty Trust (BPT) has 64.7 million barrels of proven reserves located on the North Slope of Alaska, which is the largest producing oil field in North America. As a result of Alaskan tax reform, plans have been revealed to sell off mature fields and open new wells, which should put to rest fears that BPT’s distributions will only last another 10 years.
- Sabine Royalty Trust (SBR) holds royalty and mineral interests on 6.3 million barrels of oil and 37 billion cubic feet of natural gas in Florida, Louisiana, Mississippi, New Mexico, Oklahoma and Texas. The trust was created in 1993 with an estimated productive life of 10 years. Technological advancements and the conversion of unproven to proven reserves have extended its life, so the trust should continue to distribute far into the future.
- MV Oil Trust (MVO) owns approximately 1,000 active wells in Kansas and Colorado. MVO wells have stable production profiles and payouts are expected to continue at least until 2026.
Low interest rates and stubbornly high energy prices make oil royalty trusts all the more attractive right now.
However, as I’ve discussed, these trusts ultimately have zero terminal value, so they’re not suitable as long-term investments.
But if we hold trusts with significant remaining lives, we minimize the risk factors associated with well depletion.
Furthermore, by diversifying our trust holdings, we limit the effects of trust-specific risks.
Bottom line: Energy royalty trusts like BPT, SBR and MVO can significantly augment our investment income. We just need to make sure that we don’t own any that are within 10 years of their expected terminal date.
Safe (and high-yield) investing,
Richard Robinson, Ph.D.