Energy Investing 101: Tackling Oil and Gas Royalty Trusts

Have you ever looked at the price of oil and gas and wished that you owned you own oil well? Sounds pretty tempting. Problem is, there's all that permitting and drilling and whatnot. The next best thing is to own an oil and gas royalty trust. Investing in a trust like the BP Prudhoe Bay Royalty Trust (BPT -3.49%) or the Sandridge Mississippian Trust II (SDR) can give you exposure to oil and gas without a company standing between you and the well. 

Oil and gas royalty trusts are unique creatures -- they aren't companies, so you need to look at them very, very differently. To help you better understand these investments, here is a primer on what a royalty trust is and how you can determine whether it is a good investment or not. 

Image source: Getty Images.

What the heck is a royalty trust anyways?
For individual investors, royalty trusts are generally high-yielding investments that also have some very unique tax benefits. A company, normally an oil and gas producer, will issue units of a royalty trust on the open market as a method for raising capital to develop one particular field. 

These trusts are exempt from corporate taxes because they are pass-through entities, much like master limited partnerships. But unlike an MLP, where you pay income taxes on distributions -- the name for dividends from MLPs and royalty trusts -- royalty trust distributions are considered capital gains, and therefore taxed at a lower rate. Also, since you are a part owner of the oil wells, you can depreciate those assets to lower your cost basis, which means you can delay taxes, and potentially be eligible for certain tax credits. 

There are 20 or so royalty trusts that are currently traded on the U.S. exchanges, but some are very small (less than $50 million). So here is a list of the 10 largest oil and gas royalty trusts currently traded, all of which have market capitalizations of at least $400 million.

Source: 10-K filings via sec.gov

I'm guessing that those distribution yields and the minimal tax obligations on these investments are making you salivate, but before you jump into a royalty trust you need to remember one thing: These are not stocks, and you should not buy them like they are.

A better way to think of a royalty trust is like a unique bond. This is because royalty trusts don't buy new wells to keep the party going. Rather, a royalty trust has a finite life: its value slowly declines over time until it's no longer economically feasible to pull oil and gas from a well. Once the trust meets its terminal value, the residual value of the royalties are sold and distributed to unitholders. To help you better understand this, here is a chart of a theoretical return of a 30 year trust. In this case, it assumes uniform decline and constant commodity prices.

Unlike a bond, though, the things that determine payments -- decline and commodity prices -- can change considerably over time, so there is a risk that you will not get all of your principal back. The probability of you getting all of your principal along with a return is based on the characteristics of the oil field -- which declines once all the wells have been drilled -- and oil and gas prices. This means that the distribution varies over time, so investors looking for high yields should know that distribution yields could fluctuate.

This does not mean they are bad long-term investments, though. On the contrary, the right investment in a royalty trust can produce spectacular returns. The older royalty trusts -- BP Prudhoe bay, San Juan Basin, Permian Basin, Hugoton, and Sabine -- have absolutely trounced the S&P 500 on a total return basis over the past 15 years.

BPT Total Return Price data by YCharts

How to tell that your trust won't bust

In some ways, knowing how a royalty trust works is a heck of a lot easier than knowing the ins-and-outs of a company. It's just you and those oil and gas wells, so what you need to know are the unique characteristics of the trust. There are basically three things that you need to look at when analyzing trusts: production mix, the payback period, and its remaining shelf life.

1. Production mix
Just like an oil and gas producing company, the type of hydrocarbons that are coming out of the ground have a lot to do with the success of a royalty trust. Almost any way you look at it, oil is and almost always has been a more valuable commodity than natural gas or natural gas liquids. Sure, a natural gas-heavy trust may seem appealing if you think that natural gas prices are going to climb. If you are looking to invest long term, however, it is impossible to know where the price of these commodities will be 5-10 years from now.

Source: 10-K filings via sec.gov

2. Payback period
Remember, a royalty trust doesn't grow by adding new wells, so in theory your return will come through the distributions after you cover your costs. The amount of time required to break even is the payback period, and knowing how long that time is can have a strong effect on how good of an investment that particular trust is. The simplest way to calculate payback period is one divided by the distribution yield -- but this is very crude, as it doesn't account for commodity price changes or the natural decline of a well.

To be a little more accurate, you can account for these things by doing a little extra legwork. Let's use BP Prudhoe Bay as an example. Production has declined at a rate of about 2% per year since 2009, so let's assume that continues and the distribution declines at the same rate. Also, instead of predicting where oil prices will go, let's just build a range where oil prices are 25% higher or 25% lower than today's price. This table describes the payback period on the BP Prudhoe Bay Trust based on these assumptions.

Source: BP Prudhoe Bay Trust via sec.gov, authors calculations

Looking back at that theoretical return chart at the top, this is when you can expect your investment to reach a 0% return. So in this case you have received all of your money back, but not made any money. Any distributions plus residual payments after this time are what you will receive in a return.

3. Shelf life of the trust
Now that you know how long you will need to be invested in a trust to recoup your original investment, you need to know if the trust will last long enough to meet those criteria and garner a return. This comes down to three things: total reserves, production, and trust termination conditions.The easiest way to estimate how much longer a trust has left is to divide the reserves by annual production to get the amount of years an oilfield has left. This will determine when a trust will be dissolved and what you get when the royalty interests are liquidated, because even with little oil or gas left there is still some residual value in these royalties.

Source: 10-K filings via sec.gov

The reserve to production ratio is a conservative estimate of a trust's life because it assumes no production decline. But if you are making an investment, better to be conservative, right? Another thing to consider here is that Chesapeake Granite Wash, Sandridge Mississippian II, and Sandridge Permian Trusts have not yet drilled all of their potential wells, and it's more difficult to accurately determine reserve to production ratios until all those prospective well sites become developed and producing assets. 

Let's go back to the BP Prudhoe Bay trust as an example again. A conservative payback period -- assuming 2% production decline and a 25% reduction in oil prices -- is still shorter than the current reserves to production ratio, so it's pretty safe to say that your investment will be paid back. However, by this estimate there are only a couple of years of distribution payments left afterwards, plus the residual payment, which is unknown. Assuming your residual value payment is 10% of your initial investment, which may be generous, here is what the return estimate would look like over the remaining life of the trust.

Let's remember, though, this is what the return looks like if oil prices are 25% less and the reserve depletes at an accelerated rate. So this is possibly the worst case scenario.

If you go through the three steps above for other trusts, then you should be able to reliably determine whether those trusts will be able to produce acceptable returns for you over time.

Another thing to consider: the intangibles
Knowing how to calculate a trust's return is great, but the fact of the matter is that there are several things that can happen that will have major effects on a trust's value, more specifically the proved reserves. Proved reserves are not all the oil and gas in a reservoir, but simply the amount that can be economically extracted from that specific reservoir. So the total proved reserves are actually based on the price of oil and gas over a certain period of time. For a more technical explanation, check this out.

The important takeaway is: As prices rise or new technology emerges that lowers extraction costs, reserve estimates can increase. This can both increase the total distribution and extend the life of the trust. Conversely, a big drop in prices can result in a much shorter life and smaller distributions.

What a Fool believes
One day, royalty trusts can look like extremely tempting investments. The next, they can look absolutely terrifying. That's because their value is based more on commodity prices than it would be for any other energy investment. If you are looking for a stable quarterly dividend check that you can depend on for income, this isn't the place to look. However, there is a lot of upside in a royalty trust if you have the wiggle room in your portfolio. Using the steps outlined here should help you sniff out the best trust for your portfolio.

Other subjects in the Energy Investing 101 series: 

Big Oil

Offshore Rig Companies