Oil prices have finally taken a break from their seemingly non-stop crash over the last few months, which has sent prices of oil royalty trusts like BP Prudhoe Bay Royalty Trust (NYSE:BPT) soaring.
However, there are two reasons I'd like to warn investors to stay away from what is, in my opinion, one of the worst ways to profit from oil prices' eventual long-term recovery. Instead, I submit that Linn Energy (NASDAQ:LINE), or its C-Corp holding company LinnCo (NASDAQ:LNCO) make for far superior long-term, high-yield investments.
Why high-yield investors should avoid BP Prudhoe Bay Royalty Trust
My argument against BP Prudhoe Bay consists of two parts. The first is that royalty trusts in general go against what I think is the ideal way investors should build long-term wealth -- that is, buy-and-hold investing in assets that grow over decades. Royalty trusts own a fixed asset that cannot grow over time and are often set to expire within an allotted time period.
For example, BP Prudhoe Bay will liquidate its assets once annual royalty payments dip beneath $1 million per year for two consecutive years. According to the 2013 annual report, the trust expects this to occur in 2029, meaning new investors have just 14 years to earn a decent return before their investment is liquidated.
A hidden danger in the way royalties are calculated
As this table shows, BP calculates its trusts per barrel royalty rate to the trust by using a cost adjustment factor that grows with inflation, multiplied by a metric known as "chargeable cost." Theoretically, this is supposed to ensure that BP accurately adjusts its royalty payments based on the inflation-adjusted cost of production, which seems perfectly reasonable.
However, if one looks at BP Prudhoe Bay's previous 10Qs, one finds that the adjusted chargeable costs are growing far greater than the rate of inflation. In 1994, the adjusted chargeable cost per barrel was $7.96 per barrel. Twenty years later, it was $30.15. Inflation during that time period was a cumulative 59.74%, or 2.37% per year, yet BP Prudhoe Bay's adjusted chargeable cost increased at a rate that was 190% faster, or 6.89% per year.
In fairness to BP, oil prices over this time period increased by 9.4% annually, and rising oil prices tend to increase production costs because higher demand for oil services can increase production costs. That being said, investors who view royalty trusts as a way of "profiting from rising oil prices" should be aware that the way this trust's royalty payments are calculated -- if oil prices recover into a long-term rally -- could possibly continue to push up BP Prudhoe Bay's chargeable cost in a manner that decreases their benefit to such a trend.
Why Linn Energy makes a much better alternative
Long-term income investors should look at oil and gas producing MLPs over royalty trusts for two reasons. The first is inherent in their business model. Because MLPs can purchase new assets through accretive acquisitions, their distributions are more likely to rise over time than those of royalty trusts, whose production is guaranteed to eventually decline to near zero.
While they may periodically be forced to cut the distribution in the event of an oil crash, as Linn Energy recently had to do; the potential for distribution growth via asset acquisition makes for both a superior business model, and a potentially superior long-term investment.
However, there is a more specific reason I have for singling out Linn Energy as a great long-term income choice. Its management has shown a knack for making smart, strategic deals to increase production while lowering decline rates and minimizing drilling costs. Now Linn is embracing innovative financing through a partnership with GSO Capital, an affiliate of the Blackstone Group (NYSE:BX).
Under the terms of the deal, GSO and Linn Energy will form a joint venture called Drillco. GSO will provide up to $500 million over the next five years to fund additional drilling on Linn's acreage, and it will receive 85% of the cash flow from this new production until it's repaid 115% of its invested capital. At that point, Linn Energy will receive 95% of the remaining cash flow until the new wells run dry.
According to Linn Energy CFO Kolja Rockov, this form of non-debt, non-equity deal may play a role in helping Linn acquire massively undervalued, high-quality oil assets with similar no-risk, no up-front capital terms. If such deals can be struck then Linn Energy may have found a highly cost effective way to continue growing its asset base, DCF, and distribution, which in my opinion makes it one of the better long-term income investments for profiting from rising oil prices.
Bottom line: Royalty trusts make far inferior long-term income investments in recovering oil prices
Royalty trusts by their very nature are limited in their ability to increase cash flows because they aren't allowed to grow their asset base. BP Prudhoe Bay's long-term returns have been most impressive, however its relatively short remaining lifespan means that, going forward, it's likelihood of matching anything close to those returns is far less.
Meanwhile, oil-producing MLPs like Linn Energy have a proven track record of growth through asset acquisition and innovative financial deals like the recent DrillCo agreement make, in my opinion, for the potential for strong distribution growth -- especially if oil prices recover in the long term.
Adam Galas has no position in any stocks mentioned one day hopes to invest in Linn Energy. The Motley Fool owns shares of The Blackstone Group L.P. 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.