Image Credit: Christophe Vorlet
By Jason Zweig | Aug. 24, 2012 5:05 p.m. ET
Investors reaching for yield should always bear in mind the warning label on stepladders: “DANGER. DO NOT STAND ON TOP STEP.”
Just look at what happened this past week to investors in several so-called royalty trusts. These instruments, which collect and distribute income from oil and gas or mining properties, are among the highest-yielding in the stock market, with payouts averaging 9%.
But last Wednesday, the “unit,” or share, price of Hugoton Royalty Trust fell 8% after it announced a cut in its dividend; on Tuesday, San Juan Basin Royalty Trust also cut it payout, knocking its shares down 5%. And Dominion Resources Black Warrior Trust fell 6% this past week after it declared a dividend cut the previous Friday.
Many people — especially older, conservative investors hoping to rejuvenate their shriveled bond portfolios — might not realize what they are buying when they invest in these rare, peculiar and suddenly popular instruments.
There are some 30 royalty trusts, with a combined market value of roughly $12 billion; at least seven have sold their shares to the public for the first time in the past year.
By design, they have no employees or physical assets, and most will cease to exist in 20 years or less. Their only value consists in the income they distribute. But their future payouts may well be a ghost of the yields that appear so attractive to today’s investors.
Why are the yields on royalty trusts all but doomed to dwindle?
Unlike the more-familiar master limited partnerships, which often own or operate energy, mining or other assets, the typical royalty trust holds only the right to receive income from a fixed number of properties.
Once the trusts are set up, they are frozen and can’t acquire any new interests to replenish their stream of income.
When their share prices are cheap, as many were in early 2009, royalty trusts can be a great investment.
But timing is everything, and many of these trusts are far from bargains today. Wells and mines tend to become depleted with each passing year, making a decline in yield almost inevitable unless commodity prices boom.
When there is no money left to pay out, most of the trusts will disappear—and, unlike bonds, they won’t give investors their original principal back at the end.
So, when the financial statements of these trusts use the word “depletion,” they mean it. According to Standard & Poor’s, between 2007 and 2011, Hugoton Royalty Trust’s dividends shrank to $1.41 from $2.09; San Juan Basin Royalty Trust’s, to $1.40 from $3.59.
“Unfortunately, most people who buy [royalty trusts] don’t realize that they tend to be depleting assets,” says Tyson Halsey of Income Growth Advisors, an investment firm in Charleston, S.C. “They end up being bad for retired people who think they are getting a fixed-income alternative.”
The trusts themselves, to their credit, make no attempt to hide any of this. In their financial statements, they forthrightly disclose detailed estimates of the likely income available for future payouts to investors.
In their latest annual reports, for example, BP Prudhoe Bay Royalty Trust and Whiting USA Trust I calculated that the current value of their future cash available for distributions was $1.4 billion and $109 million, respectively.
Yet this week the total market value of BP Prudhoe stood at $2.3 billion; Whiting USA I, at $123 million.
That means investors remain willing to pay 61% more for a stake in the BP trust than all its future cash flows are likely to be worth, and they are shelling out 13% more for Whiting than Whiting itself says they will probably earn from it—before tax.
How can share prices remain stubbornly above what the trusts are worth?
First, the trusts are thinly traded, making it cumbersome and costly for hedge funds and other “short sellers” to bet against them and bring their prices back into line with their fundamental value.
Second, their yields are so high that some investors seem determined to buy them on that basis alone—regardless of today’s prices or tomorrow’s returns.
“People buy into [royalty trusts] for the sake of the yield,” says a representative of Hugoton’s trustee. “If the yield gets cut, the market tends to dry up.”
Do investors understand that they are often overpaying? “In some cases, they probably don’t,” says an official at BNY Mellon, which acts as trustee for 15 of these vehicles, including BP Prudhoe Bay Royalty Trust. “I wouldn’t argue with that. That’s why it’s so important for investors to review the [financial] filings.”
When you see 9% yields in a 1% world, don’t let the word “royalty” fool you into thinking you have just found the king of all income investments. One of the most basic laws of financial physics still applies: Those who stretch too far for yield will probably topple.
Source: The Wall Street Journal, https://www.wsj.com/articles/SB10000872396390444082904577609291984902960
Note (August 2017): This column provoked intense criticism, if not rage, among investors in royalty trusts. Many insisted I had my facts wrong. The market rendered its own judgment; all these stocks have since collapsed, with several having fallen at least 90%.
For further reading:
Definitions of INDIVIDUAL INVESTOR, RETAIL INVESTOR, RISK, SAFE, VOLATILITY, and YIELD in The Devil’s Financial Dictionary
Chapter Eight, “The Investor and Market Fluctuations,” in The Intelligent Investor
Chapter Seven, “Fear,” in Your Money and Your Brain