How To Make Money From A Royalty Trust

Transcription

1 Oil and Gas Royalties The Real Secrets to Generating Huge Returns in America s Petroleum Markets 1

2 G&G Investment Society Copyright by G&G Associates Published by: G&G Associates G&G Associates Client Services: Our mission is to empower investors and consumers with unbiased information and advice to keep them in the know to protect their savings, build their wealth and prosper in good times and bad to pass an inheritance to their children s children. All rights reserved. The accuracy of the data used is deemed reliable but not guaranteed. There s no assurance the past performance of these, or any other recommendation, will be repeated in the future. 2

3 The Real Secrets to Generating Huge Returns in America s Petroleum Markets Virtually every industry has a "backdoor" way to get paid over and over again for a single idea or property. In the drug business, the big money is in patents. After all the work is done developing a new drug, a scientist can partner up with a larger company to handle the expenses and risks of testing, marketing, and distribution. Then, the patent holder is paid for every filled prescription. The guy who developed the popular pain medication Lyrica, for instance, shares in more than $2 million per month because he owns the patents. The women who owned the patents on the antifungal medicine Nystatin share more than $50,000 per month for 20 years. In the publishing business, the big money is in royalties. Once you do all the work to write a book, you just sit back and collect your share of the profits. Ex-President Bill Clinton, for example, makes more than $84,000 per month from sales of his best seller, My Life. This is why collecting lucrative royalties has been nicknamed the "Mainz" income stream secret. The printing press, which was invented in Johannes Gutenberg of Mainz, Germany, is generally considered the invention that first made collecting regular royalties possible, by allowing book publishers and authors to make a fortune reproducing valuable pieces of work. Prior to the printing press, reproducing a book was nearly as arduous as writing it. The Gutenberg press made it possible to write the book and crank out copies fast and cheap. The Mainz secret remains one of the great low-risk ways to get rich in America. You make just one investment or control one valuable asset and then get paid over and over again, while somebody else takes the risk of marketing, development, and distribution. Inside this report, you'll find the details of some incredible ways to use this secret as an investor. In short, you avoid all the normal risks of doing business and simply collect incredible streams of income for owning a valuable asset. For our purposes as resource investors, we want to use this Mainz secret to collect royalties on one of the world's most vital energy commodities. As you'll soon learn, you can regularly collect 8%-10% annual payments on some of the richest land in America. And if you follow my advice, your long-term gains could reach the thousands of percent. Let's get started 3

4 The Secrets to Royalty Success Royalty trusts are simple businesses that own the rights to some oil and gas reserves. They don't explore, drill, transport, refine, or anything else involved in producing or selling oil and gas. They simply own the asset and collect steady payments when some other company pulls the oil and gas out of the ground. Typically, a larger "sponsor" packages up a set of assets and spins them off as a royalty trust to generate capital up front for its long-lived assets AND keep receiving income from the production. They also receive tax benefits from adopting the royalty trust structure. What's important for us as investors is this: In exchange for tax advantages, royalty trusts distribute virtually all of their earnings to shareholders through regular dividends. In our case, we're interested in trusts formed by oil and gas sponsors. In addition to the high yield, oil and gas trusts offer the potential for big gains if resource prices soar like they did from 2006 to We're interested in trusts with a couple of key characteristics. First, we want trusts affiliated with strong sponsors and operators. Remember, royalty trusts are paid when the reserves they hold are being produced if the assets sit idle, then they don't add to the bottom line. We want partners strong enough and committed to producing those assets. Second, we want "mineral rights." That means our royalty is on production from an area, rather than a fixed pool of oil. Let me explain There are two kinds of oil and gas royalty companies. One owns rights to a finite pool of oil and gas. These are called "term trusts." The other owns mineral rights to an oil field. These are called "perpetual trusts." The difference can cost you a whole lot of money. One unique feature of royalty trusts is they are legally prohibited from acquiring assets and growing... Since they must pass their earnings through to unit-holders, there's nothing left to expand their holdings. They must sit on a winnowing asset base. That's why you want to make sure that asset has a long enough lifespan to keep paying you. Owning a pool of oil is like owning a loaf of bread. Every day, you eat a slice of the bread. Eventually, it's all gone. Owning the mineral rights to a field is different. When you hold mineral rights, the actual amount of oil and gas you control can grow as drilling results increase the size of a deposit's known reserves. It's natural that as an operating company works on a property, it discovers more oil than it first estimated. Trusts with mineral rights have a claim on those reserves Term trusts don't. For example, Whiting USA Trust (NYSE: WHX) is a term trust. It receives 90% net profits interest from 9.11 million barrels of oil equivalent. The 9.11 million barrels of oil equivalent should be hit by the end of the year At that point, shares of the trust will be worthless. That's about 10.5 years from now. Let's do a little math. Today, Whiting USA costs around $23 per share and pays $2.96 per share in dividends. At $2.96 per year, it'll take 7.7 years to pay for a share. That leaves about three years ($8.88 total per share) worth of dividends as upside. 4

5 That's why we don't want to invest in a commodity stock with a capped upside, it's just too risky. Now look at the BP Prudhoe Bay perpetual trust. This trust owns a piece of Prudhoe Bay in Alaska. That's North America's largest oil field. You could have bought shares of this trust in 1990 for about $30 per share. Do You Take Your Cut from the Top Line or from the Bottom Line? There are two other designations you'll run into when researching trusts: net-profits trust and over-riding trusts. Since then, you made $83 per share in dividend payments alone and the shares trade for $103. A $10,000 investment in 1990 would be worth about $50,000 today. In total, you made about 550% in 20 years. Believe it or not, that's roughly 9% per year. That's the power of compounding your returns over a long period of time. It's why we want trusts that can crank out payments over two decades like BP Prudhoe Bay. A net-profits trust gets a cut of the net profit from produced oil and gas. But the trust must kick in its shares of capital costs. These trusts act more like passive oil companies. The second kind of trust is the over-riding royalty trust. This version gets a cut of the net profit from oil and gas production. The net is calculated after capital expenses. This kind of trust is little more than a bank and a lawyer. More important, that's the kind of royalty trust we want. We want the possibility of both commodity upside and long life. If we can do that, we'll make a fortune, without doing another thing. Get Tax-Free Money From Royalty Trusts Like I said, royalty trusts enjoy tax advantages by passing on their income. Shareholders also enjoy tax perks. Shareholders do pay tax on the money they receive. But due to the depreciation and depletion of the trust's assets, these distributions are not subject to the current 15% tax rate on passive income. The IRS treats the distributions you receive differently than the dividends you get from most high-income stocks or bonds. Instead, it subtracts the distributions from the original cost of your shares and defers the taxes on until you sell the stock, when you pay the capital-gains tax rate. That's why I prefer readers hold trusts in their tax-advantaged IRAs. Also, for some of these trusts, if you file a Form 1040, you get to deduct the depletion, severance tax, and administration expense from the gross royalty income. It's not hard to do, and many of the companies publish "How to File" tax guides every year. Thanks to those tax breaks, the yields on these companies can be much higher than other companies, which only pay part of their profits as dividends. 5

6 The Field of Royalty Trusts Let's look at the field of royalty trusts. Just because one of these companies isn't a buy today doesn't mean it won't be a deal later on. If you are a serious income investor, then these tables are money in the bank. First, let's look at some of the net-profits trusts: Net Profits Interest Trusts Symbol Market Cap Enterprise Value Premium or Discount to NPV Cross Timbers CRT $210,780,000 $209,460,000 3% Permian Basin PBT $868,790,000 $862,900,000 4% Sabine Royalty Trust SBR $736,400,000 $730,820,000 12% Dorchester Minerals DMLP $751,550,000 $737,440,000-9% As we discussed earlier, net profits trusts must kick in for capital costs. You can also see by the difference between the market value and the enterprise value that these trusts usually hold cash and have no debt. Now, here's a list of the over-riding trusts: Net Profits Interest Trusts Symbol Market Cap Enterprise Value Premium or Discount to NPV San Juan Basin Trust SJT $1,040,770,000 $1,040,000,000-3% Hugoton Royalty Trust HGT $745,600,000 $740,500,000-11% Mesa Royalty Trust MTR $81,070,000 $79,080,000-9% BP Prudhoe Bay Trust BPT $2,020,000,000 $1,990,000,000 4% As we discussed earlier, these trusts usually take their cash payments from the bottom line. As you can see, four of these trusts are selling at a discount to net present value. Those are primarily gas trusts. Those are the ones that we're going to buy. Back in Bargain Territory The natural gas price fell 29% since June 21, That means the commodity is getting back to "cheap." 6

7 They use "natty" as the fuel for home heating and cooling, and for electricity generation. I like it as a government-approved long-term alternative to coal. Over the past few years, horizontal drilling and hydraulic fracturing techniques dramatically shifted the natural gas supply/demand situation. Shale rock is often loaded with natural gas. The problem is the rock is packed tight, like pages in a book. Picture a book lying on your desk. Imagine the natural gas rests in the space between the pages and can't flow. Shale is just like that. Cracks in the shale run horizontally. A single vertical well can only tap a small percentage of the gas caught between the pages. However, if you turn that well horizontally, to run along the page, you hit a lot more. In addition, they figured out that if you could somehow prop the pages of the book open, even more gas would flow out. That's why they blast the cracks in the shale with water. They put sand or ceramic spheres in the water to prop them open, and voila... huge gas production. In just the last decade, they've figured out how to do those things and its caused gas supplies to swell. In 1984, U.S. natural gas production was 18.5 trillion cubic feet. In 2009, they produced 26.3 trillion cubic feet thanks to horizontal drilling and hydraulic fracturing. However, the demand for gas hasn't kept up. In 1984, we consumed 17.9 trillion cubic feet. In 2009, we consumed 22.8 trillion cubic feet. So while we added 42% to our production capacity, we only added 27% on the demand side. This surge of production, coupled with only a creeping increase in usage, has caused a crash in natural gas prices. Just a few years ago, $7-$8 per MCF (thousand cubic feet) was a normal price. Nowadays, $4-$5 is a normal price. 7

8 And as the natural gas chart above shows, $3 to $3.50 is the new "cheap." Along with all commodities, natural gas suffered a crash in late The glut has kept the price depressed... The new range is between $6.50 on the high side and down around the $3.25- $3.75 on the low side. This is the level where most industry insiders and power-plant operators consider the fuel a great bargain. Today, the price of natural gas is around $3.70 per MCF in the cheap range. Also placing natural gas in the "bargain bin" is the oil-to-gas ratio. Oil and natural gas are energy cousins. They tend to trade in a rough "energy equivalent" band. Sometimes oil gets cheap relative to natural gas; sometimes natural gas gets cheap relative to oil. Back before the current gas glut, the market considered natural gas cheap when the oil-togas ratio was 12:1 or 14:1 meaning 12,000 or 14,000 cubic feet of gas sold for as much as a barrel of oil. Today, we can say natural gas is cheap only when that ratio spikes to 20:1 or 24:1. This ratio reached 24:1 in the fall of last year. Today, the oil-to-gas ratio is 20:1 and rising. Natty is heading back into "super-cheap" territory. Keep in mind, we do face some risk in buying these trusts. If oil and gas prices nosedive, the market will punish shares. Consider, if you bought BP Prudhoe Bay Trust in 1990, when oil prices were high, you suffered a 85% decline when oil prices dropped. I think that risk is remote right now Today, natural gas is 45% below its five-year average. That means natural gas prices would have to rise 83%, just for us to hit the average. The second risk to our investment worth noting is a potential market crash. There remains the risk of a huge market sell-off like the one we saw in The stock market is floating on a sea of Fed-created liquidity. We can't know when the big surge in stocks will falter, but we can limit our risk with a 25% stop loss. Royalty Stream No. 1: Hugoton Royalty Trust (NYSE: HGT) Hugoton's corporate structure is basically a lawyer and a bank. The trust formed in 1998 when XTO Energy spun out 80% net profits interest on assets in the Hugonton basin of Oklahoma and Kansas, the Anadarko Basin in Oklahoma, and the Green River Basin of Wyoming. It produces 90% gas, 10% oil, has no debt, and pays a 7% annual dividend. Its market cap is $800 million. XTO was the operator. It is now being acquired by ExxonMobil, probably the best operator you can have. The trust's assets are in fantastic locations. Hugoton current reserves are 117 million MCF of natural gas and 1.1 million barrels of oil. The trust owns 79,500 net acres in the Hugoton. Natural gas drilling began in Hugoton back in It covers more than 5 million acres. This is one of the largest regions of natural gas 8

9 production in the U.S. In 2009, the trust's assets produced 19,200 MCF and 50 barrels of oil per day. Those Hugoton acres became more valuable because XTO found four more productive rock layers nearby. Depending on XTO's success in those neighboring formations, we should see Hugoton's reserve life extended. An important risk: Hugoton's oil and gas is completely unhedged, which means it gets paid the spot price. That's why I see a huge amount of variability in revenue. Year Revenue Average Gas Price Dividends Per Share Dividend Yield 2007 $70 million $6.11 $ % 2008 $117 million $8.28 $ % 2009 $30 million $3.48 $ % 2010* $36 million $4.67 $ % *results through August 2010 We're buying at a good time. If the trust produces the same amount of gas this year and gas prices stay flat, we'll make at least $1.48 in dividends. That's 8% if we pay less than $18.50 per share. Reserve Information Oil Gas 12/30/ million barrels 230 million MCF 12/30/ million barrels 225 million MCF 12/30/ million barrels 178 million MCF 12/30/ million barrels 117 million MCF In 2009, Hugoton produced 8.3 million MCF of natural gas and 90,000 barrels of oil. At that rate, the trust will be around between 12 and 14 years. However, a bump in gas prices will boost reserves, as we discussed above. Action to take: Buy Hugoton Royalty Trust (NYSE: HGT) up to $22 per share and use a 25% trailing stop loss, adjusted for dividends. Royalty Stream No. 2: San Juan Basin Trust (NYSE: SJT) San Juan, like Hugoton, is basically a lawyer and a bank that collects royalty interest on about 1,137 wells and 119,000 acres in the San Juan Basin of northwestern New Mexico. San Juan doesn't do the dirty work of exploring, it just collects checks... and passes the cash along to us. It's nearly 100% gas focused, no debt, and pays an 6.5% annual dividend. Its market cap is $1.15 billion. San Juan Trust's reserves are healthy. ConocoPhillips became the operator after it acquired the former operator. In fact, it revised its reserve life from nine years as of 2009 to nearly 9

10 15 years this year. That reflects horizontal drilling and reduced well spacing performed by Burlington Oil and Gas (now a subsidiary of ConocoPhillips). Also, Burlington had spaced its wells at 160-acre intervals. It's now shifting to a much denser plan. It drilled several wells in 2008 at 40-acre spacing. In other words, it can get four extra wells in an area where it had only one before. That is significantly increasing San Juan Trusts reserves. Depending on how Burlington's drilling progresses in 2010, we could see a further increase next year as well. An important risk: San Juan Basin's gas is completely unhedged, which means it gets paid the spot price. Take a look at the table of results (below), and you'll see what happens when a company is fully exposed to the spot price. That's a huge amount of variability in revenue. Year Revenue Average Gas Price Dividends Per Share Dividend Yield 2007 $115 million $6.11 $ % 2008 $145 million $8.28 $ % 2009 $32 million $3.48 $ % 2010* $43 million $4.67 $ % *results through August 2010 If the trust produces the same amount of gas this year and gas prices stay flat, we'll make at least $2.72 in dividends again. That's 10.9% this year, if we pay $25 per share. Reserve Information Oil Gas 12/30/ ,000 barrels 220 million MCF 12/30/ ,000 barrels 195 million MCF 12/30/ ,000 barrels 156 million MCF 12/30/ ,000 barrels 133 million MCF In 2009, San Juan produced 9.8 million MCF of natural gas and 15,000 barrels of oil. At that rate, the trust will be around another 13 years. However as with its peers, a bump in gas prices will boost reserves, as we discussed above. Normally, shares of royalty trusts rise and fall in conjunction with the price of their underlying commodity. If gas prices rise a bit, we should see a capital gain as the share price rises to reflect the increase in revenue. Action to take: Buy San Juan Basin (NYSE: SJT) up to $25 and use a 25% trailing stop loss, adjusted for dividends. Don't pay a penny more. Don't worry if the price temporarily spikes after this recommendation. It will come down, and you'll have time to build your position. The longer you wait for a good price under $25, the higher your distribution yield will be. 10

11 All you have to do to start collecting your paychecks is to put in your bids for these stocks. Then just sit back and watch the checks start rolling in monthly. This is a fantastic way to collect income from safe energy supplies right here in the United States. You own the royalties, and the oil companies have to pay you by law. Published by G&G Associates Investment Research. G&G Associates welcomes comments or suggestions at info@gngassoc.com. This address is for feedback only. For questions about your account or to set up a personal consultation, call Or info@gngassoc.com G&G Associates Investment Research. All rights reserved. Any reproduction, copying, or redistribution, in whole or in part, is prohibited without written permission from G&G Associates, P.O. Box 69082, Hampton, VA or This work is based on SEC filings, current events, interviews, corporate press releases, and what we've learned as financial journalists. It may contain errors, and you shouldn't make any investment decision based solely on what you read here. It's your money and your responsibility. 11