Trust is a very important term in the world of investing. To put it in simple words, a trust is nothing but an arrangement whereby money or property is owned and managed by an individual or entity for the benefit of another. The money is invested in companies with operating assets. These assets produce income which is eventually passed to the investors. These trusts are neither stocks nor bonds but are investment trusts. An investment trust that holds ownership of an asset and pass the income earned to investors is called a securitization
or an asset-backed security
Royalty trusts buy the right to royalties on the production and sales of a natural resource company and pass on the profits to trust unit holders. Royalty trusts typically own oil or natural gas wells, or the mineral rights of wells.
Royalty trusts are found in Canada and the United States. Canadian royalty trusts, called CanRoys, typically trade on the Toronto Stock Exchange, while some of the larger trusts also trade on the NYSE. U.S. trusts trade on the NYSE or AMEX based on size. CanRoys usually offer higher yields than U.S. trusts; for non-Canadian investors, this higher yield is somewhat reduced by a foreign tax withholding that is absent in the U.S. trusts. Royalty trusts pay monthly or quarterly dividends ranging from 4% to 15%.
Let us look at an example
For example, ABC oil company has maturing oil wells with well-known rates of production and reserves. The company estimates that it will produce and sell one million barrels per year for the next 20 years at a price of $20 per barrel (thus $20 million per year). ABC wants to sell the wells, but an investment bank suggests that ABC utilize a royalty trust, so ABC sells all the oil wells to a trust, the XYZ Royalty Fund. ABC receives a payout from the investment bank and will still manage the company for a fee. (Source: Investopedia)
CanRoys versus U.S. Trust
Canadian royalty trusts are different from U.S. royalty trusts. The U.S. trusts pay out the cash flow generated by their oil and gas properties, but they do not acquire new properties. Consequently, their cash flow declines over time as their assets are depleted. CanRoys, by contract, try to replenish depleted properties with new acquisitions, and are set up to operate indefinitely. The ability to acquire new assets and generate cash flow, payout higher dividends, combined with tax-efficient structure makes CanRoys a better choice to U.S. Trusts. (Caution: CanRoys do carry some debt, due to previous acquisition activity and development capital as compared to U.S. Trusts who typically have no debt)
Taxation on dividends from CanRoys
Dividend that is payed out to U.S. investors investing in CanRoys will be taxed. The tax treatment on the dividend actually depends on whether the trust is registered in the U.S. as a foreign partnership or as a corporation. Add to that the Canadian government applies a 15% non-resident withholding tax on distributions to U.S. investors. However, U.S. citizens can apply for a refund for at least a portion of the amount withheld. Some Royalty Trusts pay out tax credits if they are producing enegy from non-conventional sources (ie. coal seam gas, biomass methane). These tax credits maybe used to reduce income tax from other sources of income.
Benefits of Royalty Trusts
High Yield: Returns higher yields compared to stocks and bonds.
No Double Taxation: Avoids double-taxation of corporate dividends leading to high return rates.
Powerful Investment Tool: They are useful for people who wish to invest directly in oil or natural gas, but who don’t have the resources or risk-tolerance to do it on their own.
Diversity: Trusts often own numerous wells, they represent a convenient way for the average investor to diversify investments across a number of properties.
Unlimited Liability: Investors have unlimited liability for the actions of the trust. However you should contact a trust directly regarding liability before investing.
Disadvantages of Royalty Trusts
Exploration Risk: Separate operating companies need to be contracted to produce, market and sell the resources. At times this might not work out as desired, leading to exploration risk.
Forecasted Revenues: The prospectus for these Royalty Trusts always talk about forecasted revenues and earnings. Investors should understand how the forecasted revenues were deduced.
Element Of Guesswork: Oil companies also realize that proven reserves have an element of guesswork, and that there might be less oil in the ground, or it may be more difficult to recover than expected. With this element of guesswork, investors cannot expect a fixed yield from the investment.
Limit On Foreign Ownership: Canadian royalty trust community have expressed concern that increasing participation by U.S. investors may cause the Canadian government to either restrict foreign ownership or otherwise change the tax rules. To avoid bringing that problem to the forefront, most trusts are attempting to limit foreign ownership to 49%.
List of Royalty Trusts
Some U.S. Oil, Natural Gas and Coal Royalty Trusts include:
- Santa Fe Energy Trust (SFF) yielding 14.30%
- BP Prudhoe Bay Royalty Trust (BPT) yielding 12.40%
- Dominion Resources Black Warrior Trust (DOM) yielding 11.10%
- LL&E Royalty Trust (LRT) yielding 10.20%
- Permian Basin Royalty Trust (PBT) yielding 8.30%
Most Canadian royalty trusts are listed only on the Toronto stock exchange. However, the following trusts are traded on either the New York or American Stock Exchanges.
- Pengrowth Energy Trust (PGH) yielding 15.30%
- Provident Energy Trust (PVX) yielding 13.10%
- PrimeWest Energy Trust (PWI) yielding 11.30%
- Enerplus Resources Fund (ERF) yielding 10.10%
Conclusion: Royalty trusts provide an excellent alternative to stocks and bonds with attractive yield. It also provides a medium for individual investors to invest in oil and gas who cannot do it on their own. As with all investments, one must take the time and do a complete analysis. Weigh the pros and cons before parking your money it in.