by Jeff Reeves | July 31, 2012 6:00 am
“What are your thoughts on the BP Prudhoe Bay Royalty Trust (NYSE:BPT)? A number of articles have come out as to how bad this investment is but quarter after quarter and year after year the yield has held and the price has as well.”
It was only a matter of time before royalty trusts started popping up again. These mega-yield players are always sought after when times are tough and interest rates are low – but they are not without risk.
The short answer: Like MLPs, royalty trusts are attractive because the companies enjoy big tax breaks and pass on big dividends – in the case of BPT, over 8% based on its last four payouts. Used correctly they can be a dividend goldmine. And in this environment, parking your cash in BPT for a year or even two could be a very wise move.
But before you dive in, understand that this is not like playing common stock. There are complicated tax rules; you get a K-1 like an MLP.
But most importantly, these trusts have a finite shelf life. Royalty trusts like BPT will literally all disappear two or three decades down the road.
The bottom line is that royalty trusts are worth little more than the underlying reserves. In the case of BPT, there are no oil rigs, no employees, no nothing on the balance sheet — just a well of crude oil in Alaska.
That’s it. Period.
Royalty trusts often bear the name of an energy company that services them – in this case, the oil major BP (NYSE:BP) – but they are wholly separate when it comes to dividends and share pricing. The operations of a trust are simply the profits made as the energy or minerals are extracted and sold. And as a tax-free pass through instead of a corporation, these aren’t really stocks in the conventional sense. They are simply a vehicle for the profits to trickle through to shareholders (technically “unit holders”) as dividends (technically “distributions”).
As you can understand, that means royalty trusts are a pure bet on commodity prices. In the case of the BP Prudhoe Bay Royalty Trust, it is driven by how much crude oil is extracted and how much the market price is when that crude leaves Prudhoe Bay. Logically if crude oil is going up in value then the trust goes up as it sells its oil for more on the open market, and vice versa.
For a commodity play, you can’t do better. The Eca Marcellus Trust (NYSE:ECT) is almost 100% natural gas, and thus lives and dies by the price of gas. Some trusts are a mix of energy sources. Some like Great Northern Iron Ore Trust (NYSE:GNI) do metals. But all are locked to the price of their underlying assets and how much of those assets they produce each quarter.
There’s one catch, of course. Royalty trusts are also called “depletion trusts” because as they have a finite life cycle. After they extract all the oil or gas from the ground they are literally worthless – shares go to zero, dividends stop, game over.
So you better be darn sure you know how long a royalty trust is going to be around before you buy in.
I’ll repeat that: These investments will go to zero eventually. You cannot ignore this if you want to buy a royalty trust.
However, most investors can mitigate this very easily by simply sitting in a trust while reserves are plush and the depletion date is far down the road. There is never a precise count on reserves and estimates fluctuate, but building in cushion ensures you won’t get burned.
All this information is available in quarterly reporting from the trusts to shareholders and the SEC.
The other big risk, of course, is commodity volatility. If oil prices crash then the BP Prudhoe Bay will see distributions crash too and there’s nothing you can do about it.
And I’ll reiterate that a minor risk, as mentioned above, is the tax complexity of these trusts. You get a special K-1 form for your taxes and often you have to file state income tax for the region in which the trust operates. This can be burdensome if you do your own taxes. Most of us mitigate this by going to a trusted CPA every April, but it must be noted here all the same.
So the only thing we must ask ourselves, really, is whether we think oil prices will stay firm and whether BPT has enough reserves underground to make it worth an investment.
Admittedly I do not believe that oil will firm up significantly anytime soon – check out my recent analysis of Transocean (NYSE:RIG) for more on that – so I would be reluctant to project significant increases in distributions due to a surge in crude.
However I don’t think prices will crash anytime soon, and that means you can have faith in the history of distributions as long as they can keep up output.
The million dollar question, of course, is reserves. How long can this run last? Well, as of the 2011 annual report the trust said it had 73.476 million barrels of proved developed reserves and another 8.828 proved and undeveloped reserves. Annual production is about 5 million barrels, and waning slightly each year, prompting a depletion date of around 2025 for BPT according to internal estimates.
According to a recent SEC filing, BPT garnered an average oil price of $93.92 in the first quarter which led to a distribution of $2.31. If you think oil will stay in the low $90’s then simply annualize this to $9.24 a year and you get a roughly 8% yield on current prices.
Not bad at all. And even if production is waning slightly, a 7% or even a 6% yield is mighty attractive in this market. If you can hang on to BPT for a dividend like that and then move your principle back out at break-even in a few years, that’s a mighty nice proposition.
The big risk, of course, may be share prices. BPT has run up over 40% since January 2011 not because of surging distributions but more because of a run on high-yield investments. A cut in the payouts or the rise of a more attractive asset class could cause prices to collapse in a hurry. But with the market choppy and the Fed keeping rates low through 2014 that seems very unlikely near-term. Shares should hang tough as long as investors are looking for high-yield, low-risk opportunity.
Just be aware that when the tide shifts away from dividend stocks, you don’t want to be the last one out of BPT. When income investors start to seek growth again and as depletion takes its toll, this stock could hit a wall.
But that wall seems two years or more down the road. Considering the dearth of alternatives and the importance of dividends right now, I think BPT may be a decent place to park some cash for a year or two – presuming you have an accountant to deal with the tax burden.
Do you have a stock that’s on your mind? Drop me a line at email@example.com and I’ll take a look at it.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.
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