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Investing At Will: Royalty Trusts

Guest article by Will, William Schmarder, May 20,2013

It's late spring, getting close to the summer, and that means a few things. Gas prices are starting to rise, refineries are switching to their summer blend, and some are going under repair. People are starting to take road trips, raising the demand for oil. When it comes to this, the average American has two choices. They can either sulk and pay their exorbitant gas bill, or they can profit from gas prices and invest in royalty trusts.

Royalty trusts are an innovative way for investors to gain exposure to the oil, natural gas, and other commodity prices. These instruments provide regular high yields to their shareholders, and are traded on the common stock exchanges. The main difference between royalty trusts and regular stocks is that royalty trusts are considered, as the name implies, a royalty. The investor doesn't actually own any of the material that is harvested from the locations specified by the trust, but receives a royalty on what is harvested, usually along the lines of 75 to 90 percent of the sale price. The price is dependent upon how much the commodity was for delivery in the month it was harvested, as well as how much of the commodity was harvested. When commodity prices are reported by media outlets, it is the futures price of the commodity for delivery in the next month. Once the end of the month is hit, there's a good idea of how much will be earned.

As royalty trusts are different from stocks, so are the taxes. Because these are royalties, the investor will be paying the full rate according to his or her tax bracket. In addition, if the investor isn't already leasing out property for rent, he or she will become very familiar with Schedule E. For those that are used to Form 1040A, stop getting that book, because the full 1040 form needs to be filed. Typically, the trustee will send the investor a nice little booklet on the amount of distributions and deductions, or will place this information online so it is readily available. Some trusts are better with making information readily available than others. The booklet will contain information on gross income, interest income, hedge income, severence taxes, administration expenses, and depletion. This information is broken out by the month, and the appropriate information will be taken based upon the months in which a distribution was received. When the shares are sold, of course, the traditional capital gains rules will still apply

Knowing this, why would someone ever want to invest in royalty trusts? Depletion is the key. One caveat about these trusts is that when they are established, a certain amount of land is able to be used, but no more. In order to account for this, the investor is able to deduct amounts for depletion as a hedge against the amount of the commodity that is able to be harvested. The formula that is used is based upon one of two things. The first is a cost depletion factor, which is based upon a percentage of your principal applied to a certain parcel of land (many royalty trusts will have several parcels of land where the commodity is harvested) LESS the amount of depletion claimed in previous years. The second is a percentage depletion factor, which is a direct percentage on the number of shares owned. Typically, the investor would claim the absolute higher of the two as an expense, and depending upon when you invest, this can result in claiming a loss. This results in a paradox: If the investor is claiming a loss, isn't the investor losing money? The only place where they are losing is the potential on what could be harvested if the royalty were on an unlimited parcel of land. The bottom line is that the investor is receiving a monthly distribution greater than $0, and if timed in a clever way, could sell the shares of the royalty at a capital gain.

Knowing what these trusts are, as well as how the taxes work, it is now time to consider investing. As with any investment, due diligence is necessary to make sure the investor gets a good deal. The things to consider are what distribution of commodity or commodities is/are harvested, how much to invest, and how long to hold the asset, including an exit strategy. When considering distributions, keep a watchful eye on the futures prices. In late 2011 to early 2012, there was a large decline in the price of natural gas, and this hit the capital value of many royalty trusts, as they typically also harvest natural gas. When considering how much to invest, this is an easy one, as typical diversification will suffice. When it comes to holding the asset, this gets a little tricky. Because depletion basis is lowered with each passing year for tax purposes, only hold shares for a couple of years. Use trends in historical charts to predict the best moment to sell. Be VERY careful when selling, especially if using DRIPs (Dividend Re-Investment Plans), as wash sales (rebuying a sold stock within 30 days before OR after the sale) can have a negative effect on your distributions. It is wise to pick a couple of trusts and swap shares between the two, but always be on the lookout for newer trusts, as more profits can be taken from these.

The following royalty trusts have been in my portfolio at one time or another:

MSB – Mesabi Trust – Iron Ore – no current holdings; held short term in 2010 to cash in on the metals boom.

CRT – Cross Timbers Royalty Trust – Oil/Gas – no current holdings; this was my first trust, held from 2010-2013. Would consider a swap back in the future.

HGT – Hugoton Royalty Trust – Natural Gas – no current holdings; held 2011-2012, sold at the time of the natural gas price bust, and low distributions along with this.

MTR – Mesa Royalty Trust – Natural Gas – no current holdings; held 2011-2012, excellent depletion rate because the trust is fairly old, but awful with communications. Distributions are rated monthly but paid quarterly.

ROYT – Pacific Coast Oil Trust – Oil/Gas – currently held since 2012; oil has exposure to the Brent crude price.

For more information on specific royalty trusts, visit http://www.dividendyieldhunter.com/US_Royalty_Trust_List.html .