I previously described what royalty land trusts are. They seem overly complex to the point of being scary what with the chance of losing all you position's money. Yet the pull of double digit yields are inticing enough to draw investors to consider it. In the end though, the hardest part with investing in land trusts is in understanding them. Evaluating them and determining potential profit and loss is far easier.
Let us set aside all the aspects of a land trust I previously discussed. They are important to keep in mind, but do not come into play very much for determining fair value. I focus on one thing and one thing only, the income stream that owning units of the trust will give. Corporations that will grow have upward pressure in their share price. They open new factories and new products. Trusts however have downward price pressure. Their value is the future payments and with every passing distribution payment, the remaining value drops. For this reason I wouldn't advise trusts for capital gains. MLPs are far better for that in the energy sector. It is certainly possible to get cap gains out of trusts and I have enjoyed great total returns in the past but there is a lot working against the investor here.
Before I get into the math and calculations I want to touch upon depletion rates. Oil and natural gas wells shoot their natural resource up out of the ground due to pressure. As oil and gas comes out there is less pressure in a well and thusly less of the natural resource will come up. A depletion rate is the estimated drop in volume of oil or gas extracted from the ground on a year to year basis. The vast majority of trusts are energy resource based so it will be important to keep in mind the depletion rate. That rate can be 5% for long lived fields or faster at 10% or more. Some trusts can last for 40+ years.
Ignoring depletion rates is the #1 most common problem I see with trust investors. They see a couple years of distributions paid out and run their numbers giving drastically inflated returns that end up causing them to overpay.
Lets take for example a trust estimated to last for 10 years at a 10% depletion rate. Two years have passed giving distibutions of $5 and $4.50. We will assume energy prices remain constant for this example.
I often see investors look at $5 and $4.50 and take the average. $4.75 a year for 10 years means this will pay $47.50 before it expires. They presume the difference in distributions between year 1 ($5) and year 2 ($4.50) was due to changing oil or gas prices or some one off event.
When we apply the estimated depletion rate we instead get a total of $32.50 ($5, $4.50, $4.05, $3.65, $3.28, $2.95, $2.65, $2.38, $2.14, $1.9). The amount of barrels of oil and cubic feet of nat gas decreases 10% a year and thusly the total amount of revenue is decreased by 10% a year.
Changing energy prices can hide this especially when rates are rising and cover up lower production totals. When prices drop coupled with dropping production you can have a collapse in the distribution and a collapse of the unit price as people recalculate their fair value estimates.
As we can see here, the majority of payments comes in the begining of a well's lifetime and pay less then half in the end.
Let's get to how I roughly estimate the value of a trust. You will need to find out the termination clauses of the trust.
Termination by date: This example trust will terminate 10 years from its start date. If it has been around for 3 years when you stumble upon it. So we know that it has 7 years of payments coming. To break even you would need a 14% yield (100% gain to cover your position / 7). If its equal to that or better then I would open up the quarterly reports and S-1 and estimate depletion rates and do further due diligence. If its yielding anything less, like say 10%, then we know its a losing investment because at best you will gain 70% of your position back in distributions before it terminates and you lose your position. You can ignore everyone telling you what a great long term investment this is, you already know with 30 seconds of work that its not worth it.
Termination by total amount of resources sold: This example trust terminates after 100 million BoE (barrels of oil or barrels of oil equivalent) have been sold. First year's production is 10 million and there is a 5% depletion rate. This turns the years of production to be 10, 9.5, 9.02, 8.5, 8.14, 7.73.... and we see that after year 13 a total of 97 millin BoE has been extracted. Very close to termination.
100%/13 years = 7.69% yield this should pay for us to break even.
As before, if it pays at least this much or better then we can do further research and then make an informed decision. If not then we don't waste our time.
The key thing here is to see if a trust is even worth your time to research. If it is, then you can dive in and determine if its an investment you want or not.
Each trust is unique and there are many different aspects that dictate how they opperate. Do not skip reviewing the S-1 form.
If you are unable to find that form do not worry. Grab the annual report called a 10-K. It will give you the termination clauses and updates and estimates when the trust is over. They are very open and direct about it and there is no reason to be caught by surprise.
Hopefully this cleared up land trusts a bit more. Figure out how many payments are left based on the termination clauses and estimate payments. My next entry will be a review of a trust that I own, Whiting USA Trust II (WHZ) and I'll be showing everything in greater detail as an example.
Disclaimer: The investments and trades discussed are not recommendations for others. I am not a financial planner, financial advisor, accountant, or tax adviser. The financial actions I talk about are for my own portfolio and money and only suited for my own risk tolerance, strategy, and ideas. Copying another person's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.
Let us set aside all the aspects of a land trust I previously discussed. They are important to keep in mind, but do not come into play very much for determining fair value. I focus on one thing and one thing only, the income stream that owning units of the trust will give. Corporations that will grow have upward pressure in their share price. They open new factories and new products. Trusts however have downward price pressure. Their value is the future payments and with every passing distribution payment, the remaining value drops. For this reason I wouldn't advise trusts for capital gains. MLPs are far better for that in the energy sector. It is certainly possible to get cap gains out of trusts and I have enjoyed great total returns in the past but there is a lot working against the investor here.
Before I get into the math and calculations I want to touch upon depletion rates. Oil and natural gas wells shoot their natural resource up out of the ground due to pressure. As oil and gas comes out there is less pressure in a well and thusly less of the natural resource will come up. A depletion rate is the estimated drop in volume of oil or gas extracted from the ground on a year to year basis. The vast majority of trusts are energy resource based so it will be important to keep in mind the depletion rate. That rate can be 5% for long lived fields or faster at 10% or more. Some trusts can last for 40+ years.
Ignoring depletion rates is the #1 most common problem I see with trust investors. They see a couple years of distributions paid out and run their numbers giving drastically inflated returns that end up causing them to overpay.
Lets take for example a trust estimated to last for 10 years at a 10% depletion rate. Two years have passed giving distibutions of $5 and $4.50. We will assume energy prices remain constant for this example.
I often see investors look at $5 and $4.50 and take the average. $4.75 a year for 10 years means this will pay $47.50 before it expires. They presume the difference in distributions between year 1 ($5) and year 2 ($4.50) was due to changing oil or gas prices or some one off event.
When we apply the estimated depletion rate we instead get a total of $32.50 ($5, $4.50, $4.05, $3.65, $3.28, $2.95, $2.65, $2.38, $2.14, $1.9). The amount of barrels of oil and cubic feet of nat gas decreases 10% a year and thusly the total amount of revenue is decreased by 10% a year.
Changing energy prices can hide this especially when rates are rising and cover up lower production totals. When prices drop coupled with dropping production you can have a collapse in the distribution and a collapse of the unit price as people recalculate their fair value estimates.
As we can see here, the majority of payments comes in the begining of a well's lifetime and pay less then half in the end.
Let's get to how I roughly estimate the value of a trust. You will need to find out the termination clauses of the trust.
Termination by date: This example trust will terminate 10 years from its start date. If it has been around for 3 years when you stumble upon it. So we know that it has 7 years of payments coming. To break even you would need a 14% yield (100% gain to cover your position / 7). If its equal to that or better then I would open up the quarterly reports and S-1 and estimate depletion rates and do further due diligence. If its yielding anything less, like say 10%, then we know its a losing investment because at best you will gain 70% of your position back in distributions before it terminates and you lose your position. You can ignore everyone telling you what a great long term investment this is, you already know with 30 seconds of work that its not worth it.
Termination by total amount of resources sold: This example trust terminates after 100 million BoE (barrels of oil or barrels of oil equivalent) have been sold. First year's production is 10 million and there is a 5% depletion rate. This turns the years of production to be 10, 9.5, 9.02, 8.5, 8.14, 7.73.... and we see that after year 13 a total of 97 millin BoE has been extracted. Very close to termination.
100%/13 years = 7.69% yield this should pay for us to break even.
As before, if it pays at least this much or better then we can do further research and then make an informed decision. If not then we don't waste our time.
The key thing here is to see if a trust is even worth your time to research. If it is, then you can dive in and determine if its an investment you want or not.
Each trust is unique and there are many different aspects that dictate how they opperate. Do not skip reviewing the S-1 form.
If you are unable to find that form do not worry. Grab the annual report called a 10-K. It will give you the termination clauses and updates and estimates when the trust is over. They are very open and direct about it and there is no reason to be caught by surprise.
Hopefully this cleared up land trusts a bit more. Figure out how many payments are left based on the termination clauses and estimate payments. My next entry will be a review of a trust that I own, Whiting USA Trust II (WHZ) and I'll be showing everything in greater detail as an example.
Disclaimer: The investments and trades discussed are not recommendations for others. I am not a financial planner, financial advisor, accountant, or tax adviser. The financial actions I talk about are for my own portfolio and money and only suited for my own risk tolerance, strategy, and ideas. Copying another person's financial moves can lead to large losses. Each person needs to do their due diligence in researching and planning their own actions in the financial markets.
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