November 13, 2009

Investing in Oil Royalty Trusts

A while ago I talked about some potential investments that I was looking at buying. One of the investments was an oil trust. At the time I didn't go into much depth about how investing in an oil trust works or how you might go about picking such a trust to buy. Today I'll cover those topics.

But first, what is an oil trust?
Wikipedia has a page on oil trusts that discusses them at some length. Or you can refer to investopedia's definition. But in short: an oil trust is a financial company that owns the rights to oil or natural gas in the ground and then gets paid for oil produced from their property, the payments are then distributed to share holders in the trust. An oil trust is a good way for an individual to invest directly in oil or natural gas. Oil trusts may own oil and / or natural gas. Most of them own both oil and gas.

Why invest in an oil trust? The key benefits of an oil trust is that you get a high dividend payout and you can profit from an increase in the price of oil. Investing in an oil trust is a hedge against energy prices as well as a direct investment in energy commodity.

How do you value them? To determine which royalty trust is a 'good' buy you have to know how to value them. Determining what the value is of a royalty trust is very different than valuation of a normal stock. When you buy a normal company stock you buy a business that makes stuff or sells a service. So with a normal company you can look at their income and debt and growth and earnings all as indicators of the health of the company. Royalty trusts are very different, they don't have employees or debts and their production is almost pure profit. But they are a depleting asset which means they are selling something that will eventually run out. The return on a royalty trust will depend on two key things : 1) the market value of the asset and 2) the amount of asset they own. Therefore its my opinion that you should be able to value a royalty trust primarily based on the current market value of their assets. In otherwords if you figure out how much oil or gas they have and find its current market value then that is the value of the trust.

So lets look at a few trusts and compare them.

Here are the list of oil and natural gas royalty trusts that I found:

BP Prudhoe Bay Royalty Trust (BPT) - SEC filing
Cross Timbers Royalty Trust (CRT) - Web Site, 2008 annual report
Mesa Royalty Trust (MTR)
Hugoton Royalty Trust (HGT) - Website, 2008 Annual report
San Juan Basin Royalty Trust (SJT) - 2008 annual report

I gave links to their website and annual reports if I could find them.

For each of the trusts I found their current dividend yield, price, 5 year dividend average, market cap and I attempted to calculate the present cash value of their oil & gas reserves. To find the reserves I had to search through their annual reports so for these cases I'm looking at the reserves at the end of 2008 which is the most recent data. For the current market values I used the current oil price of $79 per barrel from Bloomberg and $4.46 per cfm for natural gas. Those are volatile numbers that go up and down every day. The yields are a current snap shot based on the most recent dividend. Yields for trusts bounce up and down based on market conditions. So if oil goes up then the yield goes up.

In the table below I give the stock symbol for each trust, its current dividend yield, the 5 year average yield and the right column is the cash value of proven reserves / market cap (R / M).

Yield 5y avg R / M
BPT 8.8% 11.20% 2.5
CRT 7.4% 9.60% 1.4
MTR 7.5% 8.30% ?
HGT 6.8% 10% 2.6
SJT 6.2% 8.30% 0.7

I couldn't find enough info on MTR so I may as well cross that off the list. It seems that the reserves of SJT are lower than their market cap. BPT and HGT are the two that stand out as the best overall. They both have high reserves relative to market cap and they both have double digit 5 year average yields. If I'm to pick a winner from this analysis then BPT would be my choice as they have highest yields and very large reserves.

I only reviewed a few royalty trusts here because these were the ones I was able to find first. The Wikipedia page has a longer list and I may do the research on all of those royalty trusts as well.

A couple more important points about oil trusts.

Taxes on royalty trusts could get pretty complicated. The dividends are taxed as normal income but they may be treated as a depleting resource so you get to deduct that. Normally you'd have to file a schedule E for the costs and depletion deductions and a schedule B for the dividend income.
This guide from CrossTimbers Royalty Trust discusses taxes and calculation of depletion. It might be a good idea to consult a tax professional and have them figure this if the dividends are taxable. If the royalty trust is in a retirement account then you don't have to do the paperwork.

It all depends on the price of oil & gas. This may go without saying but investment in an oil trust is completely dependent on the market price of oil & natural gas. If you buy an oil trust you're betting that oil or gas will at least retain its value or hopefully go up in the future. This seems like a safe bet to me.

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