Owning Oil in Royalty Trusts

The price of oil is again dramatically down, with lots of volatility. On January 13 WTI Crude dipped below $37 only to bounce back above $39 the next day. You can make — or lose — a great deal of money fast by trading the relevant Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs). See UCO, SCO, DXO and DTO. If this is your cup of tea (I mean java), you like lots of excitement and are a market timing whiz, take this route. Your brokerage firm will love it.

However, for those of us who like to sleep at night, there are alternatives. Cash or the US dollar is a good safe place when oil prices seem high. Or you can pick up oil royalty trusts, when prices are down. There are both Canadian and US trusts available. The trusts are obligated to pay out most of their earnings in dividends, 7-13% is typical. The high dividends keep them from jumping up and down as much as the ETFs and oil stocks

Dividends track oil prices, so today's low oil prices may be a good time to purchase the trusts. Keep in mind that trust income often comes from fields which are in decline, meaning every year they may produce less oil. That is not a problem if unit price rises. Most depletion schedules go out some 10-20 years. Since all the action now is short term, I don't look at depletion as a major concern. Also, newer technology, such as horizontal drilling, coaxes more and more oil and gas from existing wells than ever before, so potential reserves may rise.

As far as I know, world governments haven't yet figured out how to print barrels of oil. Oil royalty trust reserves are buried treasure which you don't need a map for. Again, while it is true that lower oil prices will bring lower dividends, you have a proven asset. These assets are valued in paper units — dollars — which may be printed in large quantities in the near future. We will have more and more dollars chasing less and less oil. You will want to hold the oil, not the dollars.

Royalty trusts have special tax considerations and may do best in deferred tax retirement accounts, so consulting your CPA is a good idea. Here are some oil trusts to get you started: BP Prudhoe Bay Royalty Trust (BPT), Permian Basin Royalty Trust (PBT), San Juan Basin Royalty Trust (SJT) and Sabine Royalty Trust (SBR).

Disclosure: Author holds long positions in SCO and BPT

Comments

[thisonelife:]

I also have a little BPT I was wondering why the price decrease was modest compared with the drop in oil, I expected it to drop into the high 60s. I'm long so I'm not complaining, but you'll have to wait 3 months for the next dividend b/c they just paid it a few days ago.

Jan 15 05:19 AM

[kommando:]

So.....based on your disclosure you are ultra short crude (long SCO is short crude) but you also implied you like to sleep at night, so you are also long crude by owning BPT, and you explicitly suggest that individuals should not be trading crude price changes by owning the likes of SCO and the others you mention in your article.

Please clarify - are you hedging your "long crude" position in BPT against lower crude prices with your trade in SCO, or is shorting crude with the SCO position your primary trade and your position in BPT is a dividend play?

Jan 15 08:02 AM

[Steve in TN:]

One question I have is the statement that owning an oil royalty trust is best kept in a retirement account. What are the disadvantages (tax and otherwise) for owning one in your taxable account? One disadvantage I know of is very late tax reporting. So, after you complete your tax work in April you then get a "revision" that makes you re-prepare your tax work for the IRS. If anyone knows of more reasons not to hold these investments in a personal account please comment on it.

Jan 15 11:10 AM

[Bruce Vande...:]

I knew someone would point this out. I had SCO for a few weeks, sold late yesterday. I was spending way to much time watching it (not sleeping well). Now, I will now sleep better that it is cashed out.

Well, I did not say don't trade SCO., just that there are less volatile ways of shorting crude. It could be a good hedge against long oil positiions though.

Bruce


On Jan 15 08:02 AM kommando wrote:

> So.....based on your disclosure you are ultra short crude (long SCO
> is short crude) but you also implied you like to sleep at night,
> so you are also long crude by owning BPT, and you explicitly suggest
> that individuals should not be trading crude price changes by owning
> the likes of SCO and the others you mention in your article.
>
> Please clarify - are you hedging your "long crude" position in BPT
> against lower crude prices with your trade in SCO, or is shorting
> crude with the SCO position your primary trade and your position
> in BPT is a dividend play?

Jan 15 04:48 PM

[Mustang77:]

SteveTN asks why it's best to hold oil trusts in a tax deferred account. The biggest reason, in my opinion, is that the "dividends" they pay out are fully taxable. They are not qualified dividends. Thus, they don't qualify for the qualified dividend tax rate (currently 15%) and will be taxed at your current marginal tax rate. The current highest rate is 35%.

Jan 17 05:11 PM

[mc2406:]

One great reason to own these trusts in your taxable account is that you can claim percentage depletion to offset the income currently. You have to give it back by reducing your basis upon selling the trust unit (as ordinary income), but if you plan on beiong in a lower tax bracket in later years, it's a good deal.

Jan 19 05:07 PM

[Steve DM:]

Bruce,

What about these private placements that are available from companies throughout the United States and Canada that allow you to buy directly into private placements that own parts of exisiting wells as well as drill equipment that does this type of drilling. They seem to pay out 30-70% a year in dividends and seem to provide solid returns. I know the risk is that the wells dry out before we get our principal back but what are the risks of such a occurence when they average well can pay out for 10-5 years.

I would appreciate your input.

Thanks

Steve

Feb 12 08:38 PM

[M3:]

Hi, I was wondering. Can people outside the U.S. (say in Japan) buy these royalty trusts and what are the tax implication if 'yes'?

Feb 23 02:03 AM

[M3:]

Oh and one more question. If they're so hot why have their prices come down more during 2009 than the price of USO, UCO, USL, or even WTI spot prices? (BPT -24%, PBT -43%, SJT -52%, SBR -24% vs. USO -32%, UCO -58%, USL -19%, WTI Spot -16%)

Thx.

Feb 23 05:22 AM

[Jose39:]

I think holding the royalty trusts should be in your taxable account; otherwise the deduction for depletion, which is significant, is wasted


On Jan 15 11:10 AM SteveTN wrote:

> One question I have is the statement that owning an oil royalty trust
> is best kept in a retirement account. What are the disadvantages
> (tax and otherwise) for owning one in your taxable account? One disadvantage
> I know of is very late tax reporting. So, after you complete your
> tax work in April you then get a "revision" that makes you re-prepare
> your tax work for the IRS. If anyone knows of more reasons not to
> hold these investments in a personal account please comment on it.

Mar 02 02:30 PM