In these uncertain times, investors are hungry for high-yielding securities that offer reliable and growing income. With independent exploration and production companies seeking to fund ambitious drilling programs in a number of emerging shale fields, several operators have spun off royalty interests in established plays to raise capital.
U.S.-listed royalty trusts aren’t subject to corporate taxes. The trusts pass through their net income to individual unit holders who pay tax on their share of these earnings. This structure eliminates the double taxation that occurs when the Internal Revenue Service taxes earnings at the corporate level and dividends at the individual level.
Like master limited partnerships (MLPs), trusts incur significant depreciation and depletion charges that provide a tax shield. The IRS considers part of the distribution you receive as a return of capital. You won’t be taxed on that portion of your distributions until you sell your units.
In contrast to MLPs and Canadian royalty trusts, U.S.-listed oil and gas trusts are finite entities that convey the 0.50 right to unit holders to collect royalties from a specific group of wells, fields or geologic formations. The trust can’t add to these properties over time by acquisition or expansion.
As these wells mature, declining oil and gas output will force the trust to reduce the amount it disburses to investors. Most trusts are set up with a predetermined termination date, at which point the assets will be liquidated and the proceeds distributed to investors.
With about 15 publicly traded US energy trusts on the market, investors have limited options. I favor recently launched trusts, as they tend to have a longer life span ahead of them and often grow their payouts rapidly in the early years. Newer trusts also featured hedges and other safeguards that reduce immediate exposure to commodity prices and facilitate reliable distribution growth. Here’s the rundown on one of my favorites.
Chesapeake Granite Wash Trust (CHKR), spun off by oil and gas producer Chesapeake Energy Corp (CHK), holds a royalty interest in existing and planned wells in the Colony Granite Wash play in Washita County, Okla.
Natural gas liquids (NGL), higher-value commodities that tend to track the price of crude oil, account for about 47 percent of output from the Colony Granite Wash and about three-quarters of the net revenue from production.
Chesapeake Energy is the most experienced producer in the Colony Granite Wash, where it has drilled 133 of the 173 existing wells and operates nine of the 15 active rigs. Management has amassed proprietary data on historical decline rates and understands how and where new wells should be drilled.
Holders of the trust’s common units will receive 90 percent of the net proceeds from the sale of oil and gas produced from these wells. The operator intends to finish drilling 118 development wells by June 30, 2015, but has until June 30, 2016, to complete this obligation. Unit holders will receive 50 percent of the net proceeds from these wells.
Chesapeake Granite Wash Trust will terminate on June 30, 2031, at which point it will then sell its royalty interests in the Colony Granite Wash wells and distribute the proceeds to unit holders.
Chesapeake Granite Wash Trust will pay out virtually all of the income it receives to holders in a quarterly distribution. Chesapeake Energy has contributed hedges that cover 50 percent of the trust’s expected oil and NGL production through June 30, 2015; over the next four years, about 37 percent of the trust’s total revenue will be protected from commodity price volatility.
“Solid as Granite” tracks the trust’s targeted quarterly distributions, as well as the incentive and subordinated thresholds. The distribution targets reflect the amounts of oil, NGLs and gas the firm expects the trust to produce and a set of commodity price expectations. The trust’s management based these assumptions on futures prices on the New York Mercantile Exchange (NYMEX) from Oct. 28, 2011. After 2014, Chesapeake Energy assumes a 2.5 percent annualized increase in oil and gas prices but caps these estimates at $120 per barrel for oil and $7 per million British thermal units for gas.
The trust’s targeted distributions are expected to rise steadily until late 2013, flatten for a few years and fall precipitously after 2014. When Chesapeake Energy drills the 118 horizontal development wells required, the trust’s oil, gas and NGL output and revenue will increase. The trust is expected to boost its payout by about 65 percent between now and mid-2013.
When distributable cash flow drops below the subordinated threshold, Chesapeake Energy will reduce the payout it’s entitled to receive on its subordinated units until unit holders receive at least that subordinated distribution rate. This structure makes it unlikely that Chesapeake Granite Wash Trust’s payouts will drop below the minimum threshold in the foreseeable future.
Chesapeake Energy’s subordinated units also receive an incentive distribution in good times. When the trust’s quarterly distribution exceeds the incentive threshold depicted in “Solid as Granite,” Chesapeake Energy will receive a 50 percent bonus on all payments in excess of the incentive distribution level.
Although this structure limits distribution upside in strong commodity markets, that’s a small price to pay for downside protection.
Chesapeake Energy also owns almost 50 percent of the outstanding trust units and significant stakes in all of the trust’s wells, aligning management’s interests with those of shareholders.
Trusts are usually conservative when setting their distribution targets in an effort to under-promise and over-deliver on their yield. Chesapeake Granite Wash Trust should distribute more than its target payout over the next few years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.