Why Crashing Oil Prices Mean Income Investors Should Avoid These 3 High-Yielding Investments at All Costs

Oil prices have crashed to their lowest level in six years, leaving some high-quality, high-yield oil investments selling at fire sale prices. 

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However, SandRidge Permian Trust (PER), SandRidge Mississippian Trust I (SDTTU -2.86%), SandRidge Mississippian Trust II (SDR), and their parent company, SandRidge Energy (NYSE: SD), are not among them. There are two major reasons you should avoid these investments like the plague. 

Royalty trusts are terrible investments in general, but especially when oil prices are crashing 
I have warned investors in the past about avoiding oil and gas royalty trusts, but crashing oil prices have sent the economics of these investments from bad to terrible. Because these liquidation assets aren't allowed to grow and acquire new assets, the only ways for investors' distributions to increase over time is for the parent company to drill new wells or for commodity prices to increase. 

With SandRidge Energy having finished drilling wells on its Mississippian Trust I and announcing that it will complete its last wells on Mississipian Trust II in 2015. Production from both trusts already declining rapidly, there is simply no mathematical way for investors' payouts to grow in the future. 

Sources: Trust 10-Qs.

This is particularly true given that, as this table shows, the price per barrel these trusts are receiving is inflated by aggressive hedging, the contracts for which expire at the end of 2015 for Mississippian Trusts I and II and March 2015 for the Permian Trust.

Looking at the table you'll notice a few things. First, Mississippian Trust I's decline rates are much worse than Mississippian Trust II's, while the Permian Trust is actually increasing production and royalty income. This is due to the fact that Mississippian Trust I is older and has no new wells being drilled, while Mississippian Trust II had nine wells added in the third quarter and the Permian Trust had 26 wells added. However, with no new wells to be added for Mississippian Trust II after 2015 and the Permian Trust should have its last well drilled during Q1 of 2015. One all the wells are drilled production from the two trusts should decline at an accelerating rate.

In addition, the Permian Trust's royalty income is about to fall off a cliff once its high-value hedges end. For example, the Permian Trust had 208,000 barrels of oil hedged at $101.75 per barrel for the fourth quarter of 2014 and 163,000 barrels hedged at $100.9 per barrel for the first quarter of 2015. Past that, the trust has no production hedged at all, and a barrel of oil currently costs $48, 51% less than price it received per barrel in its latest quarter . 

In fact, as badly as the Mississippian Trusts unit prices have done recently, the Permian Trust is far more exposed to the collapse in oil prices because its production mix is 86% oil versus just 36% and 45% for Mississippian I and II, respectively. Thus, while investors might be attracted to the Permian Trust's 40.2% yield, they should be aware that next year's distributions will be far smaller than those of the past 12 months. The same applies to the Mississippian Trusts: 29.3% and 34.1% respective yields conceal sharp and certain distribution cuts in the future. 

Long-term investment opportunity is lacking, even at fire sale prices
In July, my Motley Fool colleague Tyler Crowe crunched the numbers on SandRidge Mississippian Trust II to see what kind of returns long-term investors could reasonably expect over the remaining 17 years of the trust's life. At the time oil was trading at $100 per barrel, and Crowe determined that, assuming a 17% decline rate in production and $75 per barrel, oil investors could expect about 2.1% compound annual returns through the life of the trust. 

Considering that inflation over the last decade has been 2.26%, and the S&P 500's compound annual growth rate since 1871 has been 9.1%, that projected return leaves a lot to be desired. Plus, when you consider that the price of oil is now 25% lower than in that model, and that the Mississippian Trust II's annual decline rate in the most recent quarter was actually 40%, it becomes highly likely that long-term investors will lose money investing in this royalty trust.

In case you think the Mississippian Trust I might do any better, consider its production decline rate of 52% in its latest quarter. Meanwhile, according to Pete Stark, senior research director at IHS, the average annual decline rate in the first year for Permian oil wells can be as high as 78%.This bodes terribly for the Permian Trust's long-term production outlook.

All told, unless SandRidge Energy drills additional wells for its three trusts, production decline rates are likely to accelerate unabated and result in potentially large losses for long-term investors.

Don't expect help from SandRidge Energy
There are two reasons to believe no help will be forthcoming from these three trusts' parent company. First, SandRidge has shown very little interest in holding on to its initial stakes in these trusts. For example, when the Mississippian Trust I, II, and Permian Trust IPO'd, SandRidge Energy owned 38%, 48%, and 43% of the respective units. The company has since sold 91%, 51%, and 42% of its respective stakes in these trusts, giving it very little incentive to invest in new wells to increase production and distributions to units it no longer holds.

In addition, SandRidge Energy's ownership of the Permian Trust's subordinated units, which make up 33% of all units, will lead to a 24% decline in per unit distributions once these units are converted to common units at the end of 2015. That's because subordinated units only receive 28% as much distribution per unit as do common units held by retail investors.  

In addition, SandRidge Energy itself faces mounting problems that have sent its stock plunging 78% in the last six months. For example, according to Bloomberg, the average breakeven price for its Mississippi Lime assets is estimated to be $78.55 per barrel, 57% above the current cost of West Texas Intermediate.  

In addition, the company has $8.5 billion in total debt outstanding, 11.4 times its market cap, and a debt-to-EBITDA ratio of 4.93, nearly three times the average of its industry peers. 

With $650 million in debt coming due on April 1 and plunging oil prices potentially triggering a credit crisis in the U.S. energy industry, SandRidge Energy isn't likely to be aiding its trusts anytime soon, or ever. This is especially true when the costs of production for the Mississippian Trusts are so much higher than current oil prices. 

The takeaway: crashing oil prices means avoid SandRidge Energy and its trusts at all costs
There are plenty of quality energy names trading at incredible values thanks to the worst oil crash since the financial crisis. However, SandRidge Energy and its royalty trusts are not among them. Plunging production, crashing oil prices, sharply falling distributions, and an overly levered and uninvested parent company means that, in my opinion, investors who buy into the false promise of these high-yielding income investments are likely to lose money, even over the long term.