Oil prices continue to their seemingly endless crash as the global glut of supply shows no sign of letting up.
This has resulted in shares of high-yielding oil royalty trusts such SandRidge Permian Trust (NYSE:PER), and BP Prudhoe Bay Royalty Trust (NYSE:BPT) taking it on the chin and declining by 31% to 51% over the last six months.
There are two particular reasons I would recommend income investors avoid the siren song of these royalty trusts.
Royalty trusts are decaying assets
The first problem with royalty trusts is that they are designed as limited life span entities that own a fixed and non-growable set of oil and gas assets and pay a distribution stream from the royalty stream of that production, which naturally declines over time. Unless a sponsor is willing to invest in new wells to increase production then only rising commodity prices can increase a royalty trusts' distributions. If oil prices drop, as they are now doing, then the distributions investors receive will decline rapidly, as will the value of the trusts units.
However, the worst thing about royalty trusts is that their limited lifespan can result in long-term losses.
Investing in royalty trusts means racing a ticking clock
The SandRidge Permian Trust is set to be liquidated on June 30, 2031, at which point the remaining assets will be sold, and unit holders will receive 50%.
The BP Prudhoe Bay Royalty Trust will exist until annual royalty payments decline below $1 million for two consecutive years, at which point all assets will be sold and divided among unit holders. While this may make it seem like both of these trusts have a good, long while before their royalty stream dry up, in fact, that is not the case.
For example, SandRidge's Permian Trust has just eight years left of oil at its current production rates. In addition, according to the Trusts' prospectus, SandRidge Energy Inc (UNKNOWN:SD.DL), the trusts sponsor, is nearly done drilling new wells. SandRidge Energy was obligated to drill 888 development wells for the Trust and as of the end of the third quarter, has completed 847 of these. At its current drilling pace, the last new well will be drilled during the first quarter of 2015, after which oil production could decline at up to 78% in the first year.
What's even worse for investors in SandRidge Permian Trust, at the end of 2015, SandRidge Energy's 13.125 million subordinated units will be converted to common units, which will represent substantial dilution for regular investors. That's because the subordinated units are paid at only 28% of the rate of common units, yet represent 33% of the total outstanding units. When the conversion is complete, it will mean each common unit will be entitled to 24% less distributable cash flow than before.
Add in the fact that the trust's hedges run out in the first quarter of 2015, and you have a combination of four painful factors that are about to come crashing down upon SandRidge Permian Trust investors' heads. Oil prices are cratering, new well drilling is about to come to an end, protective hedging is about to run out, and 24% payment dilution is coming at year's end.
Meanwhile the fact that SandRidge Energy has already sold 42% of its original stake in the Trust doesn't bode well for the company's willingness to invest in new drilling to increase production once its legal obligation is complete. Nor, for that matter, do SandRidge Energy's worsening financial and debt problems.
BP Prudhoe Bay Royalty Trust has a better sponsor, but is still likely to lose money for investors
BP Prudhoe Bay Trust is structured differently than SandRidge Permian Trust, which has proven beneficial to unit holders over time. For example, BP (NYSE:BP) owns 26% of the oil rights in the field, and the royalty trust owns 16.4246% of the BP's cash stream generated from this oil. Well -- almost. In fact, the royalty trust's royalty per barrel is the value of West Texas Intermediate oil minus the cost of production that's multiplied by a cost adjustment factor that increases each year at the rate of inflation.
In theory, this setup is better than SandRidge Permian Trusts because BP keeps over 83% of any incremental revenue its portion of the field generates. Thus, BP is incentivized to keep increasing production, which hopefully means higher distributions for royalty trust investors, and indeed, in 2013, BP announced it would invest $1 billion into two new rigs to increase the field's production.
However, there are two reasons I believe long-term investors will still lose by investing in this royalty trust.
Cost-adjustment factor will swallow royalty payments
As this chart shows, in July of 2014 BP's production cost was just $16.9/barrel, yet it was able to deduct $30.96/barrel from the trust's royalty per barrel thanks to the cost-adjustment factor.
BP estimates its reserves in this oil field will last 14 years at current production rates, so let's assume 2% inflation and see what this would mean for trust investors over the next few years.
|Year||Cost Adjustment Factor||Cost/Barrel (Adjusted 2% for Inflation)||Adjusted Chargable Cost||Royalty/Barrel Assuming $100/Barrel Oil and 18.6% Tax Rate|
As this table shows, by the time BP estimates its reserves in Prudhoe bay will be depleted, the amount of royalty per barrel the trust is receiving will be 36% lower than today thanks to the exponentially growing cost-adjustment factor.
The second reason I think long-term investors might potentially lose money on this trust is the work of my Motley Fool colleague, Tyler Crowe, who, back in June, crunched the numbers to see what kind of return investors might expect from this trust if the average cost of oil declined by 25% to $75/barrel. The answer was approximately an 18% return over the next 15 years, which comes to 1.1% per year, less than the 2.26% rate of inflation over the past decade.
With oil prices now down 50% and still dropping, and global economic growth slowing, Goldman Sachs is predicting that the long-term price of oil may settle around $80/barrel. Given the accelerating cost adjustment factor that trust investors must deal with, should oil prices remain at or near $75/barrel over the next 15 years, I think there's a very good chance that long-term investors in this trust will end up losing money, if only to inflation. However with many high-quality, high-yield oil and gas MLPs to choose from, I wouldn't recommend income investors settle for such lackluster returns.
Bottom line: oil price crash means great bargains available, just not in these two royalty trusts
Investors may see the recent oil crash and plunge in oil stocks, MLPs, and royalty trusts as a great opportunity to "be greedy when others are fearful." However, in my opinion, the liquidation time frames of royalty trusts as well as the fact that they represent fixed assets that aren't allowed to grow, makes them poor long-term investments. Income investors seeking to take advantage of the oil crash should look elsewhere for undervalued long-term income opportunities in the oil industry.
Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.