Why Haven't Whiting Trust USA I And Great Northern Crashed With Other Royalty Trusts?

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Includes: GNI, WHX
by: Night Heron

Summary

Royalty trusts have sold off dramatically over the past 2 months.

Yet small-cap trusts with high short rebates, most notably Whiting Trust USA I and Great Northern, have not participated in the crash.

There are 3 mechanisms by which short rebates might keep prices high: (1) by giving shareholders a deceptive impression of potential income, (2) by providing disincentives to short sellers, or (3) by encouraging market manipulation.

Royalty trusts have sold off dramatically over the past two months. The table below summarizes the 2-month decline of 17 royalty trusts. The average price decline is 22%, and when distributions are included, the average loss to investors exceeds 18%. The decline of the royalty trusts has been 3 times larger than the Global Natural Resources ETF (NYSEARCA:GNR), suggesting that the royalty trust sector has been hit harder than natural resource investments in general. The Forensic Accountant suggests that the decline of royalty trusts has been accelerated by tax loss selling.

But not all trusts have crashed. The two best performers have been Whiting Trust USA I (NYSE:WHX), which lost just 2% net of distributions, and Great Northern (NYSE:GNI), which actually had a positive return of 25%. This is especially startling since it's well known that both WHX and GNI are highly overvalued and near their termination dates. WHX will terminate in March and currently exceeds its fair value by a factor of 5; GNI will terminate in April and currently exceeds its fair value by 70%.

What has stopped these deaths-door trusts from declining with their brethren? One possibility is the short rebate. The overvaluation and imminent demise of WHX and GNI is so well known that at least one broker (IB) is currently charging an annualized rate of approximately -100% to short them. Across all the trusts in the table, the ones with the largest short rebate have performed the best. The correlation between the short rebate and the 2-month performance (including distributions) is -0.61.

Opening price

2-month performance

Short rebate

Market cap (millions)

Ticker

10/1/14

12/1/14

Distribution

Without distribution

With distribution

GNI

$21.20

$24.00

$2.60

13%

25%

(97%)

$33

WHX

$2.68

$2.12

$0.51

(21%)

(2%)

(105%)

$30

SDT

$4.22

$3.80

$0.25

(10%)

(4%)

(42%)

$102

HGT

$9.24

$8.61

$0.14

(7%)

(5%)

(2%)

$348

PER

$9.98

$8.46

$0.66

(15%)

(9%)

(5%)

$403

SJT

$19.15

$16.90

$0.18

(12%)

(11%)

(11%)

$767

DOM

$8.50

$7.20

$0.18

(15%)

(13%)

(98%)

$59

SDR

$6.30

$5.02

$0.40

(20%)

(14%)

(7%)

$244

CHKR

$10.75

$8.54

$0.51

(21%)

(16%)

(69%)

$322

BPT

$95.25

$76.01

$2.03

(20%)

(18%)

(30%)

$1,690

ROYT

$10.34

$8.04

$0.16

(22%)

(21%)

(5%)

$256

ECT

$5.48

$4.13

$0.20

(25%)

(21%)

(44%)

$66

PBT

$13.87

$10.68

$0.11

(23%)

(22%)

(5%)

$490

WHZ

$12.20

$8.71

$0.64

(29%)

(23%)

(7%)

$142

MVO

$26.80

$18.39

$0.90

(31%)

(28%)

(3%)

$208

NDRO

$11.50

$7.22

$0.10

(37%)

(36%)

(1%)

$219

VOC

$12.55

$7.53

$0.37

(40%)

(37%)

(1%)

$123

Average

(22%)

(18%)

(31%)

$324

GNR

$48.71

$45.68

$0

(6%)

(6%)

How might the short rebate prevent a trust from falling? There are three possible explanations. One, which I don't buy, is that a high short rebate makes overpriced trusts an attractive investment. The idea here is that when investors buy the trust they receive not just its distributions but also a share of the rebate paid by short sellers. The problem with this explanation is that it's just not relevant to the vast majority of investors. Only 10% of WHX and 1% of GNI shares are currently lent out to shortsellers, so 90%-99% of shares aren't generating any short rebate income. If you're lucky enough to have your shares lent out, you'll have to split any short rebate income with your broker, or your broker might take it all. I've walked through the numbers before and concluded that the average WHX shareholder will collect less than 2 cents in short rebate income. The average GNI shareholder will collect much less.

Of course not all shareholders understand that. Commenters on Seeking Alpha have repeatedly trotted out the idea that short rebate income can make overpriced trusts a good investment. It is possible that some investors are buying the trusts under the same misunderstanding. But not many, I suspect. The investors who make that mistake would have to be informed enough to understand what short rebate income is, but not sophisticated enough to calculate that it's not going to work out for them, and not attentive enough to notice that the hoped-for income isn't showing up in their monthly statements. The required combination of sophistication and ignorance seems like something that would be rare.

Perhaps a more plausible explanation is that high rebates discourage price discovery. Here the idea is that more investors would like to short WHX and GNI and bring down the price, but won't because the short rebate is too high. There's some research evidence to support this hypothesis, although if there's latent demand to short WHX and GNI, it's not clear why brokers don't make more borrow available at a lower rate.

A final possibility is that there's some kind of manipulation going on. I have no idea whether WHX and GNI are being manipulated, but the incentives and opportunity are present. Brokers are making a small but risk-free income stream from lending out WHX and GNI, and would of course be pleased if both trusts remained overvalued and attractive to short sellers for as long as possible. In addition, although the average shareholder isn't profiting from the short rebate, there are a small fraction who are and would like the prices to remain high as well.

The possibility of price manipulation is heightened by the fact that GNI and WHX have become the smallest-cap trusts on the market, with market caps of just $30-$33 million and only $500,000 in trades on a typical day. If a small number of market participants wanted the price to stay high, they would have an easier time propping up WHX and GNI than they would with a billion dollar trust such as BPT.

Again, I have no idea whether manipulation is taking place, but it deserves discussion alongside other possibilities. There must be some reason why WHX and GNI have lost touch not just with their own fair value, but with trends in other trusts.

Disclosure: The author is short WHX, GNI.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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