Should You Be Bullish on Oil Royalty Trusts?

One way that income-seeking investors can profit off of rising oil prices is by purchasing units of oil royalty trusts. An oil royalty trust is a company that owns oil wells or the mineral rights to the land containing the wells that a given oil company (or group of companies) is using. These trusts are sometimes set up by oil companies themselves (usually by allocating a portion of the production of a given oil field to the trust) as a way to raise capital to develop the oil field (NYSE: BPT  ) . This article will focus on one such trust, the BP Prudhoe Bay Trust (NYSE: BPT  ) .

About BP Prudhoe Bay Royalty Trust
The BP Prudhoe Bay Royalty Trust is the largest conventional oil and gas trust in the U.S. The trust was formed in 1989 by Standard Oil Company and BP Exploration, which are both part of British supermajor BP (NYSE: BP  ) today. The trust collects and distributes royalties based on a portion of the production of the massive Prudhoe Bay oil field located on Alaska's North Slope.

Source: Gary Hoefs, University of Minnesota Duluth. 

The trust typically collects royalties of 16.4246% on the first 90,000 barrels of daily production or on whatever the daily production is if it is below 90,000 barrels. Like all royalty trusts, the BP Prudhoe Bay Trust has no employees and simply collects the oil royalty checks that BP pays on the portion of the oil that is allocated to the trust and then distributes this money to shareholders.

About oil royalty trusts in general
One of the big advantages of oil royalty trusts is their tax-advantaged status. These trusts are taxed very similarly to real estate investment trusts in that the trust itself pays no taxes as long as it pays out at least 90% of its income to investors. This allows them to pay out very high distributions, in a way that is also very similar to REITs.

However, unlike REITs, oil royalty trusts such as the BP Prudhoe Bay Trust are depleting assets. This means that they have a finite life, after which time the trust ceases to exist. It is similar to an oil field in this respect because oil fields also have a finite life to them. For this reason, it is important to ensure that an investor will receive enough money in distributions to repay the costs of purchasing the investment and deliver an appealing return.

Can BP Prudhoe Bay Trust deliver this, and does it make sense to purchase it as an income play on oil at today's prices? Let's find out.

Should you buy it?
At the time of writing, trust units of BP Prudhoe Bay Royalty Trust trade hands at $85.75. In the past four quarters, it has paid total distributions of $9.25. This gives it a 10.79% yield at the current level. If we assume that the trust will continue to pay distributions of $9.25 per year, which is admittedly a fairly risky assumption to make given that the distributions depend on production levels and oil prices, then it will take just over nine years and one quarter of distributions in order to break even on this investment. According to the trust's 2013 annual report, the trustees expect that royalty payments will continue until 2029. This means that the trust will continue to pay distributions to its investors for the next 14 or 15 years. Thus, if we assume that the trust can maintain payments at their current level, then the position would ultimately result in a profit.

But how much of a profit? Fifteen years of payments at $9.25 per year is $138.75, or a 53% profit at the end of those 15 years. Additionally, you would be left with a value of $0 in the trust units. Thus, if we assume that the trust lasts for exactly 15 years and that distributions continue at their present level over that entire time, then the trust will deliver an annualized gain of 3.26% over its remaining lifetime. An investor who is looking to buy a stock and forget about it would be better off buying an oil company that yields over 3.26% such as Statoil or Total as you would most likely end up with a better return at the end of 15 years. If high current income is a necessity, then why not take a look at an upstream MLP such as Vanguard Natural Resources, which yields 8.48% ?

How does these trust yields stack up with the following 3 companies?
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