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Would High Yield Royalty Trusts Deplete A Retirement Portfolio?

 November 10, 2010 02:00 PM

As our population ages, the quest for income to fund retirement has never been greater.  With interest rates at or near all-time lows, the traditional fixed income option does not provide enough yield to meet the needs of most people desirous of living off their portfolio income.  Consequently, investors are compelled to search out alternative options. 

Royalty Trusts are an option that on the surface offers enticing yields.  However, closer scrutiny may tell a very different story.  Therefore, the purpose of this article, to rephrase a famous Waylon Jennings song lyric, is to enlighten investors so that they are not looking for yield in all the wrong places.

In our previous article in this series we covered Master Limited Partnerships s (MLPs) that primarily invest in the energy sector.  Investing in energy assets is one thing that Royalty Trusts have in common with Master Limited Partnerships s (MLPs).  But Royalty Trusts are really not operating businesses, instead they are financing vehicles.  Therefore, Royalty Trusts are typically run by banks. 

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Although they trade like stocks, they have no management and no employees.  Specific energy assets, which typically might be oil, coal and or natural gas are placed into the trust. 

Even though the Royalty Trusts we will cover in this article trade on the New York Stock Exchange, technically they are not a stock, instead they are investment trusts.  They buy the right to receive royalties on the production and sale of natural resource assets and then pass on the profits to the trust unit holders (shareholders).

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Just like any other trust, a Royalty Trust is a legal instrument that is created to hold assets for others.  Therefore, a typical Royalty Trust is a legal entity that holds ownership of an asset (asset-backed security) and passes through the income to its investors known as unit holders. 

Consequently, in contrast to a Master Limited Partnership (MLP), the Royalty Trust can be thought of as a direct play on the underlying commodity the trust holds.  Therefore, the distributions (dividends) can vary wildly as they are directly tied to the market prices of the underlying assets.

A simple way for investors to think about their Royalty Trust holdings is that they are just like owning their own oil wells (assuming of course that the trust owns oil wells).  However, it's also important that the investor realizes that they own a finite amount of the resource.  Every time a barrel of oil is produced, there is one less barrel securitizing the trust assets.  Of course, in the energy sector this is known as depletion.  So long-term investors in Royalty Trusts need to understand that once all the oil is produced, the asset is gone, and so is the value of their holding and the dividends.

Even though the typical Royalty Trust owns a finite amount of the underlying natural resource, they are often designed to produce income for periods of up to 10, 20 or even 30 years.  Also, since the trust is designed to essentially pay out all of its income to shareholders, the distributions can be very substantial.  Over time, the unit holder might receive multiples of cash distributions over and above their original investment.  To a great extent, this will depend on the price performance of the underlying assets. 

During times of rising prices, trust unit holders can expect high and rising yields.  Of course, the opposite is also true.  Consequently, many Royalty Trusts have seen their distribution yields fall with energy prices over the last few years.

Yields Tied to Commodity Prices

The following graphs reflect the price of oil and natural gas since November of 2005.  With oil peaking in early 2007 and natural gas prices peaking in the fall of 2007 there was a direct effect on the yields of Royalty Trusts that invested in oil and gas.

The following F.A.S.T. Graph™ on the Permian Basin Royalty Trust (PBT) plots the cash distributions (dividends) for this Royalty Trust since calendar year 2005.  Note how closely the dividends (blue shaded area) correlated to the price of oil in the above crude oil price graph.

PBT 6yr. Earnings and Price Correlated F.A.S.T. Graph™

The following F.A.S.T. Graph™ on the Hugoton Royalty Trust (HGT), which predominately invests in gas producing properties, offers a similar correlation of its dividend (blue shaded area) to the price of natural gas as seen in the above natural gas price graph.

HGT 6yr. Earnings and Price Correlated F.A.S.T. Graph™

The primary points of the above graphic presentations were to illustrate the direct relationship between the cash distributions that a Royalty Trust will pay to trust holders and the price of the underlying asset.  The distribution rate (dividends) of both trusts rose and fell in close to direct proportion to the rise and fall of the prices of each respective trusts underlying asset base.  At the bottom of each F.A.S.T. Graph™ you can see the dividend rate, and just above it the rate of change from one year to the next (Chg/Yr).

Depleting Assets-The Risks

In addition to the risk of volatile yields, depletion is another potential negative that Royalty Trust unit holders face.  Although wide swings in commodity prices and/or production levels can create very inconsistent distribution levels, these same factors can also cause significant changes in the current value of a Royalty Trust.  Later in this article we will present examples of Royalty Trusts that richly rewarded their unit holders over intermediate to long periods of time.

However, first we will review Torch Energy Royalty Trust (TRU) which was formed effective October 1, 1993 and holds net profit interests in oil and gas properties in the Chalkley Field in Louisiana and the Robinson Bend Field in Alabama.  This is a trust that has recently announced that it would be terminated and is currently in the windup and liquidation process. 

When looked at through the lens of our F.A.S.T. Graphs™ a couple of things become very clear.  First of all, the risk of depleting assets can be vividly seen in graphic form. Next, a review of the performance F.A.S.T. Graph™ shows that the trust did not provide returns that unit holders may have expected when they first invested. 

TRU 17yr. Earnings and Price Correlated F.A.S.T.

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