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I never liked Energy Royalty Trusts. I am a Texan, and I have seen the best oil properties reserved for the insiders, and all the marginal ones lumped into royalty trusts for public consumption. However, the older I get the more I recognize that I can learn new things, and maybe it is time to revisit the benefits of these high-yielding investments in a low-interest-rate environment.

The recent decline in the price of oil has made some of these trusts 30% cheaper, with 10%+ yields, possibly creating opportunities for contrarian investors. This article compares the pros and cons of royalty trusts, and we will look at some publicly traded investments with big income distributions.

Royalty Trusts (RTs) generally invest in energy sector assets. Royalty trusts generate income from the production and sale of natural resources such as coal, oil, and natural gas. Unlike the relatively steady pipeline-operation cash flows at some Master Limited Partnerships, RT cash flows are subject to swings in commodity prices and production levels, which can cause them to be very inconsistent. The trusts have no physical operations of their own and have little management and few employees. Rather, they are merely financing vehicles, and some are public and trade like stocks. Other companies mine the resources and pay royalties on those resources to the RT.

I decided that maybe my prejudice against royalty trusts is preventing me from seeing their investment value. My mother-in-law was a savvy investor in her way, and a three-time widow. Her first husband willed her real estate, her second husband left her petroleum royalty trusts, and her third bequeathed to her a stock portfolio. Her trusts are not publicly traded, and they were purchased in the 1970s and 1980s, when you just about had to be royalty to access the best trusts. Most of her trust assets had just about played out, but then came fracking. Now the old Texas fields are being rejuvenated, and her trust checks are growing again. The producers are offering to buy her royalty rights, and this has caused me to reconsider this investment vehicle. I figure if the insiders think those royalties are a good investment, maybe the RTs are worth revisiting.

Benefits of Royalty Trusts. Lately I have been bombarded by advisors and brokers pushing new Royalty Trusts. They always mention the great distribution yield, usually more than 10%. Additionally, this distribution is often tax advantaged with deductions as the trust assets are deleted to sell and pay the distributions.

Since Royalty Trusts distribute the earnings, they do not pay corporate income taxes before distributions, allowing about 25-40% larger payouts than common stocks with the same income per share.

One of the attractions of RTs is that they represent a pure play on the underlying commodity they produce, without the complications of commodity futures contracts. The trust reacts to positive movement in the price of oil, for instance, because its distributions are directly related to the commodity price movements.

Drawbacks to Royalty Trusts. Like most investments, the characteristics that make them desirable also give cause for caution. It is important to understand that the trusts own a finite portfolio of assets and those assets are depleted to produce income. As the resources deplete, royalties and distributions will fall and will, eventually, go to zero. In financial terms, there is no terminal value.

Because the distribution amount is usually directly related to the current price of the commodity, the distributions can be very volatile, The yield may be 14% one year and 4% the next. The market value of the trust unit is likely to tank when the yield drops. For instance, if the price of oil continues its freefall, it is likely most oil trusts will announce that their next distributions will be lower than in the last quarters.

It is notable that the owner of a RT may be required to pay income taxes to the state where the trust asset is located. Some trusts derive income from ten or more different states, greatly complicating the filings. That brings up the issue of complication of federal tax accounting also. Special forms and regulations exist for trusts that are different from common dividends.

Current Market for Trusts. If one is willing to cope with the tax and accounting complications, the yield on some Royalty Trusts can be appropriate for income-dependent investors. In most cases, we prefer MLPs, REITs or stocks with high-dividends as the Royalty Trusts dealing with energy commodities are, by nature, becoming less valuable with each year, unless the commodity price increases. However, special situations and special trust agreements and assets may make these worthwhile.

The first special situation to consider is whether the commodity price of oil is near a bottom. This week, the price of a barrel of oil cut through the $80 barrier like a sharp knife through a tender rib-eye. The yields of some of trusts are getting mighty juicy, even if they are likely to be reduced from current levels in the short term. There are fundamental arguments to believe that oil will not stay cheap for the longer term, as the world continues to use more oil than we discover annually, even with the global economic recession. Emerging markets are increasing demand, albeit at a slower pace than years past. Although, we cannot verify this, oil bulls lately have indicated that some OPEC countries require $80 oil to finance their government budgets. Regardless of this, the odds are that there will be some price rebound as a result of ominous political events in important oil producing countries.

Another consideration is the terms and life of the trust. We are inclined to look at trusts that have a long life remaining, and are in the earlier stages of their production, which lets investors harvest the largest present value yields. Many trusts boast they have a lot of resources, but if they cannot cash those in for years, the return on investment may be more lucrative elsewhere.

Another special situation may be the specific terms, management and location of the trust. Odd as it may seem, we see the recent bad press for Chesapeake Energy (CHK) is a positive for Chesapeake Granite Wash Trust (CHKR), as we believe that the trust, which is somewhat insulated from the parent company and its ex-CEO's foibles, has been punished more than the fundamentals justify. It is selling at $19.61, which is 35% off its high last month, although the trust assets remain the same.

A recent article by Saibus Research focuses on the support that the CHKR distribution enjoys as a result of the commitment of the parent company to forego full distributions on its "subordinated" shares if distributions otherwise would drop below $.61 per unit quarterly. The company retained 57% of the shares. That gives us some confidence that a conservative analysis can use that amount ($2.44 annually) in a model that currently yields 12% per year. By the "rule of 72," a unit holder can recoup his or her investment in about 6 years, although the trust has a 20 year life and was established last year.

Chesapeake Granite Wash Trust owns royalty interests in oil, natural gas liquids, and natural gas properties located in the Colony Granite Wash play in Washita County in the Anadarko Basin of western Oklahoma. Some wells are producing and some acreage is undeveloped. The accounting complication is limited due to the focus on one target formation, which also limits diversification...a two-edged sword. The continuing improvements in drilling technology may enable the trust to maximize asset production beyond current estimates. This could be a catalyst for unit price appreciation, as will an increase in the price of oil and/or gas.

At the top of this article, I mentioned my skepticism of organizers of oil royalty trusts, and the recent expose of Chesapeake management gives plenty of reason to doubt that these assets are blue-ribbon producing acreage. However, we think that if that is the case, it will take a few years for that to play out, so it is important for unit holders to watch for warning signs in reports. In the last conference call, an inquirer focused on the fact that fewer wells were drilled than anticipated in the quarter. There can be many reasons for that, and one quarter is not a trend, but it is worth monitoring with this trust.

When we screened for investments with at least a 10% dividend and analysts average rating of "buy" or better, only one RT came up, SandRidge Permian Trust (PER). We think that the good analyst rating is a result of the fact that over 80% of the revenue is from oil production, most of which is hedged at $101 per barrel until 2014. Also, there was a 4% increase in reserves in the target area.

SandRidge Permian Trust was spun off by SandRidge Energy (SD), and focuses on acquiring and holding royalty interests in oil and natural gas properties located in the Permian Basin in Andrews County, Texas. Like CHKR, PER is focused on a single area, for better accounting and less diversification. However, it is not like the Permian basin is unknown territory. Also like CHKR, this is a new trust and with many development wells to drill, and higher distributions may be in the nearer future as these wells come on line.

It is no secret that the SandRidge CEO and the Chesapeake ex-CEO are buddies from the same school of debt-leveraged operations, and if you mistrust CHK, you probably should be cautious of SD. PER currently sells for $18.57 per unit, yielding 12% annually.

Conclusion. I still do not like Energy Royalty Trusts. I question the motivations for an exploration company to sell off assets through a trust arrangement: to get rid of mediocre properties at a premium or to get funding to propel development. This is especially relevant for Chesapeake and SandRidge, who notoriously have too much natural gas, but are including predominantly oil properties in the trusts. This leads me to believe that these companies are pressing their credit limits and recognize that they need to urgently increase their liquid production. This would indicate that the inception of these trusts was a necessary attempt to do just that, and an honest motive from an investor perspective.

These trusts came out of the chute last year and shot almost straight up. Of course, the rise in the price of oil was partly responsible for this, but we think that also the big energy investors that got in on the IPOs, the "smart money" so to speak, recognized the same motive that we did and saw the trusts as a chance at a bargain. These are back near the offering price, certainly due to the drop in oil prices, but also because of sensationalist press coverage of management. If that is the case, the true value of the trust units may be closer to their recent highs than the current prices.

We are not too concerned about the tax complications of trusts, as most premium tax software, like TurboTax, can be had for about $100 and does most of the hard work. We also do not concern ourselves so much about the depletion problem with the newer entrants in this market.

Of the two, we like Chesapeake Granite Wash Trust best, because of the support for the distribution and the fact that it may be more oversold due to the scandalous reporting on the ex-CEO.

As an alternative for readers that are wary of Royalty Trusts, there are a few MLPs in the production business. Most of the popular MLPs are pipeline companies, but Legacy Reserves LP (LGCY), an independent oil and natural gas limited partnership, engages in the acquisition and development of oil and natural gas properties primarily located in the Permian Basin, Mid-Continent, and Rocky Mountain regions of the United States. LGCY pays an 8.6% dividend, and is growing revenue by 9% annually. It also has diversification to expand reserves, and there is no planned end to its life.

The timing of these investments depends greatly on your investment time frame and where you think the price of oil is going. The $80 - $82 range was an important technical barrier and it fell without much resistance. There are reasons for this: slowing economies, strong dollar, oversupply of resources, etc. This looks like a falling knife, but with a 8% to 12% income stream, a bet that something will spark an oil rally could be justified. For these possibly oversold energy trusts, a short-term profit may be available from a pop, and, if not, the income while waiting is not bad. For long-term investors, we would probably go the MLP route.

Source: A Fresh Look At Energy Royalty Trusts In The Bargain Bin