What's better than an investment that sends you a quarterly dividend check, why one that sends you a check on a monthly basis of course. For those looking for monthly income, royalty trusts such as the Hugoton Royalty Trust (NYSE:HGT) seem like very lucrative investments. After all, an investment in the Hugoton Trust has more than doubled the S&P 500 on a total return basis -- stock price plus dividends -- over the past 15 years.
There is a catch when it comes to investing the Hugoton Royalty Trust, though. First off, it isn't a stock, so you need to change your thinking. Let's take a look at the Hugoton Royalty Trust to see how it differs from most investments on the market and whether it is the type of investment for your income portfolio.
What's a Royalty Trust anyways?
Before we get into Hugoton Royalty Trust specifically, let's get a few things clear about royalty trusts. Trusts are neither a company's stock nor a traditional stock. By buying shares of a trust, the investor is an equity owner in an oil and gas producing property and are entitled to a certain percentage of the revenue from the producing assets on that property.
One advantage of owning a trust is that they are exempt from corporate taxes because they are pass-through entities. However, unlike other pass-through entity investments, distributions from royalty trusts are taxed as a capital gain instead of as individual income. Also, you get the benefits of depreciating those assets to lower your cost basis to delay taxes.
The disadvantage to this position, though, is that the success of a trust is completely dependent on the price of oil and gas. Unlike owning an oil and gas company that can do things such as change capital allocation or use futures contracts to even out earnings, royalty trusts sell all of its oil and gas on the open market. Also, once the oil and gas production on a trusts property dries up, it meets its termination conditions -- usually a set date in the future or a minimum royalty amount -- and is then liquidated and the sale value is distributed to the unit holders in the trust.
The Hugoton Royalty Trust, specifically
There is one aspect that really sets the Hugoton Royalty Trust apart from many other royalty trusts out there. It is the one of the very few royalty trusts that its production is very natural gas heavy. In the most recent quarter, more than 93% of the trust's production came from natural gas. This is expected since the trust's properties -- the Hugoton Basin in Kansas, the Anadarko basin in Oklahoma, and the Green River Basin in Wyoming -- are all mostly known for natural gas production.
Aside from production mix, there are two other important factors to consider when looking at royalty trusts: The estimated production left in the trust, and the payback period. This trust has been around for a while, and the fields within the trust are pretty much all developed. Over 87% of the trust's properties are proved, developed reserves, and based on its current production rate and the proved reserves left, it will take about 10 years before the field is completely depleted. One thing to consider with this number, though, is that production decline rates could extend that time frame, and higher gas prices could mean that some parts of the field that are currently considered uneconomical could become available later on.
To effectively invest in a trust, you need to compare this shelf life to the payback period of the trust, which is how long it will take until the cash distributions will pay off your original investment. Based on today's current yield of 11.9%, it will take just under 8.5 years to pay back your original investment. However, this dividend yield is based solely on the price of natural gas over the past 12 months, and if natural gas prices were to swing big in one direction or another it could drastically impact the dividend payments of the trust.
What a Fool believes
As these past few months have shown, investing in royalty trusts can be difficult. Without a company behind these trusts making decisions on capital allocation or production, royalty trusts are left swinging in the winds of oil and gas prices. If you want a consistent monthly income check, royalty trusts simply aren't the place for you. For those that can afford the volatility and can simply sit on the investment and buy more shares after each royalty payment, picking the right trust can be a very lucrative investment.
Based on the fundamentals of the Hugoton Royalty trust, it has enough gas left in the tank and its current dividend payment that it will likely be a net positive investment. However, that equation could change very fast if natural gas prices were to go any lower than they currently are for an extended period of time.