Don't Fall Into This Royalty Trust Trap...

There’s a new trend emerging in the energy sector… and it’s not pretty.

Now that America is oozing oil and natural gas, many investors (maybe you too?) are lining up to buy shares in royalty trusts. Buyer beware, the field is littered with pitfalls.

Today we’ll take a look at the losers as well as two companies that look to be a safe bet in the energy income space…

First, let’s back up and make sure we’re on the same page here.

A royalty trust is a fairly simple investment idea. Trusts are companies that usually own one large asset or deposit that has a multi-decade shelf life. Whether the trust produces oil, gas or metal ore, the idea is that everyday investors like you and me can buy into the trust and claim some of the profits.

Trusts trade the same as stocks, but they enjoy one special tax benefit — royalty trusts don’t get taxed on the corporate level. Thus, they are able to funnel more money, through dividends, to investors. In many cases these dividends crush what other stocks can offer — for instance, some of the higher paying royalties dish out 8-15%.

Over the years many of these royalty trusts have paid off, too.

But don’t be fooled into thinking that these trusts are a “surefire” way to collect mind-blowing dividends. Because as I’m sure you know, the hunt for dividends is littered with pitfalls. After all, who wants a sweet 8% dividend if the company you’re holding drops 28% in a year! Take a look at three prime examples:

Indeed, instead of being a long-term vehicle for solid dividend payments, a lot of these trusts have transformed into an entirely different beast.

It’s a confluence of events…

First, the need for yield is bringing more demand for royalties, which in turn bids up the price. Along with that, America’s shale plays are gaining momentum amongst mainstream investors, which also bids the price for royalties higher. So on one hand the price is high for royalties.

Meanwhile, depletion in shale plays is fast. You see, natural depletion is always an issue when dealing with oil and gas deposits. A conventional deposit like in 1960’s Texas was relatively slow – that is, you could expect oil to keep flowing at initial rates (or close to it) for years. Today’s shale plays are depleting much faster (what once took years is taking months) – thus creating a falloff in revenue for royalties.

Add to that the fact that natural gas prices are rock bottom and oil prices are relatively lackluster, and you can see why royalties aren’t the best bet today.

Fact is, today you don’t want to buy into just any royalty trust and expect it to be a long-term, safe way to collect dividend payments. Instead you need to continually do your homework.

Heck, even one play that I mentioned here last year falls into this realm: the Permian Basin Royalty Trust. Although this trust initially looked to be a turnaround story for the Permian Basin, it has a similar story to a lot of the other names listed above. Expectations simply aren’t being met – so the share price for the trust has fallen more than its dividend pays out.

Indeed, in today’s royalty space if yield seems too good to be true, it probably is.

So where is the opportunity?

To stay ahead in the income business you want to make sure your pony has the potential to increase payouts beyond expectations. This gets back to the whole premise of investing, is the stock you want to buy actually worth its price. In the examples above, clearly the payout isn’t worth the price. That’s why those trusts fell over time, they weren’t meeting expectations.

One sector that looks to break the mold is the midstream business. Unlike a producing oil field, midstream assets can gain value along the way. That is, with more oil production coming online in America’s shale patch the price to move the black goo is at a premium. Indeed, the assets that can process and transport that oil and gas could appreciate over time – and so could the dividend payouts.

One company that we’ve kept an eye on for a while here is DCP Midstream (DPM.) The yield is the double digit stuff you’ll see from some of the trusts in the chart above, but as I type the payout is north of 6%. DCP Midstream doesn’t own the rights to a depleting resource, instead it holds the deed to midstream assets – like, pipelines and facilities that process and store natural gas.

I’m of the thinking that we’re flush with natural gas, and will be for a long time (at least a decade.) That means there’s room for a company like DCP Midstream to grow and increase payouts.

Another player that could offer a substantial yield and also maintain or increase business is Terra Nitrogen (TNH.) Like DCP Midstream, we’ve covered this company before.

Terra produces fertilizer, so at first glance you wouldn’t put them in the energy trust business. But when you see how much natural gas they use to produce their nitrogen fertilizer you might as well call them a natural gas company! Plus, like DCP they share the same tax benefits as other big energy royalties.

Terra, as I type, is handing out a 7% dividend. And although the $230 share price may give you a little sticker shock, just remember if natural gas prices stay relatively low for the next decade a company like Terra could hold a global advantage in the fertilizer business.

This year the hunt for dividends is on. But instead of walking blindly into the minefield where risk far outweighs reward you’ll want to do a little homework. For now, though, keep an eye on midstream players and anyone else that can make hay out of cheap natural gas.

Keep your boots muddy,

Matt Insley

Original article posted on Daily Resource Hunter