North European Oil Royalty Trust: A Strong Inflation Hedge

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Philip MacKellar
642 Followers

Summary

  • Seeking Alpha recently announced a “top stock for a high inflation environment” competition.
  • North European Oil Royalty Trust is a solid candidate for this contest.
  • This is because energy stocks tend to do well in inflationary environments.
  • Moreover, NRT is one of Germany’s few domestic gas producers, making it of critical importance given Germany’s dependence on Russian energy and the war in Ukraine.
  • Finally, the trust has a simple business model and pays out significant and variable dividends that supplement the possibility of capital appreciation.

Oil drilling derricks at desert oilfield for fossil fuels output and crude oil production from the ground

NRT is one of Germany’s few domestic gas producers, making it of critical importance given Germany’s dependence on Russian energy and the war in Ukraine.

Maksim Safaniuk/iStock via Getty Images

Introduction

North European Oil Royalty Trust (NYSE:NRT) is one of the names best positioned for the current inflationary turmoil. The company has been operating since 1975, listed publicly since 1981, and holds royalties covering some of Germany’s few domestic gas fields. The enterprise’s business plan is simple – hold the land titles, collect cash on oil and gas sales, and distribute the funds each quarter to investors, but let industry heavyweights like Exxon Mobil (XOM) and Shell (SHEL) explore, develop, and pump the resources. In 2021, natural gas accounted for 90.4% of revenue, while sulfur sales and oil represented 8.7% and 0.9% respectively.

For full disclosure, we are long NRT here at Contra the Heard, and have owned the name since 2017 when it was acquired at $6.52. Given the name’s capital appreciation, lower upside versus when it was purchased, and expanding portfolio weight, we now consider the name a hold. Nevertheless, NRT appears to be a strong candidate for weathering high inflation.

Macro Factors: The Energy Sector And Inflation

The first reason why NRT is well suited for high inflation is because it’s in the oil and gas space. As many investors know, the energy sector tends to perform well during inflationary periods. In addition to generating meaningful outperformance versus other sectors, energy has also produced these returns consistently. This graphic by Hartford Funds illustrates energy’s strong and consistent performance in inflationary periods:

Hartford Funds “Which Equity Sectors Can Combat Higher Inflation?”

“Which Equity Sectors Can Combat Higher Inflation?” (Hartford Funds)

Fidelity has recently produced its own research that corroborates Hartford’s findings. The graphic below illustrates how energy has performed versus other sectors during four inflationary periods. These periods include the famous 1966 to 1980 energy crisis, as well as the periods of 1942 to 1951, 1987 to 1991, and 2003 to 2008.

Source: Fidelity “Top Sectors Amid Inflation”

“Top Sectors Amid Inflation” (Fidelity)

To make a long story short, energy names tend to do well during high inflation environments. Not only does energy produce relatively high returns versus other sectors, but it does so consistently. Therefore, investors wishing to beat inflation may want to scour the resource patch for interesting prospects.

Micro Factors: Perfectly Positioned To Benefit From Germany’s Energy Dilemma

Within the energy industry, NRT stands out as a particularly interesting play to beat inflation, as it sits at the intersection of geopolitics, Russian sanctions, and Germany’s energy dilemma. This is because North European Oil Royalty Trust holds royalties covering some of Germany’s few domestic gas fields. According to Germany’s Federal Ministry of Economic Affairs and Climate Action, the country produces only about 6% of the gas it consumes. This makes any domestic production vital given the terrible situation in Ukraine and the retaliatory sanctions leveled against Russia. In many ways, NRT is ideally suited to benefit from these geopolitical headwinds.

German efforts to unwind their dependence on Russian fossil fuels will be difficult and costly, but the calls to do so are growing. According to the BBC, the EU spent €35 billion on Russian fuel compared to €1 billion on weapons aid to Ukraine between February 24 and April 6. Since then, European nations have collectively continued to funnel hundreds of millions into Russia each day via oil and gas purchases. The truth is in the numbers, and these figures are stark and ugly in the light of the war in Ukraine. While countries like Poland and Lithuania have committed to ending their use of Russian energy, Germany has yet to make any such commitments.

The Germans are aware of all of this, of course, but they need to balance it against keeping the lights on. As such, they are considering a raft of measures including energy conservation, rethinking nuclear, adding more renewables, diversifying gas imports, and increasing domestic fossil fuel production. If more domestic production does occur, NRT and its owners will benefit further.

Risks To Consider And Valuations

There are risks to this thesis, however. Exxon Mobil and Royal Dutch Shell are the parties who control exploration, development, and production. In recent years, neither company has engaged in exploration or drilling. Vermilion Energy (VET) had an option to explore, but that lapsed a few years ago with nothing done. This said, higher prices and government pressure could certainly incentivize more drilling.

The operation’s reserve life presents another risk. In 2015, the net gas well proved producing reserves (i.e., economically viable reserves) were 14,400 mmcf, but last year they had declined to 5,431 mmcf. With production of 882 mmcf last year, this means the operation has about six years of life left, barring more exploration, or the reclassification of uneconomic reserves to proved producing reserves. Even if more drilling does not occur or the economic reserves don’t expand due to higher prices, today’s gas prices are still strong enough to increase NRT’s quarterly dividend payouts. Though the shares have rallied significantly over the past year, the expanding payout should compensate investors going forward. The dividend yield today is at a healthy 4.04%.

Income-focused investors interested in this name should also be aware of this stock’s variable dividend. Each quarter, the distribution changes depending on the price of gas and how much the corporation collects in royalties. Though this generates generous payments in a bull market, it drops significantly in bear markets. The payout was recently $0.25 but it bottomed out at $0.02 in 2020 as the pandemic crushed the global economy.

Excluding the yield and possible dividend appreciation, investors may question the valuations, especially the price-to-book ratio at a whopping 875 times. This metric looks crazy, but the reality is that it has always been high; over the past five years, it has averaged 600.7. This high ratio is due to the fact that the corporation’s liabilities handily exceed equity by around 13 times. Fortunately, the liabilities aren’t debts, pension obligations, or accounts payable – instead, the company’s liabilities are nearly exclusively pending cash payouts to owners. Therefore, these liabilities are benign, and the high price to book valuation is less concerning as a result.

NRT’s valuation table via Seeking Alpha.

NRT’s valuation table. (Seeking Alpha)

The final risk for investors to consider is changing trends or a reversal in inflation. Higher prices can cause recessions, and by so doing they often destroy demand – thereby bringing commodity prices back down. Some could also argue that the conflict in Ukraine may resolve itself quickly, and that Russian energy may then be welcomed in Europe once again. From this vantage point, however, neither a speedy resolution to the conflict nor openly doing business with Russia again appear likely so long as Putin is in power. Therefore, NRT’s advantageous position in the current geopolitical and economic landscape may persist for some time.

Conclusion

North European Oil Royalty Trust has many of the features necessary to excel during a period of high inflation. It is an oil and gas name, and more importantly, is one of the companies best positioned to benefit from Germany’s energy diversification efforts as the country attempts to wean itself off Russian gas. Investors interested in exposure to potential inflation-beating prospects may wish to look at NRT. As with all investments, there are risks to consider, including the possibility that inflation subsides or reverses course due to an economic contraction and reduced energy demand.

This article was written by

Philip MacKellar profile picture
642 Followers
Philip MacKellar is an analyst, portfolio manager, and investor at Contra the Heard Investment Newsletter. He has been with the company since 2011 and has been investing since 2004. The newsletter’s primary focus is on contrarian and value-oriented investment opportunities traded in the United States and Canada. In addition, Philip sometimes engages in merger arbitrage, other special situations, and holds bonds, preferred shares, and convertible securities. Contra the Heard is a Toronto based company and was founded in 1995. Philip also blogs about personal finance topics on his own website called mymoneymoves.ca in his free time. You can also follow Philip on Twitter @Rallekcam and catch him on YouTube at Contra the Heard.
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Disclosure: I/we have a beneficial long position in the shares of NRT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The opinions expressed - imperfect and often subject to change - are not intended nor should be taken as advice or guidance. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.

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