Rising energy prices are a headache for consumers, but a boon for energy producers. How can a small investor get in on it?
For most, drilling a well in the backyard is not an option. The obvious alternative is to buy stocks in energy companies like Chevron Corp. (ticker: CVX) or British Petroleum (BP). But that’s not a pure investment in energy itself, because so many other issues affect stock prices.
Those who want to work hard and can stomach a roller-coaster ride can trade futures contracts, betting on price moves by buying or selling barrels of oil, tons of coal or cubic feet of natural gas.
But there’s another way: investing in royalty trusts, which pass on income from oil and gas fields, coal mines or other commodities. Royalty trusts are similar to master limited partnerships, as both are traded like stocks and offer sizable income and favorable tax treatment.
“Investors who find themselves in higher tax brackets should examine these two options closely as they can present tax savings,” says David Hryck, partner at Reed Smith law firm in New York City.
[See: The 10 Best REIT ETFs on the Market.]
The chief difference: while MLPs own infrastructure like pipelines, storage tanks and refineries, royalty trusts own the rights to cash flow from production facilities themselves, like wells and mines. Rather than owning a share in an oil well, you could own a share of the income the well produces. That income should rise as energy prices go up, while MLP earnings are buffered from price fluctuations because pipelines, storage and processing facilities keep working and earning fees, whether prices are high or low.
“It is common for numerous oil and gas producers to sell their producing assets to a royalty trust,” Hryck says. “By doing this, the company has created a revenue stream that investors can then buy into. From there, all the royalties produced in the trust are distributed to the shareholders as income. Simply put, purchasing into a royalty trust is like purchasing specific cash flows.”
Another specialist sees a closer relationship between royalty trusts and energy prices.
“Royalty trusts do not have employees, and one should consider them as an intermediary, being they are run by banks,” says Aaron Gilman, president and chief investment officer at IFP Wealth Management in Tampa, Florida. “MLPs provide for active management and royalty trusts are passive in nature. The price of a royalty trust should also be somewhat more correlated to the price of energy, as compared with MLPs. ”
Dividend yields can be substantial. Currently, ECA Marcellus Trust I (ECT) pays nearly 12 percent. ECT owns royalties for 14 horizontal gas wells in the Marcellus Shale formation, which stretches from New York to West Virginia.
A list of 21 trusts compiled by the dividendyieldhunter.com website shows seven yielding more than 10 percent, with many of the others in the high single digits.
Of course, there is risk. As with other dividend-paying investments, an unusually high yield may signal trouble. Since yield is dividends for the past 12 months divided by today’s share price, yield goes up when the price falls, and a company with problems may earn less in the future, while investors’ enviable dividend earnings may be offset by falling unit prices.
Fortunately, with royalty trusts, the firm cannot cut the dividend to use its cash another way, because the rules require that almost all cash flow be passed on to shareholders. But the dividend will fall if the trust receives less for the resource it sells.
Daniel L. Grote, certified financial planner with Latitude Financial Group in Denver, says royalty trusts are a good alternative for people who might otherwise use futures contracts to bet on energy prices.
[See: The 10 Best Materials ETFs We Could Dig Up.]
Unlike futures contracts, royalty trust units have no short-term expiration date, so the investor can ride out a downturn just as one can do with a stock. But the unit price will drop if energy prices go down and royalty trusts do not keep paying forever.
“While the dividend yield can be strong, the share price of the royalty trust will fluctuate generally like a stock and with a direct correlation to the underlying commodity” Grote says. “With that, it is generally also important to understand that commodity prices are generally more volatile than blue-chip stocks, so there is a risk premium measurement one should consider.”
Commodity investments are often used as a hedge against inflation, he says, suggesting royalty trusts for no more than 5 to 10 percent of a portfolio.
Like MLPs, royalty trusts have no taxation at the company level and pass on to unit holder’s tax deductions like depreciation and asset depletion, reducing the investor’s tax on earnings.
The trade-off is that some of the tax savings have the effect of reducing the investor’s cost basis, or unit purchase price used to calculate taxable gains after the shares are sold. That makes the capital gains tax larger than it would be if the actual purchase price were subtracted from the sales price.
Fortunately, profits on units are taxed as long-term capital gains, which for most investors carries a lower rate than ordinary income.
Investors are cautioned to carefully read the terms before purchasing royalty trust units. Trusts typically expire on a specific date, stopping the dividend payments.
“Being a liquidating vehicle, a royalty trust’s expected life is 10 to 15 years. MLPs have indefinite lives,” says Gilman, noting that the unit price falls as the deadline approaches.
“There are two types of royalty trusts, perpetual and term,” he says. “A perpetual royalty trust is just one that exists only until all the resources are completely exhausted. A term trust terminates at a specified time, either having production or monetary goals.”
It’s also important to know where the trusts resources are and how much the producer believes is yet to be extracted.
“The value of the trust is entirely tied to commodity prices,” Gilman says, recommending that no more than 2 percent of an investor’s portfolio be put into any individual trust.
“They have the potential to be extremely volatile,” he says. “Their performance has generally lagged commodity prices over the long-term and has been generally mixed in the short-term. Furthermore, the dividend yields fluctuate greatly because of volatile commodity prices, so one should not regard the yield with great conviction.”
[Read: 5 Reasons Not to Invest in Gold.]
So although a royalty trust can be a good income producer, it should not be considered to be as reliable as alternatives like bonds or a basket of dividend-paying stocks.
More from U.S. News
11 Stocks That Donald Trump Loves
7 Ways to Tell if a Stock Is a Good Price
8 of the Most Incredible Investments of the 21st Century
How to Invest in Energy With Royalty Trusts originally appeared on usnews.com
