Earlier this month I posted about boosting yields with preferred stocks
and the diversification benefits of real estate investment trusts
. I'd like to explore another tool for boosting returns – royalty trusts. Royalty trusts are not technically companies. They are legal structures – special-purpose financing vehicles – to hold assets for another company or shareholders. Generally, royalty trusts purchase the right to royalties on the production and sales of a natural resource company (e.g., timber, oil, natural gas.)
Unlike a normal company, trusts must distribute all cash flows to the shareholders, usually in the form of a dividend. As a result, these trusts often provide high yields, sometimes in the double digits. I looked at five mid-cap royalty trusts: BP Prudhoe Bay (BPT
), Cross Timbers (CRT
), Hugoton (HGT
), Provident Energy (PVX
), and San Juan (SJT
). Reviewing these five trusts, there are two things that stand out: 1) the returns over the past twelve months averaged over 30% and 2) the trusts yield an average of 11.4%. Four of the five trusts are focused on energy extraction so it’s not surprising that they performed well last year. Over the past five years, the group is up more than 200% while the S&P 500 was flat. They also outperformed the Energy Select ETF (XLE
) during that period.
It’s easy to see how royalty trusts can boost income. It is also, however, important to understand some of the major issues associated with royalty trusts. The issues include:
- Dividend payout: the dividend is based on a percentage of income. If income rises, dividends rise. If income falls, dividends fall. Price volatility can play a big role in the dividend payout. For example, the price of a barrel of Brent crude oil in 2005 ranged from approximately $40 to $67. This may be partially hedged through long-term contracts.
- Tax implications: trusts are treated much like mutual funds and must pass earned income to shareholders. As a result, the earnings (and their tax treatment) retain the form when distributed to shareholders. This includes depletion tax credits.
- Depletion: The earnings of a royalty trust come from depleting the asset. Eventually, the asset will be depleted and the trust will be worthless. It is important to read the information on these trusts to monitor how much of the asset remains. As the assets are depleted, the value of the shares is at risk.
I was first introduced to royalty trusts in a Paul Strum article in Smart Money magazine in 2002. And while I don’t generally follow the stock recommendations of magazines, this is one piece of advice that I’m glad I followed.
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