Dividend investors searching for yield sometimes stray into danger. With microscopic interest rates for money markets and continued low bond yields, income investors have flocked to dividend stocks in the last few years. Many investors push to find higher and higher yields.
When this happens, investors sometimes try to stretch themselves into areas they are less familiar with.
Enter royalty trusts.
Royalty trusts feature similar pass-through income to master limited partnerships (MLPs) and real estate investment trusts (REITs), where royalty trusts pay no income tax as long as they distribute most of the income to “unit holders” (investors). Payments are technically called “distributions” and are similar to dividends..
A key difference between royalty trusts and MLPs or REITs is that trusts don’t own or operate a business; instead, they hold leases or royalty rights, which entitle them to a percentage of profits from that business. Royalty trusts usually are concentrated in oil and gas or mineral rights, and when the underlying assets run out, the trusts are terminated.
The eye-catching appeal for investors is that many of these royalty trusts pay high distributions — some outrageously high, such as 10%, 15% or more.
The questions investors should ask, though, is what’s the tradeoff for such high dividend yields, and are they worthwhile investments?
Royalty Trusts to Sell: Whiting USA Trust (WHX)
Distribution Yield: 89.6%
Whiting USA Trust (WHX) is an oil and gas royalty trust which receives payment from Rocky Mountain, Permian and Gulf Coast assets of Whiting Petroleum (WLL). The units are selling at $2.58 each, and based on the past four distributions, they yield an astronomical 90%!
So what’s the catch?
The trust is scheduled to terminate on March 31. Ergo, WHX has a short life remaining — so regardless of the huge distributions this royalty trust is paying out, investors who get in now won’t make their money back from that income.
This is just the natural life cycle of royalty trusts. Just a few years ago, Whiting Trust’s share price was almost $25 — but as a royalty trust nears the end of its life, the market price begins to reflect the trust’s finite clock.
So ignore the headline yield. This is a dying star.
Royalty Trusts to Sell: SandRidge Mississippian Trust I (SDT)
Distribution Yield: 26%
SDT sold for just over $35 per unit in 2012 and now sells for just under $4. A bargain? Hardly.
In this case, though, it’s not a ticking clock (SDT won’t expire until 2030) — it’s just poor production. Take a look at the falling quarterly distribution, which was $1.086 in August 2011 but just 24.7 cents when it paid out this month, and investors can taste the empty meal of unfulfilled promise.
The Mississippian Trust I has lost more than 90% from its peak, and a quick glance at the Sandridge Trust’s recent press release announcing its distribution payment gives ample clues as to why. The business that SDT stock has a royalty interest in had lower oil production than the trust’s estimates, and no new wells have been drilled since April 2013.
Given that all royalty trusts feature royalties on diminishing assets, lower production itself is not always necessarily alarming. What should concern investors is the rapid decline in production (and therefore royalties), thus the markedly lower distribution. In the case of SDT stock, the depletion of assets along with lower oil production than expected has been dramatic, which has led to a drastic repricing of SDT shares and has demolished the value of the investment.
So yes, SDT also has a mouth-watering headline yield, but again — it has its roaches.
Royalty Trusts to Sell: SandRidge Permian Trust (PER)
Distribution Yield: 29.6%
Another Sandridge trust, another big question mark.
SandRidge Permian Trust’s (PER) current yield is nearly 30%, but here again, lower volumes of sales along with falling global oil prices have worsened the problem with this oil trust.
PER follows a similar pattern as SDT and WHX — shares have declined nearly 65% from February 2012 highs, though the distribution has at least held up much better. Still, the dynamics that have been in play for SDT and WHX (and other oil-intensive trusts) have come into play for the Permian Trust.
In PER’s case, lower production than the trust’s initial estimates paved the way for the unit price to keep shrinking; the trust’s units have fallen by one-third this year.
Royalty trusts can be worthwhile investments, but the speed of asset depletion needs to be more gradual, and the estimates of both production and resource prices need to be accurate. Not all royalty trusts are bad investments — quite the contrary, many are great sources of income — and not all high-yield stocks should be shunned.
But it’s always worth giving a sky-high yield a closer look.
As of this writing, Greg Sushinsky did not hold a position in any of the aforementioned securities.