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SandRidge Mississippian Trust I (NYSE:SDT) is a royalty trust with interests in oil and gas properties in the Mississippian formation in Oklahoma. This type of trust is very simple to understand. As a unit holder, you are entitled to a portion of the revenue stream from the sale of oil and natural gas extracted from wells drilled on this property by SandRidge Energy (NYSE:SD). The only function of the trust is to collect royalty payments and distribute them to unit holders. An investment in units of the trust is subject to certain risks. Among them:

  • The EPA could suspend or forbid hydraulic fracturing.

  • Prices for oil and gas are volatile.

  • SandRidge might not complete its drilling obligations.

As for the first item, I don't know how to counter this risk except to not own any stock participating in this market. As for oil and gas price volatility, a little more than half of the expected revenues upon which the target distributions are based through December 31, 2015 are hedged in order to minimize the impact of this volatility. Now let's look at the third potential risk.

The trust has a 90% net royalty interest in the production from 37 wells which were in production at the time of the trust formation, plus a 50% net royalty interest in the production from 123 wells to be drilled by SandRidge. The additional wells are to be completed by December 31, 2014. The unit holders have a level of assurance that SandRidge is properly motivated to complete their obligation for drilling. The company has retained a 49% interest in the trust through 6,625,000 common units and 7,000,000 subordinated units. Let me briefly explain the subordinated units

The first 5 years of the trust- during which time the additional wells will be developed- is referred to as the "subordination period". In the prospectus for SDT, SandRidge has provided a projection of distributions to be paid to the unit holders through the life of the trust by quarter, the target distribution. During the subordination period, they have also defined a subordination threshold, 20% below the target distribution and an incentive threshold, 20% above the target distribution. During the subordination period, if the cash available for distribution would result in a payment below the subordination threshold, then the distribution to the subordinated units will be reduced or eliminated in order to increase the distribution to the common units up to the subordination threshold. Conversely, if the cash available for distribution exceeds the incentive threshold, then SandRidge would receive 50% of the amount by which the cash available for distribution exceeds the threshold, with all unit holders sharing the other 50%. Here is a chart from the prospectus of the expected production volumes: (Click to enlarge)

SDT Production

And here is a table of the target distributions through the first 6 years of the trust. As you can see, distributions are expected to peak in 2014 once all development wells have been completed.

SubordinationTargetIncentive
ThresholdDistributionThreshold
2011: 1st & 2nd Quarter0.811.011.22
2011: 3rd Quarter0.530.670.80
2011: 4th Quarter0.510.630.76
2012: 1st Quarter0.520.650.78
2012: 2nd Quarter0.560.700.84
2012: 3rd Quarter0.590.740.88
2012: 4th Quarter0.580.730.87
2013: 1st Quarter0.590.740.89
2013: 2nd Quarter0.610.760.92
2013: 3rd Quarter0.610.770.92
2013: 4th Quarter0.610.760.91
2014: 1st Quarter0.620.780.93
2014: 2nd Quarter0.660.820.99
2014: 3rd Quarter0.700.871.04
2014: 4th Quarter0.720.891.07
2015: 1st Quarter0.670.841.01
2015: 2nd Quarter0.620.770.93
2015: 3rd Quarter0.580.720.86
2015: 4th Quarter0.540.680.81
2016: 1st Quarter0.520.650.78
2016: 2nd Quarter0.500.620.75
2016: 3rd Quarter0.480.600.72
2016: 4th Quarter0.460.580.69

Let's take a look at how the trust has performed so far with respect to distributions:

Target

Actual

+/-

2011: 1st & 2nd Quarter

1.01

1.07

5.94%

2011: 3rd Quarter

0.67

0.82

22.39%

2011: 4th Quarter

0.63

0.79

25.40%

Note that the first distribution covered income from production during January 1, 2011 through May 31, 2011, less some start up expenses. The distributions for the 3rd and 4th quarters exceeded the incentive thresholds. Let's see how the stock price has performed as a result:

(Click to enlarge)

SDT since IPO

So, the question is whether SDT is a good investment today. A royalty trust isn't for everyone and it isn't a buy and forget investment. It has a finite life and the distributions will peak and then trail off as the resources are depleted. Generally, you evaluate this type of investment based upon the internal rate of return. In this case, if you buy today and assume that you will receive the target distribution for the remaining life of the trust, the IRR is 1.17%. Not very impressive. However, if we look at the expected yield for 2012 based upon the target distributions, you'll get 8.3%. If it continues to return at the incentive threshold level, then your 2012 yield would be 9.9%. Either one provides you a very respectable near term return. You should be aware that these payments are not qualified dividends. SDT is organized as a publicly traded partnership and unit holders will receive a Schedule K-1.

Disclaimer: Please do your own research prior to making any investment decision. This article is not a recommendation to buy or sell any security and is the opinion of the author.

Source: SandRidge Mississippian Trust I Paying Above Targets