Benefits of Oil and Gas Royalty Trusts

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
“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.