Hold Your Nose And Start Buying Royalty Trusts
Nov. 29, 2014 9:18 AM • ndro
- The market for royalty trusts is small and inefficient which offers buying and selling opportunities from time to time.
- Trusts have declined precipitously in both popularity and price over the last few years. This is offering investors opportunities.
- Tax-loss selling has exacerbated the price declines.
- Start buying low-decline, higher quality trusts in tranches and wait for the cyclical recovery in oil.
Every once in a while the market offers up bargains that seem too delicious to be true. If it wasn't so scary to buy them everyone would do so. Case in point - there were many closed-end funds trading at 50% discounts to NAV and 25%+ dividend yields during the 2008-2009 meltdowns (FLC preferred income is one that I owned at the time). People didn't care. They temporarily lost their sanity, forgot what the funds were actually holding. and sold them. Why? Mainly because they were down in value and no one wants to invest in "a loser".
I realize there are many philosophies on how to treat your portfolio losers. A newsletter group that I subscribe to regularly advocates setting trailing stop orders that will sell you out of a trade once the stock declines by a set amount. This is certainly a good way to limit your losses, but my experience with it usually has me selling right at the bottom of a dip, only to see the stock pop right back up after I'm no longer in it to enjoy the bounce. Feel the pain, but don't experience the pleasure.
My philosophy is generally to get very comfortable with a company or investment before dedicating money to it. Do lots of homework, don't over-allocate, and then once I buy, I tend not to worry about it too much. If it dips and its intrinsic value is comparable to the value that I saw when I originally made the investment, I would be more inclined to average down than I would be to sell and find a new company. One might attribute this to laziness because, much like a marriage, it takes time to get to know a company and the corporate culture that management fosters in that company. Over time, you get to see how they will respond to various challenges and opportunities, and you get a good idea of how they plan to steward your investment capital. Just like there is no perfect mate and divorce shouldn't come easy because of the difficulty of "starting over", one must sometimes accept a measure of dysfunction in an investment that goes hand in hand with getting to know its value. Unless a company uses its shares as currency (and this is part of its business strategy), when you invest according to the intrinsic value of a company price is only important when acquiring and disposing of shares - not in between.
Not too long ago royalty trusts were being gobbled up by investors faster than Wall Street could supply them. In a low-yield world, they were viewed as an income alternative to 1% CDs and 2% annuities. But the drilling results of some of these trusts, coupled more recently with the severe slide in crude oil prices, have not lived up to the expectations of their early investors. As a result, they are not only down significantly in value, they have been taken out to the woodshed and bludgeoned to death with a hammer. But every income producing asset has a price at which it becomes attractive regardless of soured expectations. While a further slide in crude prices could bring further slides in unit prices, I think we are definitely in the long-term attractive stage. This looks like 2008 all over again, and though it could still get worse, buying here looks like a no-brainer if one can have some patience. It's important to note that since trusts usually pay distributions based on the revenue from several months' prior production, it is likely that the next couple of quarters will see further drops in income to reflect the slide in WTI pricing. I no longer think these investments are trading based upon their income potential.
Tax Loss Selling
To further exacerbate the decline in these investments, we must look at where the gains have been in the last couple of years. Anywhere but here. Common stocks have performed well over the past few years and have produced a lot of unrealized capital gains in portfolios. People who have recently rebalanced their portfolios and harvested gains in their other investments are looking for losers to sell that will offset those gains for tax purposes. Pretty much anything in the natural resources sectors are becoming tax-loss victims, pushing down their share prices even further than the commodity prices declines would normally take them.
Further Risks to know in advance
U.S. based trusts cannot acquire additional assets, nor can they use debt to leverage themselves. So when the price of oil collapses as it has recently, some of the inventory will necessarily get sold at unattractive prices, limiting future value. Since many of the recently issued trusts have defined lifespans (some of which contractually leave no residual value for unit holders at dissolution), these depressed sales could be problematic if the price of oil stays low for too long. It could make it more difficult to make a profit off of the investment before the trust expires. Furthermore, many of the trust sponsors regularly drill new wells to keep the production rates up. These new wells will be postponed in many cases if the sponsors feel like they will not be profitable. While this lack of new drilling activity can preserve future value, it would certainly harm current income as production from the old wells declines and new wells are not brought online to offset those declines. Lastly, many of the newer trusts are profit-sharing trusts, rather than pure royalties. This means that the trust will pick up a percentage of the cost of the drilling of each new well and then share in a proportional amount of the profits. As the revenues decline due to lower crude prices, the upfront cost of new wells that do end up being drilled will represent a larger percentage of future income and will further eat into the distributions that unit holders receive.
There appears to be ample reason for the price of crude to stay low for a while. Some market observers have speculated that the West politically benefits
from the lower price of crude because it acts as an unimposed and unofficial (yet still effective) sanction against Russia, who is one of the largest oil producers in the world. Other observers note, however, that Saudi Arabia has nefarious motives in helping to push the price of oil below the marginal production cost of its newest competitor - shale oil from the United States. This would bankrupt many of the smaller players in the industry, shut down the marginal projects that require a higher crude price to achieve viability, and halt the industry growth that has been estimated to add nearly 2.5 million barrels of oil per day to world production.
(Citi Chart showing the price at which the marginal production areas become unprofitable)
While there are a number of potential negative catalysts to oil trusts, there are also a number of potential positive catalysts to gas trusts and those which produce both oil and gas. These mainly center on the price differential between natural gas in the U.S. and natural gas in the East, which U.S. producers should be able to begin to capitalize on through export terminals that have been authorized and are currently being built. In either event, we should realize that oil and gas are both boom/bust cyclicals. Prices drop but they never stay down forever. In fact, the cure for low prices in any commodity is low prices.
My favorites in the sector
Conservative trust investors will generally gravitate to the larger and older names like BP Prudhoe Bay (NYSE:BPT ) and San Juan Basin Royalty Trust (NYSE:SJT ). Those trusts have done well over time, but in my opinion don't offer a lot of income while you wait, nor do they offer a lot of upside in a recovery. My favorite ways to invest today are to identify and take advantage of the low prices that can be found in some of the newer long-lived or perpetual trusts with lower decline rates.
I've written in the past about VOC Energy (NYSE:VOC ) and why I believed at the time that it was undervalued relative to other trusts. I do like the assets that VOC controls and I like the incentives that the sponsor has to continue to drill on those lands throughout the trust's lifespan. But what I like even more is that the price has dropped 55% from its recent highs of only 5 months ago. VOC doesn't terminate for another 16 years and is 63% cheaper than it was when it IPO'd in May of 2011.
Another one of my current favorites is Enduro Royalty Trust (NYSE:NDRO ) which is a perpetual trust that can engage numerous third-party partner drillers. I like Enduro partially because there is no time limit by which the assets need to begin producing. If low prices persist, long-term value doesn't waste away from time decay like it would on a trust like Whiting (NYSE:WHX ) which has only about four months of production remaining before it terminates with zero value (As an aside, I've privately asserted for a several years that Whiting would make a great short sale for someone who was patient, and it still appears to fit that bill, trading substantially over its net present value).
Enduro has a sizeable acreage in oil rich lands and if there is one thing that the shale boom has shown is that oil can often be found at multiple depths on the same land. In other words, the best place to look for oil is where oil has already been found. Enduro also offers a nice incentive to producers by covering a substantial portion of the cost of the drilling. While this can increase risk to trust holders if the well doesn't go as planned, it can also decrease risk by reducing upfront costs to drillers - thereby incentivizing new drilling and thus regularly replenishing trust income as older wells deplete. The main reason I like Enduro right now is that it is trading at a 52% discount to its recent highs in July, and it has recently added a number of new wells - the revenue from many of which have not even begun to hit the bottom line profitability of the trust. Enduro also has the added appeal of being a monthly pay trust. You get paid to wait for a recovery, and paid often.
VOC and Enduro also don't have any share subordination issues looming that will cause future distributions to suddenly fall off a cliff. I'm not a big fan of surprises and a few of the trusts that are out today have some of those in their future.
Since these trusts are trading at such depressed levels right now, should the price of crude begin to tick back up to recent highs, there is an enormous opportunity for capital appreciation in the unit prices as well as income growth. The current environment seems like 2008 again where free money is hanging from trees, but no one wants to eat it. The geopolitical climate seems to reinforce this mindset and I acknowledge that low crude prices could go still lower and could last longer than they did in 2008. That is why I think the best approach to buying these trusts is to dollar cost average into them. Either buy in small tranches and buy consistently over the next year or buy today and reinvest your distributions for a while. If you do choose to reinvest your distributions, be aware of which trusts will eventually terminate and when they do so that you do not perpetually reinvest into an asset that is designed to decay. These are thinly traded and will be super volatile, so don't buy if you have a weak stomach or if you will need the money in the short term.
There are many risks, but the rewards are also real. It's a good time to begin accumulating solid royalty trusts.
Disclosure: The author is long VOC, NDRO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Clients of author's firm may have positions in any or all of the investments listed in this article and may increase or decrease those positions at any time. This article should not be construed as individual investment advice nor should it be relied upon as justification for an investment in any company referenced herein.