Getting to Know Your Crude: Royalty Trusts

Michael Teague |

There are numerous ways to play commodities markets.

Speculating on spot prices, futures trading, Exchange Traded Funds designed to track almost any type of movement one can think of, and plain old stocks are among the most well-known of these entry points. But for investors and traders with a penchant for high-yielding resource plays, royalty trusts are an equity-investment that might make a good deal of sense.

Much the same as a Real Estate Investment Trust (REIT), a royalty trust is a corporate entity whose business consists of its ownership of oil and gas wells and mines, or the mineral estates (as opposed to the surface estate) to land from which these commodities are extracted. Thus, while royalty trusts trade on the exchanges just like any other stock, their structure is fundamentally different.

From the standpoint of an investment tool, the main basic attraction of royalty trusts is the dividend. Though technically defined as a corporation, a royalty trust distinguishes itself from the latter in that its profits are exempted from taxation at the corporate level. This is because the trust returns a much greater percentage of its profits to investors in the form of enormous dividend payouts, often well upwards of 15 percent. Shareholders, for their part, assume the entirety of the tax burden when their payouts are levied as personal income.

Aside from greater dividends, royalty trusts offer investors the ability to put their money as directly as possible in to the business of extraction and mining, without themselves having to own a well or a prospect. While a trust is comprised of any combination of holdings in mineral rights, and ownership of drilling platforms and mines, it can generate profits without having to navigate the risks associated with the day to day operations.

Trusts can be an excellent way to take advantage of higher commodity prices, because higher prices typically translate into larger returns. Trusts can also benefit in times of rising interest rates, when commodities become a favored means of hedging against inflation.

Along with the great potential for generating returns for shareholders, however, trusts have their pitfalls. In the United States, a royalty trust is prohibited from buying additional properties once it is formed. This restriction to original properties effectively makes it impossible for a royalty trust to grow in the way more traditional publicly-traded corporations are expected to by their shareholders. Royalty trusts are the caretakers of finite reserves that, however large and productive, will of necessity depreciate in value over time as these reserves dwindle.

When a trust is no longer capable of providing the returns its shareholders expect, it no longer has a reason to exist, and can be dissolved. Still, in optimal conditions, the substantially higher dividends they offer can more than adequately compensate for the impermanence and depreciation of their holdings.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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