Why Income Investors Should Avoid Royalty Trusts, and Better Alternatives

Royalty trusts offer mouthwatering yields of 20%-40% but come with a catch that makes them bad long-term investments. This article explains why income investors should steer clear of Royalty trusts and instead choose high-quality, high-yielding upstream MLPs instead.

Jun 11, 2014 at 12:12PM

In an age of near-zero interest rates, yield starved income investors may be attracted to royalty trusts such as SandRidge Mississippian Trust I (NYSE:SDT) and SandRidge Mississippian Trust II (NYSE:SDR). After all, with a current yield of 29% what's not to love about these plays on America's oil boom? Well, as this article will show -- plenty.

First, a brief explanation of what a trust is. These are securities that have no employees or assets. Their sole reason for existing is to own royalty rights to extract hard assets such as oil or gas and pay out distributions based on this revenue. But a trust's very nature results in several negative aspects that potential investors should be aware of.

Trusts are not allowed to grow. No new lands are allowed to be acquired and the only way for a trust's distribution to rise is for production to increase (by drilling new wells for example), or for commodity prices to rise. In addition, many trusts have limited lifespans, at which point they dissolve. This creates a very tricky situation for long-term income investing, as I'll demonstrate with the two SandRidge Mississippian Trusts.

Why investors should avoid trusts
I believe in investing in strong businesses with good management and prospects for long-term growth. A trust, by its very nature, is a depreciating asset with no hopes for growth once the drilling is done. In the case of SandRidge, both trusts were created by SandRidge Energy as a means of financing its growth. The company had an obligation to drill a certain number of wells by a certain period and has completed this obligation for Trust I and will reach this point with Trust II by 2015.

Once the drilling is done, oil and gas production will quickly decline, which will take distributions and the unit price with it. 

SDT Chart
SDT data by YCharts

In its first quarter 2014 report, SandRidge Mississippian Trust II announced a 17% decline in oil production and an 8.9% decline in gas production. This resulted in a 13.9% decline in distributable income. This is particularly concerning for investors because SandRidge is still drilling new wells (albeit at a slowing pace). Once drilling ends by the end of next year, the trust's production is likely to fall off even faster; SandRidge Mississippian Trust I's production decreases in the first three quarters after drilling ended were 26%, 21%, and 22%.

As the charts above indicate, both trusts have been disastrous long-term investments, which is something that is not likely to change anytime soon. But there is still a way for yield-hungry investors to cash in on America's oil and gas boom, but one that allows for the trifecta of investing: high-yield, growing income, and capital gains. 

Upstream MLPs: a better way forward
Exploration and production MLPs such as Breitburn Energy Partners (NASDAQ:BBEP) are a great way for long-term income investors to grow their wealth from America's oil and gas renaissance, but in a smarter, more Foolish manner. Breitburn's last quarter exemplifies the strength of a well managed MLP: the ability to grow through accretive acquisitions.

Last year Breitburn Energy purchased $860 million worth of oil-rich land in Oklahoma's panhandle (part of $1.8 billion in successful acquisitions since 2012).

Because of this acquisition the MLP announced a record quarter with adjusted EBITDA up 84% and distributable cash flow (DCF) up 88%. The distribution coverage ratio improved from last quarter's .93 to 1.0, and management's guidance for 2014 is very promising:

  • 27.5% production increase
  • 36% adjusted EBITDA growth
  • $600 million in additional accretive acquisitions
  • long-term distribution coverage ratio of 1.1
With $773 million in available liquidity, Breitburn Energy Partners is well on its way to not only delivering consistent distribution growth (6.3% CAGR growth over the last four years with 4.8% growth in 2013) but also accelerating it as well. 
In fact, analysts at S&P Capital IQ are predicting 10-year compound earnings growth of 32.6% and distribution growth of 22%.

BBEP Total Return Price Chart
BBEP Total Return Price data by YCharts

Since its IPO (in 2006), Breitburn Energy Partners has had a total return (includes distribution reinvestment) of 9.7% CAGR -- 50% better than the market's 6.7%. Given its track record of successful growth through acquisitions, high caliber of management, and ample liquidity, I have every confidence that Breitburn Energy Partners will continue to generate strong, growing income and market-smashing total returns over the long term.

Foolish takeaway
Royalty trusts, with their inherent lack of growth prospects, variable but declining distributions, and limited lifespans are a bad idea for income investors seeking to cash in on America's oil and gas bonanza. Rather, high-quality, high-yielding upstream MLPs, such as Breitburn Energy Partners, are a far better method of earning generous income that grows over time and results in capital gains and market-beating total returns. 

Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends BreitBurn Energy Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information