October 17, 2004; Kurt Wulff quoted in NY Times on Royalty Trusts by Alex Tarquinio

Published Sunday, October 17, 2004

Not an Oil Baron? You Can Still Get Oil Royalties


New York Times

OIL prices have climbed more than 70 percent over the last year, and energy experts say they expect the cost to remain high as long as there is political unrest in oil-rich countries like Iraq, Venezuela, Nigeria and Russia.

Of course, soaring commodity prices have been a boon for huge energy companies like Exxon Mobil, which closed at $49.02 on Friday, up 30 percent from a year ago. But investors who want to tap into the high price of energy may want to consider an investment that is not as well known: energy royalty trusts.

"The wealthy Texas families have owned these for years," said George B. Lucas Jr., a principal of Lucas Capital Management of Red Bank, N.J., that specializes in energy investments. "Much of our investment philosophy is about making up for the fact that none of us inherited oil wells."

Energy royalty trusts are required by law to pay shareholders most of their income from oil and natural gas as dividends. Though trust share prices have soared in the last two years, trust yields are still high because commodity prices have kept pace. And because the American trusts don't spend money on exploration, they are more or less a pure commodity play.

Mr. Lucas says the trusts are generally a good alternative to owning bonds, whose prices move in the opposite direction of interest rates. Energy trusts may rise if interest rates shoot up on fears of inflation, he said, because commodities are often viewed as an inflation hedge.

But investors shouldn't be entirely dazzled by the trusts' current payouts, he said, adding that it was important to study the depletion rates of their energy reserves. "If you open a bottle of Coke, you get a big rush of bubbles, and then it runs down," Mr. Lucas said. "Our job is to analyze at what rate each of these trusts is running down."

The United States energy royalty trusts that trade publicly are much like the family trusts that cut checks for the descendants of oil barons. By law, they must be passively managed to avoid corporate taxes; that means they cannot buy new properties, for example, or hedge future commodity prices. Owning an asset with depleting reserves also has tax advantages.

In Canada, where energy trusts are more popular, they operate more like traditional, actively managed companies, with executives who can issue new shares, hedge commodity prices and borrow money to buy new oil fields. But once a United States energy trust is set up, no oil or gas fields can be added, and an outside company operates the fields.

"To the degree that anybody is running the U.S. trusts, it's a sleepy banker who sends out royalty checks once a month," Mr. Lucas said.

The Canadian trusts are also much larger, both in production and in market capitalization. They produce about 11 percent of the oil and 23 percent of the natural gas in Canada and have a combined market capitalization of 34 billion Canadian dollars, or about $27 billion, said Michelle Dathorne, a Standard & Poor's credit analyst who covers the oil and gas industry from Toronto. But the United States trusts, which tend to focus on natural gas, produce only about 0.5 percent of the gas in the nation and have a combined market cap of less than $5 billion, said Kurt H. Wulff, an independent energy stock analyst who publishes research on his Web site, www.mcdep.com. By comparison, the five largest global oil companies have a combined market cap around $900 billion.

Investors in either the American or Canadian trusts might get a nasty surprise if commodity prices slid suddenly, some industry experts say. For instance, if natural gas prices fell to $4.50 per million B.T.U.'s from the current $6.70 and stayed there, shares of trusts that primarily receive royalties from natural gas could fall by about one-third, said Ashton Lee, a portfolio manager and energy stock analyst at Lucas Capital Management.

That is because the cost of production is the same no matter what oil and gas are selling for, so the huge increase in commodity prices has been pure profit for shareholders. But consider the reverse: if oil fell to $32 a barrel from more than $54 - and it cost a trust $20 a barrel to get it out of the ground - profits would fall by more than 60 percent.

"If you're willing to accept that risk, there's nothing wrong with investing now, because investors are making significant amounts of money now" from the royalties on energy trusts, Ms. Dathorne said.

She said concerns about supply were adding a "risk premium" to the price of oil, which she estimated would be about $30 a barrel, based solely on demand. That would still be well above the 10-year average of around $23. Ultimately, she expects prices to fall back to $25 to $30 a barrel.

But Mr. Wulff said that the market was in a historical period of "upward adjustment" in oil and natural gas prices. "We're running out of clean oil, so we're going to have to produce more dirty oil and spend more money refining it," he said. He predicted that in 2010 the price of oil would be at least $60 a barrel - about $50 in current dollars - and that natural gas would cost at least $10 per million B.T.U.'s in today's dollars. "It will be higher relative to the cost of oil," he said, "because gas is cleaner, so it has an increasing environmental premium."

SOME of the most popular United States energy trusts are almost exclusively in natural gas. Shares of the Hugoton Royalty Trust and of the San Juan Basin Royalty Trust have both climbed 150 percent over the last two years. Hugoton, which trades at $28.18, yields 8.7 percent and San Juan, which trades at $30.05, yields 9.1 percent. Both trusts distribute royalties from natural gas production; Hugoton's fields are in Kansas, Oklahoma and Wyoming; San Juan Basin's are in New Mexico.

Mr. Wulff stopped recommending new investments in San Juan Basin on Aug. 2, when shares hit $28.25, or 128 percent of what he says they are worth, based on his estimate of the future value of their reserves. "I like to recommend shares at 80 percent, but I'll ride them up to 120 percent," he said.

The Canadian Oil Sands Trust, based in Calgary, Alberta, is the only energy royalty trust that he still recommends buying. It closed on Friday at $49.04, well below his $62 estimate of present value. The dividend yield of Canadian Oil Sands, 4 percent, is about half that of other energy royalty trusts. Yet it could have a 15 percent yield if it paid out all of its income, Mr. Wulff said. Instead, the trust is using some income to build a refinery that will turn dirty oil mined from sand into higher-quality crude oil, he said.

Although there are tax breaks for owning a depleting resource, the filing of taxes for energy royalty trusts can be a nightmare. For one thing, they need to be filed in every state in which the wells are found. And the payouts will be taxed as income, rather than as dividends, because the trust does not pay corporate taxes. A wealthy investor whose taxes are prepared by a professional should hold shares in a taxable account, Mr. Lucas said. But he said that an investor with few shares - or one who doesn't want the trouble of all the filing - should hold shares in an individual retirement account.

Canadian trusts are subject to a 15 percent tax that is withheld by the broker. Investors in the United States can get a refund of this tax; but again, Mr. Lucas said, smaller investors may not want to deal with the paperwork. The tax will not be deducted if shares are held in an I.R.A. "You give away some of the tax efficiency, but you also give away the bookkeeping," he said.