Why These Royalty Trusts Are Guaranteed to Fail and 1 MLP That Won't

Yield-starved investors can be attracted to the sky-high yields offered by royalty trusts, but these yields are a fantasy. This article explains why two specific royalty trusts are poor long-term investments, especially compared to Linn Energy, a MLP with a high, safe yield and a strong track record of growth.

Jun 24, 2014 at 3:32PM

In a previous article I outlined why royalty trusts were terrible long-term investments and why income investors should choose upstream MLPs as an alternative. Since that time, while researching Linn Energy (NASDAQ:LINE) and its recent deal with ExxonMobil a stark contrast has become evident to me that I wanted to share with you. 

As pointed out by my colleague Matt DiLallo in this article comparing SandRidge Energy (NYSE:SD) and SandRidge Mississippian Trust II (NYSE:SDR), SandRidge Energy's trusts were established as mere financing vehicles for the parent company to invest in its own drilling program. For example, SandRidge Energy has plans to invest $1.55 billion annually in its Mississippi lime assets through 2016 in order to grow production by 20%-25% annually (in spite of expected decline rates of 35% in 2014, 20% in 2015, and 15% in 2016).

SandRidge Energy has stated that it will complete its drilling program for SandRidge Mississippian Trust II by 2015. The pace of drilling has been dropping (6.9 new wells drilled in Q1 vs 10.7 in the prior quarter) and despite the fact that new wells are still being added, SandRidge Mississippian Trust II reported a 17% decline in oil production resulting in a 13.9% decline in distributable income on a quarter-to-quarter basis. 

SDT Total Return Price Chart
SDT Total Return Price data by YCharts

As the chart illustrates, SandRidge's other royalty trust, SandRidge Mississippian Trust I (NYSE:SDT), which has already had its final wells drilled, has been experiencing a severe decline in distributions, a result of its massive quarterly production declines of 26%, 21%, and 22% immediately after the last well was drilled. 

A royalty trust, by design cannot grow through acquisitions. The only way for distributable income to grow is through additional drilling or commodity price increases. With SandRidge Energy stating that its drilling program is coming to a close both of its trusts are facing perpetual declines in production, distributions, and unit prices. Why would SandRidge Energy cut off its trusts and refuse to invest in additional drilling? Simply put, because it has concluded that the assets owned by its trusts are tapped out and not worth further investment.

According to its prospectus, SandRidge Energy started out owning 38.4% (6 million units) of its Mississippian Trust I and 47.7% of Trust II (12.2 million units). It received incentive distribution rights of 50% of distributable income for exceeding certain target distributions by 20%. 

Today, SandRidge Energy owns just 528,000 units of Mississippian Trust I and 6.24 million of Trust II, having sold 91% and 51% of its respective stakes. A key investing principle at The Motley Fool is investing alongside management (high insider ownership). If a founder of a company liquidated such enormous percentages of his/her original holdings, shareholders might rightfully worry about the company's future. In this case, SandRidge Energy's lack of further investment in its trusts is a clear sign to investors that SandRidge Mississippian Trusts I and II have no future and don't deserve a position in your portfolio. 

Linn Energy: growth you can believe in
I view Linn Energy and its non-MLP alternative LinnCo (NASDAQ:LNCO) as one of the highest quality high-yield investments in America, specifically because of its strong track record of accretive acquisitions and growth (60 acquisitions worth $15 billion since its 2006 IPO).

LINE Total Return Price Chart
LINE Total Return Price data by YCharts

But what has me really excited about Linn Energy is its latest deal, a massive land swap with ExxonMobil, and what it means for the future of how this MLP does business. 

For an in-depth explanation of the deal see this article, but the bottom line is this: Linn Energy traded 25,000 acres of Permian basin land (expensive to drill and fast depleting) for 500,000 acres of Hugoton basin land (already producing substantial natural gas and a 6% decline rate).

In the process it lowered its costs, overall production decline rate, and secured its distribution. But Linn Energy might just be getting started. It still owns 30,000 acres of Permian land (that's sitting atop 75 billion barrels of oil in the world's largest oil deposit) as well as 545,000 net acres of Midcontinent assets that face high decline rates but are still of interest to companies such as Apache and SandRidge Energy.

With Linn Energy's CEO Mark Ellis stating a desire to monetize not only Linn's Permian but also Midcontinent assets, future land-swap deals could be in the works, which would mean likely continued distribution growth for Linn Energy and LinnCo investors (historically 4% annual growth on top of a 9.4%-9.8% yield).

Foolish bottom line
Royalty trusts are designed to be a decaying short-term investment. Upstream MLPs, such as Linn Energy and LinnCo, on the other hand, are living, growing investments with a proven track record of safe, consistent income, and distribution growth along with excellent long-term prospects. Investors considering SandRidge Mississippian Trusts should follow the example of SandRidge Energy: sell their positions, and consider Linn Energy or LinnCo as superior alternatives. 

Do you know this energy tax "loophole"?
You already know record oil and natural gas production is changing the lives of millions of Americans. But what you probably haven’t heard is that the IRS is encouraging investors to support our growing energy renaissance, offering you a tax loophole to invest in some of America’s greatest energy companies. Take advantage of this profitable opportunity by grabbing your brand-new special report, “The IRS Is Daring You to Make This Investment Now!,” and 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 has no position in any of the stocks mentioned. 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