By Paul Tracy
Right now, you can buy one of my favorite royalty trusts at an incredible price. In fact, I think the opportunity is so good, I've decided to include this security as one of my Top 10 Stocks for July 2012.
In a nutshell, royalty trusts exist for one reason: to take in millions of dollars in royalties and pass that money to investors in the form of distributions. So far, this strategy has been extremely successful. In the past decade, I've seen royalty trusts return as much as 687%, 1,558%, and even 2,730%.
Those weren't some "one off" opportunities that you had to be lucky to find, either. In just six months, the royalty trust I'm about to tell you about returned 80% after I added it to my Top 10 Stocks portfolio last October.
I think a similar opportunity is setting up once again. The trust I'm referring to is SandRidge Mississippian Trust (SDT), one of 27 active oil and gas royalty trusts trading on U.S. exchanges. As a royalty trust, SandRidge Mississippian Trust owns a stake in dozens of wells run by its parent company, SandRidge Energy (SD).
SandRidge Energy takes care of the drilling, production, marketing, and selling of the oil and gas produced (production is split roughly 40/60 between oil and gas). The royalty trust -- SDT -- is passive in the relationship. It doesn't have to do a thing. In return for the initial investment when it went public, its investors get a cut of all the oil and natural gas sold from the wells.
For the Mississippian Trust, SandRidge Energy packaged a 90% interest in 36 of its oil and natural gas wells in Oklahoma. In other words, for every dollar in oil or gas pumped by these more than three dozen wells, owners of the royalty trust are entitled to 90 cents in royalties.
But that's just the start. That's because in addition to the 36 wells it owned at its inception, the trust also gets a bonus. Between its inception in December 2010 and December 2015, parent company SandRidge must drill an additional 123 wells, of which SDT will own a 50% stake. (Already, the trust has drilled 66 of the 123 wells.)
In other words, over the next several years each unit of this trust will have a stake in an increasing number of wells. And there is a powerful incentive in place for the parent company to get those wells drilled, and increase distributions, sooner rather than later.
As is common practice, SandRidge Energy retained ownership of over 10 million of the 28 million outstanding units of SDT. But most of those (7 million units) are subordinated shares. Unlike the shares we're investing in, those subordinated shares don't receive dividends unless regular common unitholders get a predetermined minimum payment each quarter. If the distribution falls below that threshold, the payments to the subordinated shares will be reduced to make up the difference to the regular units.
This means these shares have a built-in buffer to ensure we see strong distributions going forward. And to also help keep distributions high, the trust hedges its production. For instance, about 60% of SDT's projected oil production this year is hedged at an average price of $104 per barrel. While the trust is fairly new, SDT has paid an average quarterly distribution of $0.80 per unit, giving a yield of more than 12% at today's price.
Keep in mind that because it is tied to oil and natural gas prices, you can expect the trust to move alongside energy prices. Now, you'd expect that opportunities to pick up royalty trusts at good prices would be next to impossible. After all, who doesn't want a stake in an oil field -- especially when that stake throws off a yield of 12% or more? But there are opportunities that appear time to time. Due to the recent market pullback, and the fall in oil prices, shares of SDT have sold off recently.
Also weighing on the trust is a sale SandRidge made to Morgan Stanley (MS) last week. All told, SandRidge sold close to one million shares of SDT to the investment bank in order to raise additional capital. Since SDT is thinly traded, the stock price took a hit as a result.
But nothing has materially changed with the trust itself. So to me, this is not a reason to panic. It's an opportunity. The last time SDT sold off like this was during the market downturn in the fall of 2011. From the middle of June to the beginning of October, the stock fell from $29 a share to $19 as panicked investors dumped their holdings. At the time I saw an opportunity and added shares of SDT to my Top 10 Stocks portfolio. Within months, my subscribers and I were up over 80%.
Today, the shares have fallen from the upper $30s to the current price of $24.60, boosting the yield to 12.9%. If history is any indicator, SDT could have tremendous upside from here.
Risks to Consider
But it's the opportunities that appear during a sell-off like this that I believe can make you the most money. With SDT trading close to its 2011 lows, paying a rare double-digit yield, and supported by 7 million subordinated shares, I think this stock looks like one of the best opportunities to profit in the coming months.
Disclosure: Paul Tracy does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of SDT in one or more if its "real money" portfolios.