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A casual market observer might believe Facebook (NASDAQ:FB) was the biggest loser this past week, down ~20% since its $38 IPO on May 17. However, the loss to an investor speculating in the Facebook IPO pales in comparison to that of an investor chasing yield and natural gas prices in Hugoton Royalty Trust (NYSE:HGT), which is down almost 50% in the past week. Such yield chasing offers additional risks and rewards. Whiting USA Trust (NYSE:WHX) could potentially also decline precipitously in value, and investors in Gale Force Petroleum (OTCQX:GFPMF) may experience valuation uplift from Gale Force converting into a trust.

This article on Seeking Alpha explains in detail why HGT is down so much. The short version is that a lawsuit settlement will likely prevent dividend payments for the next 18 months. Furthermore, additional legal issues could defer resumption of dividend payments for an indefinite period of time.

In case you're wondering what a royalty trust is, Wikipedia has a great definition:

Royalty trusts typically own oil or natural gas wells, the mineral rights of wells, or mineral rights on other types of properties. An outside company must perform the actual operation of the oil or gas field, or mine, and the trust itself, in the United States, may have no employees. Shares of the trust generally trade on the public stock markets, but the trust itself is typically overseen by a trust officer in a bank.

They are a powerful investment tool for people who wish to invest directly in extraction of petroleum or mining of other materials, but who do not have the resources or risk-tolerance to buy their own well or mine. Additionally, since trusts often own numerous individual wells, oil fields, or mines, they represent a convenient way for the average investor to diversify investments across a number of properties. Also, since commodities are considered a hedge against inflation, the popularity of royalty trusts as investments rises as interest rates rise, and their shares often rise as a result.

Royalty trusts had previously been considered "dangerous" securities to short because they generate yield. As a result, short sellers are required to pay that yield (thereby increasing holding cost) while waiting for the security to decline in value. HGT's travails have increased the volatility of royalty trust unit prices. Typically, income-oriented investors prefer less volatile security prices, and short sellers are attracted to more volatile securities. So the recent event may attract more short-selling attention and may encourage owners of other royalty trusts to reduce their positions.

There is another opportunity somewhat similar to HGT, which has not yet fallen off a cliff: Whiting USA Trust. WHX is expiring in two and a half years, at which time no additional payment will be made to unit holders. At the current rate of distribution, roughly $7 will be paid to holders of WHX over the remaining lifetime of the units, vs. the current unit price of just under $17. Also, with the price of oil lower than it was last quarter, it is possible that even less than $7 will be paid in distributions. The possibility of a 50%-plus drop in WHX's price is discussed more eloquently here.

From the valuation of WHX, and observing the valuations of other royalty trusts, an investor may be interested in finding other ways to benefit from the high valuation awarded to royalty trusts. One way I am doing so is by investing in companies that will convert to royalty trusts. The general idea was discussed in Barron's this past week. While the article discusses REITs, the principle is the same -- converting from a corporation to a trust reclassifies the entity. In the current market, this can lead to substantially higher valuations.

I have exposure to this theme through an investment in Gale Force Petroleum. It is a rapidly growing oil company trading at a discount to its proved developed reserve value, with assets primarily in East Texas. It is currently producing approximately 400 barrels of oil equivalent per day, of which over 80% is oil. Management has guided to production of over 800 barrels of oil equivalent per day by the end of the year, and 1,000 by early 2013. Royalty trusts seem to trade for $300,000 per barrel of oil equivalent per day produced: For example, Pacific Oil Trust (NYSE:ROYT) had its IPO recently around that valuation, and Sandridge's Permian Royalty Trust (NYSE:PER) and Mississippian Royalty Trust (NYSE:SDT) seem to trade around there as well. If Gale Force achieves a similar valuation in a royalty trust spinoff next year, it could achieve a valuation of $300 million vs. a current enterprise value of ~$20 million.

Obviously there are a number of steps Gale Force will need to take in order to do such a conversion, but it appears as if its on the path to do so. The potential return seems more than sufficient to compensate for execution risk along the way.

Source: Royalty Trust Wealth Destruction And Opportunity