by Aaron Levitt | January 19, 2012 1:59 pm
Investors typically see the energy sector as a way to add capital gains to a portfolio. After all, with oil prices continuing their latest rise, various exploration and production (E&P) firms have seen their share prices surge lately.
While all this price appreciation is certainly great, investors looking for much-needed income are often left out in the cold when it comes to the energy patch. High capital expenditure requirements needed for drilling and exploration often leave energy firms paying little in the way of dividends. The broad-based Energy Select Sector SPDR (NYSE:XLE[1]) yields only around 1.5%, and most oil and gas firms pay nothing. Only the largest integrated energy companies, such as Conoco (NYSE:COP[2]) with a 3.8% dividend, offer a respectable payout.
However, as the U.S. shale boom continues to draw investors in, there are new ways for portfolios to gain some valuable income from the sector. To raise money for capital spending, a variety of E&P firms have now begun to monetize their assets as royalty trusts. And these trusts could be exactly what investors need to fulfill their income requirements.
While master limited partnerships[3] (MLPs) have gained in prominence over the last few years as baby boomers have begun to retire, American royalty trusts are mostly ignored. Unlike their Canadian cousins, American trusts generate dividend income from the development of natural resources such as coal, natural gas, and crude oil. These cash flows are subject to the prices of the underlying commodity. If oil, coal or whatever is at all-time highs, the dividends will reflect that fact.
The trusts are strictly finance vehicles with no production operations, and their corporate tax structures require that essentially all of the royalty income received must be paid to unit holders. This results in big distributions for investors.
For several years after the last royalty trust went public in 1999, no new trusts were issued. But over the last few years issuance has exploded, and 2011 saw the birth of three trusts. Analysts expect that more firms will raise money via this security type in order to tap into the vast abundance of shale gas and oil.
SandRidge Energy (NYSE:SD[4]) has been one of the most prolific issuers of the security type. The E&P firm recently raised significant capital by issuing two trusts, the SandRidge Mississippian Trust (NYSE:SDT[5]) and SandRidge Permian Trust (NYSE:PER[6]). More recently, SandRidge filed to raise up to $604 million by offering a new trust in its 1.5 million acres in Mississippi[7].
SandRidge is already the leading player[8] in the Mississippi’s Lime formation, and its first Mississippian Trust has been dynamite for investors. Production in the region jumped more than 650% in the third quarter 2011 versus 2010, and the trust’s 37 wells have performed admirably.
In addition, SandRidge is expected to drill an additional 123 wells in the region, and the trust will receive 50% of those royalties[9]. So far, distributions from the trust have exceeded expectations due to higher oil prices, resulting in a juicy distribution yield of 11.5%.
SandRidge’s newer Permian trust investors get access to an 80% royalty interest in 509 developed wells located in West Texas. Like its sister trust, the E&P firm plans on drilling nearly 900 more wells in the region, in which the Permian trust will get a 70% interest in. PER currently yields 13.5%.
If there was a major natural gas find over the last few years, odds are Chesapeake (NYSE:CHK[10]) was a part of it, and the firm’s rush to monetize assets was no different. It IPO’d its Granite Wash Trust[11] (NASDAQ:CHKR[12]) in November and currently covers 69 wells in western Oklahoma. Chesapeake plans on drilling an additional 118 wells for the trust.
Already, sales and production volumes and realized prices have exceeded expectations, and the trust was able to increase its initial distribution by 7%. Currently, units yield 10.1%, but investors could be in for more dividend increases as the trust really ramps up.
As the surge of drilling activity continues in America’s shale basins, firms needing to raise money are increasingly turning to royalty trust structures. For investors, these often-ignored security types can provide much needed income and offer a portfolio component outside capital gains. The previous three trusts are great place for investors to start their energy income prospecting.
Aaron Levitt doesn’t hold any of the securities mentioned here.
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