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I recently wrote an article about BP Prudhoe Bay Royalty Trust (BPT) in which I stated that the company faced substantial headwinds due to an artificial and potentially rapidly increasing adjusted chargeable cost calculation. Even though the Royalty Trust might produce an "ok" return under a scenario of steadily increasing oil prices, I concluded that there were other oil company investments that would potentially perform much better under such circumstances. One excellent alternative is Petroleum and Resources Corporation (PEO), a closed end fund which invests mainly, although not exclusively, in oil company stocks

PEO has been in existence since 1929 and has an excellent track record. It was created at a time when the only way for individual investors to own stocks was through a closed end fund; they were not permitted to buy individual stocks. PEO owns a diversified portfolio of major companies in the sector. Its top 10 holdings are as follows:

Ten Largest Equity Portfolio Holdings (12/31/12)

Market Value

% of Net Assets

Exxon Mobil Corp.

$124,063,367

16.9

Chevron Corp.

93,000,400

12.7

Schlumberger Ltd.

43,306,250

5.9

Occidental Petroleum Corp.

27,579,600

3.8

Anadarko Petroleum Corp.

22,293,000

3.1

Noble Energy, Inc.

19,330,600

2.6

EOG Resources, Inc.

18,722,450

2.6

Dow Chemical Co.

17,776,000

2.4

National Oilwell Varco, Inc.

17,087,500

2.3

CF Industries Holdings, Inc.

17,079,458

2.3

Total

$400,238,625

54.6%

Among the attractive features of the fund are the following:

A Diversified Portfolio of Energy Related Stocks

For someone who is bullish on oil, PEO's diversified asset portfolio of financially strong companies in the sector provide an opportunity to share in the upside of the oil market, without being exposed to unexpected or poorly understood events affecting individual entities. Although some of the industry sub-segments it invests in do not benefit directly from an increasing oil price (refiners, for example, profit mainly from the spread between the cost of crude and the sale price of refined products), a robust oil market will generally benefit the companies PEO has invested in.

Discount to Underlying Asset Value

PEO currently is trading at a 12.5% discount to net asset value. Its price as of the close on January 29, 2013 was $26.38 vs. a net asset value [NAV] of $30.18. Although closed end funds are always quoted as a percentage of net asset value, (usually at a discount, sometimes at a premium), conceptually I prefer to look at them the other way around. Viewed from this perspective, PEO's NAV is 114.4 % of its market price, so you are getting 14.4% for free compared to buying the underlying stocks directly (or, "buy 7 shares, get one free!"). In contrast, there is heated debate as to whether BPT is trading at a premium or a discount to its underlying asset value, depending upon what assumptions are used.

Consistent Income Generator

PEO has a history of making substantial distributions to shareholders, averaging 6.9% per year for the past 5 years. Last fall, it formalized its distribution policy to guarantee a minimum annual distribution of 6%. However, investors should expect fluctuations in the amount because in some years the company has had substantial realized gains and therefore made much greater distributions, such as the 11.6% distribution made in 2007. Also, if the underlying value of the stocks decrease in a bad year due to factors affecting either the oil industry or the market in general, the 6% minimum would be calculated on a smaller number.

Investors should be aware that typically the bulk of the distribution is made at year end, when net investment income, realized capital gains, and if necessary, a return of capital, is distributed. Smaller income dividends are distributed during the year.

Likelihood of Growing Income Stream and Value Increase

Because the underlying earnings of its investments are greater than the distribution, as measured by their "earnings yield," (the reciprocal of p/e), and will most likely remain so, PEO's value should continue to grow, and the size of future distributions along with it. BPT, on the other hand, will undoubtedly see a decrease in distributions and an ultimate value of zero; the only debate is how long it will take for this to happen, and how much cash it will generate in the meantime.

PEO's Distributions Generally Taxed at a Lower Rate

For investors holding these instruments in taxable accounts, distributions from PEO are generally taxed at an advantageous rate. Almost all distributions are typically either dividends or long term capital gains taxed at the lower rates for these categories of income, while only a small portion is short term capital gains taxed at ordinary income rates. In 2012, the entire distribution of $1.60 was taxed at the lower rate, while in 2011, only $.02 of the $1.97 distribution was subject to the higher ordinary income rate.

On the other hand, royalty income from BPT is taxed at ordinary income rates, after deducting the permitted depletion allowance. Since the depletion allowance represents a return of a part of your initial investment (a return of capital), you shouldn't be taxed on this amount in any case.

There is one minor "quirk" I should mention, however, with respect to unrealized appreciation that may appear on the balance sheets of closed end funds, including PEO. As of September 30, PEO had about $12/sh. of unrealized gain. This means that if the fund had been liquidated at that time, investors would have received the net asset value of $30. However, investors, subject to tax would have also had a tax liability to pay on the $12 unrealized appreciation, which assuming a 15% rate, would have been $1.80.

Of course, the fund was trading at $26.24, $3.76 below net asset value, so this would simply absorb part of the differential. Under normal circumstances, for a fund which expects to remain in business indefinitely, such as PEO, unrealized appreciation would generally be expected to be at least somewhat stable, if not growing, so this should be a non-issue for investments in taxable accounts, although it is one factor that some analysts believe causes closed end funds to typically trade at a discount to NAV. This tax issue also provides a disincentive for activist investors to force closed end funds to be liquidated, realizing the NAV, unless the discount becomes large enough to overwhelm the tax consequences.

Of course, there is also a tax basis risk of a somewhat different nature with BPT. Since depletion taken on your tax return reduces the tax basis of your investment, it is still possible to sell a unit of BPT at a price substantially less than your purchase price and have a taxable gain on the sale.

Accounting is simpler for PEO

Although I may have scared some investors with my discussion of obscure tax issues regarding PEO, all necessary figures are calculated by the company and reported on your 1099 at year end. The figures from the 1099 simply need to be plugged into TurboTax or handed over to your accountant. You may just want to keep in mind that, under most circumstances, but not necessarily all, you are paying a very low tax rate on your distribution.

On the other hand, each individual investor in BPT (or their accountant) needs to calculate their own depletion figure using the methodology and rates contained in the lengthy tax booklet distributed annually by BPT, which contains multiple worksheets to complete. BPT has no way of calculating this directly since it is dependent upon your purchase price and how much depletion you have taken in prior years.

Management Expense

PEO's expenses are typically in the 50-60 bp range, which is at the low end of what one typically sees in closed end as well as mutual funds, where it is not unusual to incur fees of 1% or more. BPT does not explicitly have a management fee, but I would argue that the difference between what the Trust pays as the Adjusted Chargeable Cost and BP Alaska's actual cost of getting oil out of the ground (which is not disclosed in BPT's financial statements) effectively constitutes a management fee, and it is most likely a substantial number.

Information is More Readily Available for PEO

PEO's website (here) is extremely informative and easy to read. They publish understandable quarterly and annual reports, as well as readable and informative background information on the fund. They provide updated price and NAV information on a daily basis. BPT, on the other hand, being a financial instrument represented by a Trustee, simply publishes the standard required financial filings, (10-Q's, 10-K's etc.) and brief press releases announcing quarterly distributions.

Conclusion

In consideration of all these factors, I believe that Petroleum and Resources Corporation will provide a more attractive return than BP Prudhoe Bay Royalty Trust over the long term under almost any scenario. Just as importantly, price performance and cash distributions will likely be more consistent and understandable. An investor in Petroleum and Resources Corp. should be able to sleep well at night without waking up the next morning to find that their investment has gone up or down 10% or more in a day for no readily apparent reason.

Source: Petroleum And Resources Corp: An Attractive Alternative To BP Prudhoe Bay

Additional disclosure: I am a long term investor in PEO but I have a short position in BPT.