Beware Of White Elephant Royalty Trusts

Includes: AMJ, AMLP, BPT, YMLP
by: Derek Blain

Author's Correction: Apologies on my misinterpretation of the 10-k, as I was using the figure from discounted cashflow analysis instead of total projected payouts, which stand at $2.4 Billion, an increase of $1 billion against my initial appraisal. This would equate to a total payout value per share of $111.93/share.

A word of caution, however - The assumptions within the 2011 annual report are based on projections of an oil price of $96/bbl. Oil production has been on a tear domestically since its 3,961,000 bbl/day trough in September of 2009. Since that time, it has increased to 6,838,000 bbl/day, an increase of 72.6% in just a little over three years, with proven reserves also swinging up to above 2000 levels at 23,267,000,000 bbls of oil.

We see a very similar story in natural gas as well. Proven reserves have swung up dramatically from 164,000 Billion cubic feet in 1998 to an all-time record 304,000 Billion cubic feet of natural gas. Gross withdrawals and production are also at record high levels.

Also of not, that average annual price of $96.00/bbl for oil is beyond a "rosy" prediction. Oil has never had an average annual price over $91.48, which was 2008's figure. With the US actually set to become a net exporter within the next decade, investors can expect domestic sellers to receive prices more along historical norms for production of oil. Also, considering that Alaska has been in a constant tailspin for its own oil production levels (2.1 million bbl/day in 1988, dramatically down to 660,000 bbl/day in 2011). BPD bulls seem to ignore that its own production has fallen off a cliff this year - from 94,335 bbl/day in Q1 2012, to 85,917 bbl/day in Q2 2012, and off a cliff down to 66,592 bbl/day for Q3 2012 - a staggering drop of 29.4% in less than one year. This confirms what investment professionals have been saying - expect a serious cut in the yields on these types of investments. Experts are also expecting supply to outstrip demand next year.

I would also like to add that, since my article was originally published, mistake and all, BPT's stock has continued its freefall, and I still firmly hold to the technical support points that lie lower still on my original charts.. I do not recommend investors attempt to catch a falling knife and find themselves losing multiple quarters' worth of distributions in a matter of a few trading days or a couple of weeks. As a trade, I still recommend the short position in my original publication, which I currently have open (and is handsomely profitable after merely a few trading days), and recommend long investors stay on the sidelines until BPT makes its way down to historical support levels and exhibits internal divergences in price momentum - something we have yet to see even a hint of.

Thank you everyone for reading and offering criticism and compliments, both. I apologize again for my huge error in reading BPT's annual report, and am grateful that Seeking Alpha has such a sharp investor community that it was brought to the attention of staff both quickly and professionally, and I am able to submit a correction for readers.


Royalty trusts are a specialized class of investment assets. They are equity instruments with strict limitations, meaning that the underlying property or mine or well whose production they own cannot change -- royalty trusts cannot add new properties or assets once they have been created. Once the trust is formed, it exists until the underlying resource has been fully exploited, and then closes down.

This can be dangerous territory for investors, who take one glance at the whopping dividend yield that some of these equities offer, and scramble to grab shares so they can compensate for the pitiful yields that arbitrarily low interest rates are generating in their bond portfolios. One example is the popular BP Prudhoe Bay Royalty Trust (NYSE:BPT), which has many similar traits to other income trusts that are guaranteed value traps for investors desperately seeking yield in a 0% interest rate world.

Why would I make a statement like "BP Prudhoe Bay is a guaranteed loss at these prices"? The answer comes down to one single word: depletion. This word shows up in the annual financial reports of every royalty trust, and the reason it shows up is to measure how much of the finite resource that the trust owns actually remains. Because once that finite resource has been fully exploited, there are no distributions left to pay out and, therefore, there is no reason left to own the asset.

BPT, in their latest annual report, estimated a total remaining payout on the Trust's assets at $1.4 billion. At the time of the report's release, the total market cap for the trust was over $2 billion, and currently sits at $1.566 billion. What this means is that investors are paying $1.566 billion for a total estimated distribution of $1.4 billion as of Jan. 1, 2012. If you subtract the distributions from this year already ($54 million, $56.5 million, and $49.4 million, total of $159.9 million), that leaves you, the prospective investor, with an estimated distribution return of $1.241 billion. Investors buying the stock at current prices will receive a maximum return of 79.24% of their invested capital before the trust is shut down. The price of BPT needs to drop by an additional 21% from here in order to get to a breakeven point on distributions -- this still means, however that investors are essentially getting paid nothing for tying up their money for the six or so years left in this resource.

If you are going to invest in a Royalty Trust, I recommend trying to find one that beats annual yield + return of principle on a five- or 10-year CD. Right now, the high end of five-year CDs are at 1.8%, compounded daily. This means that the $7311 required to purchase 100 shares of BPT at its closing price on Dec. 13 would appreciate to a total payout of $7999.49, with interest payments of $688.49, or 9.42% return on capital.

Right now, the total payouts for the $7311 required to invest in 100 shares of BPT would come in at $5,793.23, after which the underlying shares are essentially worthless. This means that breakeven price for return is $57.93/share. In order to match the total return of a guaranteed CD, prices would need to fall an additional $5.46, to $54.57. Adding in the distribution sensitivity based on the underlying price of its commodity, I would leave an additional 10% margin before I would consider this anywhere near a safe place to park your money. Entry point for this to be profitable and risk-rewarding is below $49.50/share, or a 32.29% drop from these levels.

Click to enlarge images.

As this realization comes to existing shareholders, I expect this downtrend to carry on sharply through early next year. traders can target a short sell to previous support levels at $63.25 and $50.00 even, where it double-bottomed in 2009. People looking for a long position can target the $50.00 area as well, but do not forget to keep discounting further quarterly distributions if you are going to sit on the sidelines and wait.

Because of the depreciation to zero of Royalty Trusts, as a prospective investor searching for long-term, cash-generating holdings, it is imperative that you actually review the financial reports, management letters, and other pertinent documents published by the company you are looking to invest in. These numbers are not hidden off in a corner somewhere, but are in plain sight, and yet the drive for yield causes investors to blindly jump into these assets, pushing them up into territory where investors are paying good money for a 100% guaranteed loss of principle.

I tend to avoid Royalty Trusts entirely, unless they are sitting at a steep discount to their projected payouts, because of the depletion element. I prefer MLPs, which are able to keep adding assets to their pipeline and therefore carry on paying distributions after their initial resources are depleted.

That being said, picking MLPs and other income vehicles can be risky business. There are potential pitfalls that can come up unexpectedly and hurt a yield hunter's investments. I will deal with a few of them here:

Risk No. 1 -- Commodity Risk: MLPs are generally price sensitive to the underlying asset that they deal with. An MLP that runs producing natural gas or oil properties will have to slash distributions if the price of natural gas or oil drops (as we saw with the huge plunge in both off of the 2007 commodities bubble peak). Getting a good handle on commodity price cycles can let you know when you are buying an asset that is undervalued relative to likely future distributions (i.e. a cyclical low has been put in in the underlying resource, therefore distributions are likely to rise and future income yields will be greater at your entry price).

Risk No. 2 -- Change in Regulations: Let's face it, the only reason MLPs and other trust-like and limited partnership, yielding investment instruments exist is because the tax code currently says that they can. The entire business structure within its intangible, legal context, only exists as it does because of the tax codes. As such, the stark reality is that this can be changed on the whim of the political class. With the "fiscal cliff" "debate" taking place, one can expect that any avenue whereby the politburo can extract more wealth from private society will be explored -- including Trusts and MLPs. And, as we retail investors have already witnessed, governments who need or want money can change their mind about who needs to pay and how much they pay, very quickly.

Risk No. 3 -- Dilution of Shares: Because MLPs pay out at least 90% of their profits in distributions, there is no cash left over to add new cash-flow-generating business assets. Some MLPs have credit lines they can tap to add assets, and roll the interest and debt service into existing operational expenses, however share dilution is very common among MLPs. If they want to buy a new property and drill new wells, or build a new pipeline or expand it, they have to raise capital. Credit drawdowns mean that more money goes to interest and less to distributions for a while, and share dilution means units usually take a hit until the new revenue shows up.

Risk No. 4 -- Tax Liabilities on Distributions: Sometimes, MLPs opt to maintain distributions at current levels even when profits come in lower (i.e., they might only generate a profit of $0.26/quarter but pay out $0.32). This is called a Return of Principle, where part of your original investment is actually returned to you, meaning that your overall yield actually drops off over time, even drastically if this becomes a regular practice. This also forces you to adjust your cost-basis on the shares and can change how much tax you owe in capital gains -- be sure to read through the financial statements issued by your MLP to determine what sort of tax liability you might have.

If you are a retail investor who doesn't have the necessary available time to pore through financial reports of prospective investments, but are still looking for a high yield return in an MLP structure, I recommend investing in one of the many MLP ETFs that are on the market today. Buying an MLP ETF allows you mitigate the risks that each individual MLP can be exposed to while still generating a sizable yield.

A few options are as follows:


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Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in BPT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.