A Closer Look At The New Cushing Royalty & Income Fund

by: Zvi Bar

Last week, I had the opportunity to speak with Dan Spears and Judd Cryer of Cushing MLP Asset Management, a subsidiary of Swank Capital that developed the Cushing MLP indices and funds. The company recently added a new closed end fund, the Cushing Royalty & Income Fund (NYSE:SRF), which intends to focus its investments in the securities of energy-related U.S. royalty trusts, exploration and production master limited partnerships and Canadian exploration and production companies, many of which were formerly CanRoys.

Many investors believe that these royalty and E&P companies present a compelling supplement to an income-oriented portfolio, while simultaneously providing a commodity-based investment allocation. This is a somewhat stark alternative to pipeline MLPs, which typically earn stable income from the transport of oil, gasoline and/or natural gas, and attempt to offer little to no real exposure to the price of the transported commodity.

Generally, non-competitive pipelines have an industry standard annual price increase of PPI + 2.65 percent. Conversely, royalty and E&P companies have no guaranteed future prices beyond those that they hedged into the future. As such, their future distributions will fluctuate along with the price of oil & gas, as well as their ability to effectively extract the commodities from the ground.

I inquired as to what investments this brand new fund is making, as due to the fund's young age there is a lack of regulatory filings and/or other information as to its holdings. The managers stated that they are still acquiring investments, but that some of the investments they have already made include, among others, in alphabetical order, EV Energy Partners (NASDAQ:EVEP), Linn Energy (LINE), Permian Basin Royalty Trust (NYSE:PBT) and Sandridge Permian Trust (NYSE:PER).

Royalty trusts may very well become the next oil & gas investment of interest, much like MLPs have become a fashionable portfolio addition over the last few years. A royalty trust is a type of corporation that is usually involved in oil and gas production or some type of natural resource mining. Royalty trust profits are not taxed at the corporate level so long as the bulk of the trust's profits (at least 90%) are distributed to shareholders as dividends. Those distributions are then taxed as personal income, and not at the lower corporate dividend rate. T. Boone Pickens created the first royalty trust in 1979.

This system is similar to real estate investment trusts (REITs), in that royalty trusts avoid double taxation of corporate income if it is distributed to shareholders. Generally, royalty trusts have high yields that remain well above the average corporate dividend yield, even after paying income taxes. These companies usually own only the claims or the land where a resource can be harvested.

Royalty trust companies often own multiple individual claims, but in the U.S., trusts are not allowed to acquire additional properties once they are formed. This is very different than the MLP model, where new assets are often dropped into an already existing MLP. Also, another company usually performs the actual extraction, under license from the royalty trust.

Presently, royalty trusts offer above average income (averaging about 8.5%), as do E&P MLPs (averaging about 7.5%), but both offer a capricious yield due to their commodity price exposure. If interest rates were to rise and oil demand and/or price continues to grow, or at least remain stable, future dividend increases appear possible for these companies. Of course, these dividends will sustain decreases if energy commodity prices were to decline.

According to Mr. Spears and Mr. Cryer, Cushing believes that global demand for oil should continue to grow, In particular, they noted that the present use of oil by the average American now stands at about 23 barrel per person, per year, while Chines oil consumption is now at 3 barrels and Indian consumption is at 1 barrel per person, per year. Essentially, despite any attempts that may occur on the domestic front to curb U.S. consumption, these emerging markets are likely to increase their energy consumption at a greater rate than those theoretical domestic decreases.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.