After suffering from the pandemic last year, the energy sector is by far the best-performing sector of the stock market this year making royalty trusts worth another look.
Thanks to the massive rollout of vaccines and the deep production cuts of OPEC and Russia, the price of oil has rallied to a 3-year high while the price of U.S. natural gas is at a 2.5-year high.
Given also the markedly high dividend yields and monthly dividend payouts of Sabine Royalty Trust (NYSE:SBR), Permian Basin Royalty Trust (NYSE:PBT) and PermRock Royalty Trust (NYSE:PRT), it is only natural to wonder whether it is the right time to purchase these stocks.
Before buying, investors should know the various pros and cons of oil and gas royalty trusts.
Important Characteristics of Royalty Trusts
Trusts are different from the well-known oil and gas companies in some aspects.
First of all, they offer a different distribution every month, based on their actual production levels and their realized prices of oil and gas.
In addition, in contrast to the popular oil producers, most trusts have static assets, meaning they cannot add new properties to their asset portfolios.
Consequently, their production is expected to decrease in the long run due to the natural decline of their fields. This is of paramount importance, as it means that the only material growth catalyst for them is an increase in oil and gas prices.
That said, if oil and gas prices rise, it could be highly rewarding for owners of royalty trusts in the form of high distributions. Three of the top oil and gas royalty trusts are discussed below.
Sabine Royalty Trust (SBR)
Sabine Royalty Trust is an oil and gas trust that has royalty and mineral interests in producing properties and proved oil and gas properties in Florida, Louisiana, Mississippi, New Mexico, Oklahoma and Texas.
The trust has no operations or capital expenses. It just distributes the royalties it receives from its produced commodities (minus general and administrative expenses, which consume 5%-8% of royalties) to its unit holders.
SBR was formed in 1982, with an expected lifetime of reserves of 9-10 years. However, the trust has exceeded expectations by an impressive margin and thus it is still in place.
Moreover, the trend of the reserves of SBR has been promising in the last few years. Instead of declining, the proved developed reserves of oil and gas of SBR have grown 4% and 16%, respectively, since the end of 2017.
This trend signals that this high-quality trust has good chances of remaining in place for a few more decades.
SBR has offered total distributions of $1.59 per unit in the first seven months of the year. These distributions correspond to a 6.5% annualized distribution yield.
Given the recent rally of oil and gas prices, SBR is likely to offer above-average distributions in the upcoming months, as its distributions lag the trends in commodity prices by a few months.
Therefore, the trust is likely to offer a higher than 6.5% yield in the full year.
As long as the economy continues to recover strongly from the pandemic and OPEC+ remains committed to its production quotas, the yield of SBR should be considered safe.
On the other hand, the energy market is highly cyclical, with dramatic swings in commodity prices. Whenever the next downturn shows up, SBR will reduce its distributions.
To provide a perspective, SBR cut its annual distribution 20% last year due to the pandemic, from $3.02 to $2.40. The latter corresponds to a 5.7% distribution yield at the current stock price.
Overall, SBR is one of the most attractive trusts, as its production has exceeded expectations by a wide margin for decades. It is also offering an attractive 6.5% yield.
Royalty Trusts to Buy: Permian Basin Royalty Trust (PBT)
Permian Basin Royalty Trust (PBT) is a medium sized oil and gas trust, with approximately 70% oil production and 30% gas production.
It is also a combination trust: unit holders have a 75% net overriding royalty interest in Waddell Ranch Properties in Texas, which includes 332 net productive oil wells, 106 net productive gas wells and 120 net injection wells.
It also includes a 95% net overriding royalty interest in Texas Royalty Properties, which includes various oil wells.
In the first quarter, its average realized price of gas jumped 67% but its average realized price of oil declined 24% over last year’s quarter.
The trust grew its oil production 7% but its total royalty income plunged 66% due to high drilling costs on the Waddell Ranch properties, which eliminated the royalty from these properties.
Due to the high operating expenses on the Waddell Ranch properties, PBT has offered a total distribution of only $0.11 per unit in the first seven months of the year.
This distribution corresponds to an annualized yield of only 3.3%. Given the impressive rally of the prices of oil and gas, this yield is undoubtedly disappointing.
On the bright side, the realized prices of PBT lag the trends of the benchmark prices and the trust is likely to improve its distributions in the upcoming quarters. However, the market has already priced a strong recovery in the distributions of PBT.
This helps explain the exceptionally low distribution yield of the trust. Moreover, the high operating costs of PBT cause some uncertainty over its ability to fully benefit from the favorable price environment.
It is also important to note that the production of oil and gas of PBT has declined at an average annual rate of 6% and 2%, respectively, over the last six years.
Overall, PBT has limited growth prospects and the market has already priced most of the future growth potential in the stock.
PermRock Royalty Trust (PRT)
PermRock Royalty Trust is focused on the acquisition, development and operation of oil and natural gas properties in the Permian Basin. It produces oil and gas at an 83/17 ratio.
The Permian Basin is the most prolific oil-producing area in the U.S. The properties of PermRock consist of long-life reserves in mature, conventional oil fields, with shallow, predictable decline rates.
In addition, the trust can enhance its oil production via water-flooding techniques, while it also expects to identify new reserves in the area in the upcoming years. PermRock believes it can produce oil for many years.
Thanks to the rally of the oil price to a 3-year high, PRT has raised its distributions significantly this year.
In the first seven months of the year, the trust has offered total distributions of $0.26 per unit, which correspond to an annualized yield of 6.2%.
Even better, its first distributions were depressed due to the pandemic and therefore its total annual distribution yield is likely to be higher than 6.2%.
In contrast to the other two trusts, PRT expects to grow its production over time. It thus has two growth catalysts, namely greater output and a rising oil price.
However, it is important to realize that the price of oil seems to have limited upside potential from its current 3-year high level.
While its strong momentum is likely to remain in place in the short run, the oil market is highly cyclical and therefore the price of oil will probably have significant downside whenever the next downturn shows up.
While its management has pledged to grow production over time, the trust has reduced its production by 7% in total in the last two years. Therefore, PRT has a long way to go to prove that it can grow its production consistently.
Last year, the trust suspended its distribution for five consecutive months due to the coronavirus crisis. Even in the months in which it offered a distribution, the amount was dismal.
Overall, as long as the price of oil remains elevated, PRT will continue to offer an attractive distribution. Its latest monthly distribution of $0.0607 per unit corresponds to an annual yield of 10.1%.
Final Thoughts
The rally in oil and gas prices has rendered the energy sector by far the best-performing sector of the stock market this year.
Nevertheless, investors should be particularly careful in their stock selections, as the market has already priced a significant portion of future growth in most energy stocks.
From the aforementioned oil and gas trusts, Sabine Royalty Trust seems to be the most attractive one thanks to its unparalleled business performance and its attractive distribution yield.
On the date of publication, Bob Ciura did not have (either directly or indirectly) positions in any of the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Bob Ciura has worked at Sure Dividend since 2016. He oversees all content for Sure Dividend and its partner sites. Prior to joining Sure Dividend, Bob was an independent equity analyst. His articles have been published on major financial websites such as The Motley Fool, Seeking Alpha, Business Insider and more. Bob received a bachelor’s degree in Finance from DePaul University and an MBA with a concentration in investments from the University of Notre Dame.