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Royalty Trusts: Are They Really Worth The Risk?

By Edited Jan 26, 2016 1 0

When investors feel that typical stocks and bonds are not cutting it, they usually turn to alternative investments. One of these investments are called Royalty Trusts. They are considered to be types of corporations (although some money managers do not see them as corporations) that deal with producing minerals or some other form of commodity. Oil and gas production is the most common form of income that royalty trusts rely on. However, unlike most corporations, the profits generated from a royalty trust are not taxed at the corporate level, but are taxed as personal income. This income is then given out to shareholders in the form of dividends or distributions.

Oil and mining companies perform the actual operation of the oil or gas field, or mine, and the trust itself typically has no employees. The trust is typically overseen by a trust officer in a major bank and all of the finances are managed by the trust officer.

Royalty trusts trade just like stocks and pay large dividends to shareholders. In many cases, the dividends are not always quarterly, but sometimes even monthly. Many investors see this as a way to generate quick income. In reality, are royalty trusts risk-free investments? Or are they investments that are hiding crucial information from investors?

 

Office

The majority of them operate oil and gas fields in U.S. states such as Texas, Oklahoma, New Mexico, Louisiana, Mississippi, and Colorado. The trusts generate income from the oil fields and pay back the profits directly to investors. It is almost as if you owned the oil and gas wells and never had to pay insurance and maintenance costs, but still got paid anyway. One thing that royalty trusts hide from investors are several crucial factors which can change everything.

First, the price of the commodity which the trust produces, can easily change the profit and ultimately the payout that the trust distributes. When oil prices were near $100 a barrel everyone invested in royalty trusts. The payouts were colossal and they kept on getting bigger. What happened when the price of oil plummeted to $50 a barrel? The price of the trusts did not just plummet, but the payouts also slowly diminished. Investors saw their income streams slowing down as the price of oil and the equity itself kept on falling in price.

Another potential issue is if bad weather hits the areas where its assets are held. For example, what if a tornado strikes a handful of its oil wells? They will be out of commission for a given period of time and it will cost extra money to repair the damaged wells. Even if insurance covers the damaged wells, the overall profits will still shrink. Remember, these aren't behemoth companies with assets spread across the globe, they typically have assets in small areas.[1]

Oil Well

Now, here is another issue with trusts. Investors tend to believe that just because a trust may have been formed in 1980, it will produce income interminably. In reality, this is false. All of these equities eventually liquidate and their operations completely cease. This means the price will decrease to unprecedented levels and eventually reach zero. The only problem is; when do trusts officially deplete and run out of resources? Unfortunately, that is the million dollar question that investors must find out on their own.

Now, this doesn't mean that all royalty trusts are worthless investments and that money can never be made with them. Historically speaking, investors such as T. Boone Pickens saw immense returns with these investments. Moreover, some investors may have invested in them at the perfect time and retirement came early for them. In the end, one should be cautious with trusts because they are tricky investments. At the same time, one should also consult a tax professional when investing in them because these equities require seperate paperwork.

 

 

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Bibliography

  1. Peter Beck Canadian Income Funds: Your Complete Guide to Income Trusts, Royalty Trusts and Real Estate Investment Trusts . Toronto: Wiley, 2009.

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