A royalty income trust is a special-purpose financing vehicle which allows those who invest to partake in income that’s generated by energy-producing concerns, such as oil wells, coal mines, and gas deposits.
First incorporated in 1956 and most often found within Canada, royalty trusts mean that unitholders of the trust get paid monthly, as long as the companies are both operational and moving their products. When the natural resource in question runs out, the trust is then dissolved.
Seems simple enough- but in this day and age, are royalty trusts actually good investments? There are many factors to consider, all of which the following article will cover in detail.
What Are Royalty Trusts?
Royalty trusts are special purpose vehicles that are used by those who own energy producing assets, in order to sell forward production at affordable prices.
By selling future production to a trust at a predetermined price, asset owners can obtain stable and predictable future cash flows. The profit from production is distributed to the trust’s shareholders.
It’s the trust that takes on the risk of variables like commodity price fluctuations and changes to production costs, in return for increased unitholder returns thanks to rising commodity prices. So, at its essence, a royalty trust exists purely to pass income that’s generated from the sales of energy producing assets onto shareholders.
At the corporate level, there is no income tax requirement, just as long as the majority of the income (at least 90%) is provided to shareholders via dividends or distributions.
Types Of Royalty Trusts
The two main types of royalty trusts are Canadian and American.
American royalty trusts are primarily focused on maintaining the assets that investors already own, and less focused on making capital expenditures. Money is distributed to shareholders until the asset (the asset being a natural resource) has been depleted. While this can lead to very high payouts, they leave not much money at all for future growth.
Back in the 80’s, the types of assets that trusts could hold were limited by Congress. Additionally, trusts in the United States could no longer fund new acquisitions, whether this was by raising debt capital or by issuing new units. This means that trusts in the United States are now simply dissolved when the resources run dry, as they have no value. US trusts also don’t qualify for the 15% tax rate on dividends.
Over in Canada, however, no such laws were ever introduced, at least none with such drastic changes. A lot of Canadian royalty trusts (sometimes referred to as ‘CanRoys’) can pay out yields of percentages up in the double-digits. They can also offer tax-advantaged exposure to income investors in the energy market.
Trusts in Canada can also raise money by borrowing funds or issuing shares. Money they borrowed can be used to either develop their properties or buy new reserves. Those are the main differences between Canadian trusts and American trusts; sustainable distributions.
It should be noted that although some Canadian trusts are interlisted, meaning they trade in the United States as well, Canadian trusts tend not to be listed on American exchanges. They are usually only traded on the Toronto Stock Exchange (TSX), which is the third largest exchange in North America, and the 11th largest in the world.
Are Royalty Trusts Good Investments?
In order to determine whether royalty trusts are actually a worthwhile investment, it’s important to weigh up all the pros and cons. The following is a list of all the main benefits to investing in royalty trusts, as well as all the negatives.
Pros of Royalty Trusts
High yield: Almost all of a trust’s cash flow is paid out in distributions. This means that most royalty trusts have yields that are above average, and some yields are exceptionally high.
No corporate income tax: As previously mentioned, no corporate income tax is required when it comes to trusts, because they’re investment vehicles where the money is simply being passed through. While with other investments there can be issues like the double taxation of dividends, those issues do not apply here.
Other tax advantages: To the IRS, distributions from most trusts are rarely regarded as income, thanks to depreciation and depletion. The non-income distributions are used in order to reduce an owner’s cost basis in the stock. This will then be taxed at the lower capital gains rate, and deferred until the owner decides to sell. Trust unitholders are sometimes also entitled to tax credits, although these credits tend to be nothing significant and the laws surrounding them are constantly changing.
Cons of Royalty Trusts
Volatile Distribution: Distributions tend to be paid out every quarter or every month. If royalties have fallen during the period when the distribution is to be paid out due to a substantial decrease in the underlying price of the commodity, this will naturally lead to lower distributions. These changes can be volatile; there is not much stopping a yield of, say, 13%, dropping to as low as 1% (or lower) within as little as a year.
Depletion: Because the royalties are owned on a finite resource, the royalties and distributions will gradually fall as said resource depletes. Of course, the upside is that it usually takes decades for the resources to deplete, but eventually they will run out.
Tax complexities: Owners of royalty trusts must report the pro rata portion of their trust’s total expenses and income on their tax returns. This not only means filing both Schedules E and B, but there will also be additional filing required with Form 1040.
State income tax: In the United States, owners of royalty trusts must pay income tax in the states in which the trust is generating its royalties. There are varying thresholds for when exactly the taxes must be filed and paid, and the chances of owing income tax across multiple states increases aside the size of a given ownership position.
The Business Model of Royalty Trusts
Because royalty trusts don’t really have employees, management, or energy-generating operational activities, their finances tend to be quite simple.
Royalty trusts are a means of financing by owning a certain amount of oil or gas revenue rights that are sold by upstream energy companies. This is their primary business model, rather than owning hard assets and engaging in productive activities.
How To Invest In Royalty Trusts
There are many publicly listed royalty trusts. You can invest in units in a trust just as you would any other stock. There are an assortment of easy-to-use online trading platforms that will give you access to the entire market.
Is Investing In Royalty Trusts Bad For The Planet?
Scientific debate on the topic is ongoing, but it’s widely accepted that the planet will not be able to support the models of production and consumption that are most prevalent now. The pressure on natural resources, which are where all the money in royalty trusts comes from, is set to increase dramatically.
This increase will only be accelerated by the Earth’s climbing temperatures, which many scientists fear may now be irreversible. As it stands, the planet’s current resource and energy-intensive methods when it comes to agricultural production are a significant factor in terms of greenhouse gas emissions. This is one of the foremost contributors to climate change.
While investing in royalty trusts can lead to many years of high yield, it’s always worth considering your carbon footprint.
Alternatives To Royalty Trusts
One of the main alternatives to royalty trusts is MLPs (master limited partnerships). With MLPs, the investors buy units of the partnership rather than stocks, so are referred as unitholders, just like with royalty trusts. The main difference between MLPs and royalty trusts is that MLPs offer consistent distributions in the long term.
Most businesses operated as MLPs see very stable, consistent cash flows every quarter. Their distributions generally are a far safer bet than those of royalty trusts.
MLPs also come with a notable absence of taxes, at least at the corporate level. This leads to a lower cost of capital than most corporations, which means MLPs can pursue other projects.
It may seem like such high-yield stocks would be an ideal way for investors to gradually grow their wealth, but when it comes to long-term investments, there’s far better options out there.
Because they’re not growing organizations, the cash flows are rarely consistently stable. Due to the inevitable termination date, most of your distributions would essentially just be returns on your original investment. This means that anyone investing in them is acquiring a substantial amount of risk. This is mainly down to volatile distributions, but also the fact that your total returns may well end up being negative.
The tax complexities are yet another reason why royalty trusts shouldn’t be your go-to long-term investment, and this is before factoring in the impacts that depleting natural resources are having on the planet.
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