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    Benefits of Oil and Gas Royalty Trusts

    Guy Conger

    Benefits of Royalty Trusts
    Royalty trusts, like MLPs, generally invest in energy sector assets.
    Unlike the steady cash flows at MLPs, royalty trusts generate income
    from the production of natural resources such as coal, oil, and
    natural gas. These cash flows are subject to swings in commodity
    prices and production levels, which can cause them to be very
    inconsistent from year to year. The trusts have no physical
    operations of their own and have no management or employees.
    Rather, they are merely financing vehicles that are run by banks, and
    they trade like stocks. Other companies mine the resources and pay
    royalties on those resources to the trust. For example, Burlington
    Resources, an oil exploration and production company, is the
    operator for the assets that the largest U.S. royalty trust, San Juan
    Basin Royalty Trust (SJT), owns the royalties on.
    Royalty trusts end up on most investors’ radar screens because of
    the incredibly high yields some of them offer, many in excess of 10%.
    In a low-interest-rate environment, it’s easy to understand why such
    an income-producing investment might be garnering more attention.
    Many of the positive and negative attributes of owning a royalty
    trust are similar to those faced by MLP unitholders. The benefits are:
    High Yield. Trusts are required to pay out essentially all of their cash
    flow as distributions. Because of this, nearly all royalty trusts have
    above-average yields, many wildly above average.
    Tax-Advantaged Yield. Due to depreciation and depletion,
    distributions from most trusts are not considered income in the eyes
    of the IRS. Rather, these nonincome distributions are used to
    reduce an owner’s cost basis in the stock, which is then taxed at the
    lower capital gains rate and is deferred until an owner sells.
    No Corporate Income Tax. Trusts are merely “pass-through”
    investment vehicles. The issues surrounding double taxation of
    dividends do not apply.
    Peculiar Tax Credits. Have you ever received a tax credit forproducing fuels from nonconventional sources? If you own a royalty
    trust, you might qualify for such credits. The laws on this issue are in
    flux, and the credits are generally small, but it’s still a nice potential
    perk.
    “Pure” Bets on Commodities. Want to bet on the future price
    appreciation of natural gas but don’t want to get involved with the
    futures market? An excellent way to do that would be to buy a
    royalty trust that owns gas. The value of any given trust and the
    distributions it pays are directly tied to the prices of the underlying
    commodity. Just remember the sword cuts both ways here. The
    trust’s income (and therefore probably the trust’s stock price) could
    end up falling if commodity prices go down instead of up.

    The MONEY® Network