At today's prices SandRidge Mississippian Trust II (SDR +0.00%) has a jaw-dropping distribution yield of 28.7%. If you are pinching yourself at this income opportunity, know this: royalty trusts aren't your typical income investments. With SandRidge Energy (NYSE: SD) expected to drill the last well on this trust's acreage by the end of this quarter, oil and gas production will be in perpetual decline until the company liquidates the trust in 2031. Can you squeeze enough value out of the trust before the wells run dry? To see how this might play out, let's run through a series of scenarios that will offer a better 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 mindset
A big trap for investors is to believe that a royalty trust is a stock. It's not. Over the long term, share prices in a royalty trust should continually drop as the reserve base for that trust is diminished. The only way the share price can go up is if the value of that commodity rises faster than the reserve declines. So, when making an investment in a royalty trust, you should base your decision solely on whether the distributions from the trust will exceed the price you pay for a share.
Source: Sandridge Mississippian prospectus via sec.gov.
SandRidge Mississippian Trust II and SandRidge Mississippian Trust I (SDT +0.00%) were set up mostly as a way for SandRidge Energy to fund the development of the Mississippian Lime formation in Kansas and Oklahoma. While certainly successful in raising money for the company, they haven't produced much in the way of returns for investors.
SDR Total Return Price data by YCharts.
Mississippian Trust II today produces about 45% liquids and 55% gas, which is slightly less liquids than what SandRidge estimated when it set up the trust. However, the overall production numbers have not been as promising. According to the prospectus from 2012, production was set to peak in 2016 once SandRidge had completed all of the potential wells.
Source: SandRidge Missisippian Trust II prospectus via sec.gov.
But decline rates have been greater than anticipated, so the drilling program has been accelerated to end in this quarter. Even with new wells still coming online, production is already on the decline.
Still, if making an investment today, we would assume that the distributions over the remaining life of these wells will be significant enough to repay our original investment. Hopefully the return will be great enough to be worth our while.
Image source: Getty Images.
Breaking down the return scenarios
We can't really predict the long-term return of a royalty trust because there is no way of knowing oil and gas prices in the future. Instead, we can look at the physical characteristics of the wells and how they will impact the distribution over time. SandRidge presently estimates that the Mississippian Trust II has about 19.9 million barrels of oil equivalent that can be extracted based on today's oil and gas prices. Based on the most recent production numbers, the trust has a reserve-to-production ratio of about nine years. However, and this is where things get a little tricky, that assumes constant production. In reality, the production decline between fourth-quarter 2013 and first-quarter 2014 was 17%, but that was with additional wells producing. Once all wells have been drilled, expect that decline to increase.
For now, though, let's use 17% as a decline estimate and the current annual distribution so 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.
Based on those assumptions, and if oil and gas prices to remain constant throughout the life of the trust, you could be looking at a return of a little less than 90%. Of course, there are likely to be some changes on oil and gas prices over this time, so here's what those returns would look like if prices were to swing 25% in either direction from where they are today.
| Scenario | Estimated Return Over Life of Trust (17 years) | Compound Annual Growth Rate |
|---|---|---|
| Oil & gas prices remain constant | 86% | 3.73% |
| Oil & gas prices increase 25% | 42% | 5.03% |
| Oil & gas prices decrease 25% | 131% | 2.09% |
Based on these projections, an optimistic return on the trust would be an annualized compound return of 3.73%. While that sounds pretty healthy, it doesn't quite meet the annualized return of the S&P 500 -- since 1871, when records were first kept, the S&P has an inflation-adjusted compound annual growth rate of 6.86%. Also, the downside risk is that over that 17-year period, a sharp decline in oil prices would lead to a compound annual return of only 2.09%, which isn't a whole lot better than inflation today.
What a Fool believes
It's impossible to predict the price of oil and gas, which is the risk with royalty trusts, but the long-term prospect of the Mississippian Trust II suggests it's highly unlikely that you will lose money from your investment. That would require oil and gas prices to decline well over 25% during the next 17-year period, and there haven't been many instances where that has happened. At the same time, a 4% annualized return over more than 15 years with very high decline rates at these wells hardly makes it seem like a compelling investment. Bottom line, there are much better investments out there for the long term.
