Editorial Note: This article was updated on May 5th, 2015 from the original article published on June 30th, 2014.

Sandridge Permian Trust's (NYSE:PER) spectacular distribution yield of almost 51% is enough to make just about every income investor say, "this is too good to be true." In the case of royalty trusts, that can very much be the case. Now that Sandridge Energy (NYSE:SD) has drilled its last well as part of the covenants with the Permain trust, the Sandridge Permian Trust will go into a state of perpetual decline until Sandridge dissolves the trust in 2031. So, the question for long-term investors is if they can make a decent return on the trust through its distributions before the party is over. To better understand this, let's run through a series of scenarios that will help give a clearer picture of what to expect from this Trust over the long term.

If you are looking at a royalty trust for the first time and are not quite sure what they are and how they operate, check out this quick primer

It's not a stock, so change your mind-set
A big trap for investors is to think that a royalty trust is a stock. It's not. Over the long term, share prices in a royalty trust should perpetually be in decline as the reserve base for that royalty trust is diminished. The only way a share price can go up is if the value of that commodity goes up faster than the reserve declines. So, when making an investment in a royalty trust, you should base your decision solely on whether the distributions that the trust will exceed the price you pay for a share. 

Oil pump silhouettes on an orange background

Image source: Getty Images.

The Sandridge Permian Trust is quite possibly the most direct way an individual investor can make an investment on oil in the Permian Basin. Unlike the other trusts that have been issued by Sandridge Energy, the Permian trust is predominately an oil trust. Its current production is more than 85% oil, compared to the Sandridge Mississippian Trust I (NYSE:SDT) and Sandridge Mississippian Trust II (NYSE:SDR), which produce about 36% and 45% oil, respectively. 

So, in this specific case, we are making the bet that oil from the wells in this particular part of the Permian Basin will generate a return over the life of the wells greater than our original investment, and hopefully that return will be superior to other investment opportunities. 

Breaking down the return scenarios
In reality, we can't predict the long-term return of a royalty trust because, frankly, we have no way of knowing what the price of oil will be in the future. Instead, we can look at the physical characteristics of the wells and how that will impact the distribution over time. Today, Sandridge estimates that the Permian Trust has about 11.8 million barrels of oil equivalent that can be extracted based on today's oil prices. Based on the most recent production numbers, the trust has a reserve to production ratio of a little more than 7.8 years. For the trust to last until its terminal date in 2031, though, that would mean today's production would need to decline 10.3% on average to make the reserve last the entire duration of the trust.

Using this decline estimate and the current annual distribution, we can project a rough estimate of the trust's longtime return. Let's assume the trust's distribution declines at the same rate as production and that when the trust is liquidated at the end of its life, you get 10% of the current value of the trust. Using this assumption, the estimated return over the life of the trust would look something like this:

Source: 10-K via sec.gov, author's calculations.

So, based on those assumptions, and were the price oil to remain constant throughout the life of the trust, then you could potentially generate a greater than 200% your money over this 16 year period. Of course, there are likely to be some changes on oil prices over this time, so here's what those returns would look like if oil prices were to swing 25% in either direction. 

Scenario Estimated Return Over Life of Trust (16 years) Compounded Annual Growth Rate
Oil prices remain constant 232% 7.7%
Oil prices increase 25% 313% 9.27%
Oil prices decrease 25% 152% 5.94%

Author's note: These projections assume that distributions from the trust are not reinvested back into the trust

Based on these projections, an optimistic return on the trust would be an annualized compounded return of 9.27%, which assumes that oil prices over the life of the life of the trust will be 25% higher than what they are today. That isn't too much of a stretch considering where oil prices are today. Since 1871, when records were first kept, the S&P 500 has an inflation-adjusted compounded annual growth rate of 6.86%, so investing directly in the Permain Trust has the potential to do much better. 

The one thing that you need to consider, though, is that half of the royalty revenue over the past 6 months has come from settlements of futures contracts that have allowed the Trust to realize higher than market prices on its oil. As these hedging contracts expire, the Trust will be more exposed to the market price of crude oil today and will likely result in much lower distributions. 

What a Fool believes
If you were to invest in the Sandridge Permian Trust and hold it until its liquidation, it's very likely you won't lose money. So, if you are looking to protect your principal over a 15-year period, then perhaps the Sandridge Permian trust is a place to invest since it will likely beat inflation. In fact, at toady's low share price, there is a pretty good chance that the Trust's distribution returns could be greater than the S&P 500. The one concern is that the expiration of those derivative contracts will significantly decrease the Trust's distributions over the next couple of quarters.

At the same time, its future is completely reliant on where oil prices go from here. If history has taught us anything, it's that there is no real way for us to know this. Investors who want to play it safe shouldn't count on oil prices to rise any time soon. Based on this, there are probably better opportunities out there.