Course 503: Unconventional Equities
Benefits of Royalty Trusts
In this course
1 Introduction
2 Benefits of REITs
3 Drawbacks of REITs
4 Benefits of MLPs
5 Drawbacks of MLPs
6 Benefits of Royalty Trusts
7 Drawbacks of Royalty Trusts
8 The Bottom Line

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 for producing 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 perk.

"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.

Next: Drawbacks of Royalty Trusts >>

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