What it means
Imagine a company that drills for oil on land it leases. The landowner, or the company that holds a royalty interest in the land, is paid a share of the revenue from every barrel sold, without paying any of the drilling costs.
A royalty income trust packages that stream of royalty payments into units that investors can buy on a stock exchange. The trust itself is a simple structure with few employees and few costs.
It collects the royalty income, pays its small administrative expenses, and distributes nearly all the rest to unit holders, often monthly or quarterly. Because it pays out most of its income, it usually keeps little cash and does not reinvest.
This makes the investment attractive to people who want income, but the income is not guaranteed. When commodity prices fall or production declines, distributions fall as well.
A drop in price from $90 to $60 a barrel, for example, can reduce royalty revenue sharply while the trust's costs barely change. An important feature is depletion.
Oil and gas wells and mines produce less over time, and eventually the reserves run out. Part of each distribution is therefore, in economic terms, a return of capital rather than a return on capital, so a high yield does not necessarily mean a high profit.
Tax treatment depends on the country and the structure, and it can be different for the trust and the unit holder. In some places, the trust passes income straight to unit holders, who then pay tax on it, while in others, the rules for trusts have changed over time.
Investors should take local tax advice before buying. For analysts, the key questions are the size and life of the reserves, the contracts under which royalties are paid, the sensitivity to price, and the quality of the operator that actually produces the commodity.
A trust whose royalties come from a well-run operator with long-life assets is generally safer than one dependent on a few ageing wells.
In practice
Real-world examples.
Example
A retiree buys 10,000 units of a royalty trust at $5.00 each, an investment of $50,000, for monthly income. At a distribution of $0.38 per unit per year, she receives 10,000 x 0.38 = $3,800 a year. She knows the amount could fall if energy prices drop.
Example
A fund manager compares two royalty trusts. One is backed by long-life gas fields, while the other depends on older oil wells that are in decline. He chooses the first, even though its yield is lower, because the income should last longer.
Example
A mining company sells part of its royalty on a gold project to a trust to raise cash. It receives $20,000,000 upfront and gives up a 2% share of future revenue. The company uses the money to pay down debt, while the trust earns income without running the mine.
Formula
Calculation
Distribution per unit = (royalty income - trust expenses) / units outstanding
Yield = annual distribution per unit / unit price
Suppose a trust receives $12,000,000 of royalty income in a year and pays $600,000 of expenses. Distributable income = 12,000,000 - 600,000 = $11,400,000. With 30,000,000 units outstanding, the distribution per unit = 11,400,000 / 30,000,000 = $0.38. If the unit price is $5.00, the yield = 0.38 / 5.00 = 0.076, or 7.6%.Case study
Seen in the real world.
Redstone Royalty Trust is an illustrative, fictional trust that holds royalties on natural gas wells, with 20,000,000 units in issue. In a strong year, royalty income was $9,000,000, expenses were $400,000, and distributions were 8,600,000 / 20,000,000 = $0.43 per unit.
The next year gas prices fell and production from the older wells declined. Royalty income dropped to $5,000,000, and with expenses of $400,000, the distribution fell to 4,600,000 / 20,000,000 = $0.23 per unit.
Unit holders who had expected a steady payment were surprised, and the unit price dropped by almost half. The illustrative lesson is that a royalty trust's income follows commodity prices and reserves, and a high past yield is not a promise.
Watch out
Common mistakes.
- Assuming the distribution is fixed like interest on a bond, when it moves with prices and production.
- Treating the whole distribution as profit, when part of it is a return of capital as the reserves are used up.
- Ignoring the quality and life of the underlying reserves when comparing yields.
Questions
People also ask.
How is a royalty trust different from a company?
It owns royalty rights rather than operating assets, has very few employees, and pays out most of its income instead of reinvesting.
What happens when the reserves run out?
The royalty income eventually ends, and the trust may be wound up, with units losing most or all of their value.
Are royalty trust distributions taxed?
Yes, but the way depends on the country and the trust structure, so investors should seek local tax advice.
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