Recently, Canada’s largest natural gas producer EnCana (ECA) highlighted one of the most ignored ways to profit from the energy sector; ECA announced that they will place around 5.2 million acres worth of oil and gas reserves/wells in Alberta, Canada into a new subsidy called PrairieSky Royalty. EnCana will sell shares of the firm in order to raise some much needed cash. PrairieSky should IPO by mid-June.
The key for ECA and, ultimately for investors, is that the new shares will actually be a royalty trust.
Often overlooked, royalty trusts offer income seekers a chance to get some pretty high dividends.
So what exactly are royalty trusts, and do they below in your portfolio?
A Royalty Trust Primer
PrairieSky won’t actually be drilling for oil or natural gas on its properties, nor will it be transporting it through pipelines. That’s because a royalty trust is an entity that own the production rights on oil wells, natural gas fields or, as in the case of Great Northern Iron Ore Properties (GNI), iron ore mines.
That means other firms do the heavy lifting, and the royalty trust owners sit back and collect fees & mineral rights tied to that production. There’s no growth plan here, since royalty trusts are strictly finance vehicles for the underlying land owners — and as a result, a reliable income stream for investors.
For the owners of the royal trust units, they are treated to some hefty dividends. Like master limited partnerships (MLPs) and real estate investment Trusts (REITs), royalty trusts are designed as “pass-through entities” that get preferential tax treatment because of their business model. As such, they kick-back virtually all of what they earn in the form of distributions to shareholders. And because of that fact, these investment vehicles often yield in excess of 7%.
Another added benefit is that due to depreciation and depletion, distributions from most trusts are not considered income in the eyes of the IRS. These non-income distributions are treated as return of capital and are used to reduce an owner’s cost basis in the royalty trust. Owners are taxed once they sell at the lower cost basis or if that basis hits zero.
Now despite the benefits, royalty trust do come with some risks as well.
The first is, obviously, commodity pricing risk. Many of the royalty trusts underlying fees are tied directly to the prices of oil and natural gas pulled from their lands. If natural gas is trading at multi-decade highs, their cash flows and dividends will reflect that with big paydays for investors. Consequently, if it’s at lows, you’ll see dramatically lower pay-outs. Many trusts monthly dividends fluctuate rapidly based on commodity prices.
Then there is the most important aspect of all: royalty trusts have a finite life span. As finance vehicles, the trusts aren’t allowed to add new acreage or wells to their holdings. That means when the oil and natural gas are gone, they’re gone, too. As the energy is produced and depleted, distributions will fall and eventually hit zero… As will the trusts share price.
Three Top Royalty Trusts
With EnCana only filing the shelf registration for PrairieSky trust, investors looking to add some royalty trust income to their portfolios do have a few options. Here’s three high yielding trusts to consider.
BP Prudhoe Bay Royalty Trust (BPT): BPT is the largest conventional oil and gas trust in the U.S. and was originally formed in 1989 by BP (BP). The royalty trust collects fees on the first 90,000 barrels of oil collected in the massive Prudhoe Bay oil field located on Alaska’s North Slope. While production in Prudhoe Bay have slipped over the last few years, BPT is expected to continue pumping out dividends for another 15 years. This royalty trust yields a very hefty 11% based on the last four distributions.
San Juan Basin Royalty Trust (SJT): Rising natural gas prices have been a boon to SJT as the royalty trust owns natural gas wells located in New Mexico. Units of trust are up around 30% this year on the back of these higher prices. Also up are SJT’s distributions. The royalty trust paid out 4 cents per share per month last year. This May, SJT paid 10 cents- a nice 150% gain in dividends. SJT currently yields over 6% based on the last 12 months of monthly dividend payments.
VOC Energy Trust (VOC): Formed by a private energy firm, VOC owns both oil and gas wells in has wells in Kansas and Texas. The royalty trust owns an 80% net royalty on the wells on its properties. That makes a prime play on rising energy prices- no matter which fuel is doing well. VOC’s royalties will expire at the end of 2031 and yield no terminal value. Meaning shares will go to zero. Yet, VOC features a trailing yield of about 14% based on the last four payments.
As of this writing, Aaron Levitt did not own a position in any of the stocks named here.