How about instead of investing in oil companies, why not just invest in oil directly with oil trusts? Photo credit: Eric Kounce via commons.wikimedia.org

If you are wondering what a oil trust is, chances are you saw the distribution yield on one of them and thought to yourself, "This has to be too good to be true." Oil trusts can be extremely high-yielding investments, especially if purchased at an opportune time. Don't let the fact that they are traded on the major exchanges fool you, because these are not stocks.

Instead, they are a very unique investment vehicle that allows you to invest in the oil and gas industry in a very special way. Let's take a look at what oil trusts are, why you might want to consider one for your portfolio, and what you should look for when investing in oil trusts. 

What is an oil trust?

An oil trust is a method for exploration and production companies to fund the development of a particular field. What they do is designate a certain property that will have a known quantity of wells drilled on it and sell a royalty interest stake from those wells on the open market. The money from that issuance is used to develop the field by the operator. 

In exchange, the owners of the royalty trust are entitled to a percentage of the revenues generated from those wells, minus costs incurred by the operator as well as any other fees associated with the sale of that oil and gas. So unlike investing in a company, you are just investing in a set of oil and gas wells, and the revenue generated by that well is passed on to you directly through cash distributions. 

How big are oil trusts?

Oil trusts are a pretty niche market in the oil and gas world. There are about 20 or so currently traded on the open market, all of which have a market capitalization well under $1 billion. There is one exception, though: the BP Prudhoe Bay Royalty Trust. It is by far the largest royalty trust with a market capitalization well over that $1 billion mark and more than double the size of the second largest trust.

How do oil trusts work?

Shares of an oil trust are bought and sold on the stock exchange just like any other company, but that is where the parallels between the two end. When you buy a unit of an oil trust, you are buying a share of the revenue from wells. No more, no less. Unlike investing in a company that can explore new regions and drill new wells, once all of the predesignated wells are drilled and producing on the trusts' acreage -- that's it.

The trust will continue to pay you a distribution on a quarterly basis depending on how much oil and gas these wells produce until the trust meets its terms of termination. These terms are either a predetermined date or certain financial covenants, such as minimum revenue generation. Once these terms are met, the royalty interest on the wells is sold -- typically back to the operator -- and investors receive a distribution of the residual value from the sale. 

The benefits of owning an oil trust are that they traditionally pay out huge cash distributions per quarter, they are tax-advantaged investments that allow you to defer taxes, and you can also be eligible for certain tax credits. The drawbacks of owning one, though, is that you will probably need to spend a couple extra hours doing paperwork come tax time, you will likely need to pay state taxes where the trust property is located, and -- most importantly -- you are directly exposed to the whims of commodity prices, which can mean those distributions can change wildly from quarter to quarter. 

What are the drivers of oil trusts?

Two very simple things: commodity prices and geology. 

There is no way of really knowing where oil and gas prices will go in the future. There is a myriad of factors, ranging from simple supply and demand to complex geopolitical events that can sometimes spring out of nowhere. So don't fall into the trap of oil price speculating by using oil and gas trusts because you can get burned.

To invest in oil trusts over the long term means that you need to tune out lots of these factors and focus on these things when it comes to oil prices: demand for oil has grown at a pace of 2.2% annually since 1965; the cost per barrel around the world is increasing as the easier-to-access oil and gas sources are becoming fewer and farther between; and then there is the simple inflation. These will help settle the stomach when oil prices fly all over the place in the short term.

Then there is the geology of the formation you are buying as part of the trust. The largest determinants on the long-term success of the trust are the total recoverable resources in the field, the production mix in the field, and the decline rate of production. Investors shopping for an oil trust should keep a lookout for these three factors before making any purchase. 

Tyler Crowe has no position in any stocks mentioned. You can follow him at Fool.com under the handle TMFDirtyBird, on Google +, or on Twitter, @TylerCroweFool. 

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