A High-Risk, High-Reward Energy Play

10/11/2012 2:00 am EST

Focus: INCOME

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

The risk profile of US royalty trusts are best suited to the most aggressive part of one's portfolio, but their yields are often much higher than their MLP cousins, says Elliott Gue.

Well investors may be aware of MLPs—master limited partnerships—but they have a cousin, the US Royalty Trusts. What are those and how do those work? My guest today is Elliott Gue to talk about that. Elliott, first of all, what is a US Royalty Trust?

Well, I think a lot of American investors are actually more familiar with the old Canadian Royalty Trusts. A few years ago, those were very hot, popular securities to own—high-income bank securities. And then the Canadian government switched the tax law, which kind of eliminated all lot of the advantages they have.

There’s a similar structure in the United States to what the Canadian Royalty Trusts were, but it’s a little bit different. One of the key things to remember about US Royalty Trusts is they’re not operating companies. They typically have no employees, they’re legally prohibited from making acquisitions, taking on hedges, or really building anything, so they really can’t grow their asset base much.

What happens is a trust is created, typically certain assets are put into the trust, and those are the assets that are going to exist in that trust for the life of the trust.

The other thing to remember about trusts is they typically have a finite lifespan. Typically when they’re set up, they’re set up to exist for 20 years or ten years—some finite lifespan—and after that, they’re terminated. Often, some sort of final distribution is made to unitholders.

But the real advantage of them is most of them today are based in the energy business. Most of them are involved in actual production of oil and natural gas, and like master limited partnerships, they’re pass-through entities. There’s no corporate tax structure there. They pass through all of the cash flows that they generate directly to the unitholders, much like an MLP would do, and then you pay taxes on your portion of those distributions.

Are they traded the same way MLPs are traded?

Yes. Most of them trade on the New York Stock Exchange. Some of them are very liquid. Often when they’re first listed, they can be a little bit less liquid, but they’re traded just on the NYSE just like any other company.

I would say another distinguishing factor between them and MLPs is they tend to have a little bit more commodity-price exposure. In many cases in the early years of their lives, they’ll have a few hedges covering some of their production. But after a few years, typically the hedges end and they’re totally pretty much at the mercy of commodity prices.

So if oil prices go up, their distributions will go up. If oil prices go down, their distributions will go down. They can’t go out and acquire. They can’t put on additional hedges. So it’s simple—it’s like going out and buying a series of oil and gas wells with a number of other people and then just distributing the profits amongst yourselves, but it’s kind of a publicly traded version of that.

You do get some tax advantages because of depletion allowances, depreciation, that sort of thing. It shelters part of your income from income tax, so they do have some tax advantages as well.

Another nice thing is they do typically pay out very nice yields. Right now, a lot of trusts that are out there are paying 13% or 14% yields, compared to your average MLP more like 6%, 7%. So a little riskier, but a little bit higher yield.

I was going to say, 13%, 14...I think anybody looking for income would be thrilled with that, but at the same time I got to think there’s got to be a tremendous amount of risk in order to get that. Is that the case?

Well, the main risk is commodity prices. You have to be very careful.

For example, right now I’m more bullish on oil than natural gas prices. So you look out there, some of them are heavily leveraged to natural gas. There’s a risk if natural gas prices stay where they are. You’re not going to get much in terms of income out of this because the sale prices are not worth that much. They’re not selling gas for very much. The oil focused ones have been doing very well. So that’s one thing you've got to look at.

The other thing you've got to look at is the individual structure of the trust. Each one is a little bit unique. How are they set up?

What I like to do is look at the new ones just coming public. Every few months, there’ll be a couple more. Every quarter you’ll see two or three more of these come out. Look at how they’re structured.

If you look at the prospectus, some of them are structured such that they’ll have say 500 wells on a particular piece of property and the parent company of the trust will agree to drill another 500 wells on that same property. So that means you’re going to see production ramp up and distributions are going to grow for the first three or four years. That’s a very interesting structure, because oftentimes people don’t really realize the full distribution power of that trust.

In other words, their first quarterly dividend payment might be 25 cents, but as production grows as new wells come on stream, that could double or triple over the course of a two- or three-year period. So I think a lot of times that’s a great time to get involved with these: early on in their life cycle, before people fully recognize what the distribution power is.

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