How You Can Invest in Energy With Royalty Trusts

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The rise in energy prices is a boon for energy producers but a consumers nightmare. What’s the best way for a small investor to enjoy some of the action?

For most of us, we don’t have the option of drilling a well in the backyard, so the most sensible solution is to buy energy companies stocks such as British Petroleum or Chevron Corp. The problem is that isn’t a 100 percent investment in actual energy, because so there are numerous things that affect the price of stocks.

If a person is ready for some hard work and is up for a roller-coaster ride then you can trade futures contracts, which is simply you betting on price moves by buying/selling barrels of oil, cubic feet of natural gas, or tons of coal.

However, you have another way that you can invest in royalty trusts, which passes on income from coal mines, oil and gas fields, etc. Royalty trusts are like master limited partnerships, because both trade like stock, providing sizeable income with favorable taxation.

Which shares should you own?

How to invest in energy

David Hryck, who is a partner at Reed Smith law firm in New York City, says, “Investors who find themselves in higher tax brackets should examine these two options closely as they can present tax savings.”

The main difference is that MLPs own infrastructure like storage tanks, refineries, and pipelines; whereas royalty trusts own the rights to cash flow from the production facilities. This means that instead of you owning a share in an oil well, you can own shares in the income the well produces. Your income should increase as energy prices go up, while earnings from MLP are safeguarded from price fluctuations because storage, processing facilities, and pipelines keep working and generating revenue, regardless of whether the prices are high or low.

Hryck says, “It is common for numerous oil and gas producers to sell their producing assets to a royalty trust. By doing this, the company has created a revenue stream that investors can then buy into. From there, all the royalties produced in the trust are distributed to the shareholders as income. Simply put, purchasing into a royalty trust is like purchasing specific cash flows.”

Trust types

Royalty trusts

Another specialist feels there is a closer relationship between energy prices and royalty trusts.

Aaron Gilman, president and chief investment officer at IFP Wealth Management in Tampa, Florida, says “Royalty trusts do not have employees, and one should consider them as an intermediary, being they are run by banks. MLPs provide for active management and royalty trusts are passive in nature. The price of a royalty trust should also be somewhat more correlated to the price of energy, as compared with MLPs.”

Dividend yields can be significant. Right now, ECA Marcellus Trust pays almost 12%. ECT owns royalties for 14 horizontal gas wells in the Marcellus Shale formation, stretching from New York to West Virginia.

The dividendyieldhunter.com website compiled a list of 21 trusts, which show seven yielding more than 10%, with many of the others in the high single digits.

Like with other dividend-paying investments there is always a risk, and an unusually high yield might be a sign of trouble. Since yield is dividends for the past 12-months divided by today’s share price, when the price falls yield goes up, and a company that has problems could earn less in the future, while the dividend earnings of investors may be offset by falling unit prices.

Best trusts to invest in

Investing in energy

Gilman says, “There are two types of royalty trusts, perpetual and term. A perpetual royalty trust is just one that exists only until all the resources are completely exhausted. A term trust terminates at a specified time, either having production or monetary goals.”

It’s vital for you to know where the trusts resources are and then how much the producer think is till available for extraction.

Gilman says, “The value of the trust is entirely tied to commodity prices, recommending that no more than 2 percent of an investor’s portfolio be put into any individual trust. They have the potential to be extremely volatile. Their performance has generally lagged commodity prices over the long-term and has been generally mixed in the short-term. Furthermore, the dividend yields fluctuate greatly because of volatile commodity prices, so one should not regard the yield with great conviction.”

So while a royalty trust can be a solid income producer, you should not consider it to be as reliable an alternative like dividend paying stocks or bonds.

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