San Juan Basin Royalty Trust: Long Life for Value, Short Life for Taxes

| About: San Juan (SJT)

We no longer feature the units of San Juan Basin Royalty Trust (NYSE:SJT) as a Buy recommendation because the McDep Ratio exceeds 1.0. We try to concentrate Buy recommendations among lower McDep Ratio stocks, which we expect to return more than higher McDep Ratio stocks. Buying stocks at lower McDep Ratios and scaling back on them at higher McDep Ratios is our model for adding value to oil and gas sector performance. At the same time, we believe in core positions in high-quality stocks like SJT. In that case, our advice translates to trading around a core position. Those investors who don’t wish to trade can be comfortable that the long-term return in SJT remains attractive. The main near-term variable is natural gas price, which appears to be in the early stages of a new upward trend. The main long-term variable is the durability of the San Juan Basin resource, which has thousands of low-cost wells yet to be drilled that are being postponed at today’s low price. Eventually, we expect that in a stronger natural gas market the trust will receive a higher price on less decline or actual growth in production. When those conditions are closer at hand we would have a basis to raise estimated Net Present Value from the current $25 a unit. Meanwhile, investors collect a tax-advantaged distribution estimated at 5.4% for the next twelve months. Financial risk is low because the trust has no debt.

Long Life for Value, Short Life for Taxes

The distribution yield of SJT is almost always attractive. Harder to judge is how long the distribution will last. If we judged by the latest estimates by the trust’s independent engineer, we would say that cumulative future volume is 8.3 years at last year’s rate. For that to be true, volume would have to decline by some 12% a year. Instead we see that actual volume declined at just 4% a year for the past decade. Volume might indeed decline by 12% a year if the operator did no investment in workovers, recompletions and new wells. Instead the reinvestment of 22% of cash flow over the past decade reduced decline to 4% a year. The slower decline more likely signals cumulative future volume of perhaps 25 years, three times the independent engineer’s estimate. Indeed, ConocoPhillips (NYSE:COP), the largest producer in the San Juan Basin and the operator of the trust’s properties, estimates that its resources in the basin are 26 times last year’s production.

The conservative engineer’s estimate is an advantage for income tax purposes. Investors are entitled to reduce distributions by cost depletion to determine taxable income. In other words, a 5% distribution from units of SJT purchased today would generate cost depletion of 12%, which would result in negative taxable income for the first year. Negative taxable income turns positive after units are held a few years because cost depletion also reduces the basis against which the 12% rate would be applied. We have further discussions on tax issues in an appendix.

Natural Gas Price Recovering

SJT distributions in the first three months of 2011 may be the lowest of the year as natural gas price guided by the futures market increases in each subsequent quarter. As of the settlement on March 31, futures prices for the delivery of natural gas in Louisiana over the next six years reached $5.67 a million btu. The quote maintains the new trend above the 40-week average that began with the Japanese nuclear accident. The trend is good for SJT on a long-term basis despite our lifting our buy designation for now.

Appendix on Tax Issues

For simplicity, investors could just as well ignore depletion and treat the trust as any other dividend payer as would automatically be the case if the trust were held in a tax-deferred pension or retirement account. We suggest holding large, or long-term positions in a stock like SJT in a taxable account, where the size of holding makes the tax calculation worthwhile, and to keep smaller or more trading oriented positions in a tax-deferred account where individual securities have no immediate tax consequences.

Tax Consequences and Opportunities in Sales

The tax advantages benefiting distributions from SJT become potential disadvantages upon selling units. There is a normal capital gains tax plus a “recapture tax” on the amount of depletion claimed to reduce tax on regular distributions. Moreover, for many taxpayers the tax rate on the recapture portion might be some 35% compared to the tax rate that might be 15% for the capital gain portion.

The potentially higher tax consequences on selling can become advantages for investors considering charitable gifts. Most donors are aware that giving securities has an advantage over giving cash to a charity because donors do not incur a capital gains tax. In the case of a royalty trust, gifting also saves recapture tax.
Gifts made to a charitable remainder trust may offer further advantages. A portion of the gift is credited to the charitable remainder interest and the other portion to the income interest. In a typical arrangement a donor and spouse may retain a lifetime income interest to be paid at the rate of perhaps 5% a year, while the principal is paid to the charity when the donor or spouse is no longer living. The capital gains and the recapture tax can not only be saved for the charitable remainder interest, but also deferred for the income interest. The deferred amount may eventually be paid at the rate it can be assessed as a tax on the income payments.

Meanwhile a donor can reestablish a position in the same royalty trust after a short waiting period or immediately in another royalty trust and start the depletion clock running again on the new higher, undepleted cost basis.

Our explanation of the tax idea is not complete enough to be a tutorial, nor do we claim any qualification or intent to give tax advice. To the extent gifting saves taxes, there is still a net cost of the gift to the donor and the main beneficiary of any tax saving and deferral is the charity, which is the intent behind the tax rules.

Originally published on April 1, 2011