Macroeconomic trends and the supply-demand balance in oil and gas markets are important drivers of energy-related equities. Although bigger-picture trends have dominated the tape for much of 2011, I still spend more than half my time analyzing individual names; stock-specific stories eventually will drive trading again.
The Energy Strategist’s coverage universe already includes more than 100 equities, but subscribers often ask for my take on names outside my watch list.
Recently, subscribers have asked me about a number of US oil and gas trusts, pass-through entities that offer high yields and exposure to movements in commodity prices. US independent oil and gas producers have launched a number of new royalty trusts in the past two years; the success of these initial public offerings, coupled with producers’ efforts to restrict spending to cash flow and ramp up drilling in emerging shale plays, should lead to several new listings in 2012.
In the Nov. 29, 2011, issue of The Energy Letter, I analyzed ECA Marcellus Trust I (NYSE: ECT) in detail. And in this week’s issue I take a look at another trust that several subscribers have been asking me about.
San Juan Basin Royalty Trust (NYSE: SJT) was formed on Nov. 1, 1980, from assets carved out of the Southland Royalty Company. In the intervening years, the trust’s sponsor was subsumed by Burlington Resources, which, in turn, was taken over by ConocoPhillips (NYSE: COP).
A subsidiary of ConocoPhillips now manages the properties underlying the trust, operating the wells and making key decisions regarding the amount of capital allocated to drilling new wells and maintaining existing wells.
The area of mutual interest covered by the trust includes about 119,000 net acres in the San Juan Basin of northwestern New Mexico. Under the terms of the agreement, the trust disburses 75 percent of the net profit from these wells to unitholders in the form of a monthly distribution. The trust only receives royalties from oil and gas produced in the Dakota formation or shallower regions.
San Juan Basin Royalty Trust currently generates revenue from about 1,173 net producing wells. Some of these wells have multiple completions–that is, a single wellbore that produces hydrocarbons from more than one rock formation. At the end of the third quarter, the trust’s area of mutual interest now includes almost 1,500 net completions, a figure that’s adjusted to reflect the sponsor’s stake in the well.
All the existing wells underlying the trust are conventional (i.e., vertical) wells, though in 1988 the operator began to extract natural gas from coal seams within the trust’s area of mutual interest.
Producers have flowed oil and gas from these formations in northwestern New Mexico for more than three decades, providing a wealth of geological data that reduces the risk of drilling a dry hole. At the same time, production from these mature fields will continue to decline at a steady-bud-predictable pace in coming years.
Annual output from these wells will also vary based on demand and commodity prices, as well as available capacity in regional pipeline systems. For example, a glut of gas can increase pipeline pressure, reducing throughput from the trust’s wells.
San Juan Basin Royalty Trust lacks a fixed termination date; if 75 percent of all unitholders vote to end the trust, its assets would be sold and the proceeds distributed among investors. The trust would also expire if its annual revenue declines to less than $1 million in two consecutive years.
At present, the trust’s annual revenue is a long way from the threshold that would trigger automatic termination. Despite depressed natural-gas prices, the pass-through entity in 2010 generated more than $170 million in revenue.
San Juan Basin Royalty Trust is exempt from corporate tax and passes through the royalty payments it receives to unitholders in the form of distributions. Unitholders are responsible for paying income taxes on their share of all royalties received.
Besides eliminating the issue of double taxation, the trust generates significant depletion allowances that defer a portion of unitholders’ tax liability. San Juan Basin Royalty Trust’s website includes detailed tax information from the past few years and worksheets that help investors to calculate their tax liability and depletion allowances.
Unlike master limited partnerships (another pass-through structure), San Juan Basin Royalty Trust’s distributions are reported on the standard 1099 form distributed by your broker. However, you will need the information sheet provided by the trust to account for your taxes and maximize your depletion allowances.
Although investing in oil and gas trusts can increase the complexity of your annual tax return, the explanatory documents on the trust’s website, your trading records and your 1099 form contain all the information needed to complete your tax return. Most investors find that the tax benefits and high yields offered by these pass-through structures outweigh the cost and complexity associated with filing tax returns.
Compared to the latest batch of oil and gas royalty trusts coming to market, San Juan Basin Royalty Trust has little upside to offer.
For one, natural gas-producing wells account for the majority of the trust’s underlying assets. In 2010 the trust generated about $163.2 million in net proceeds from the sale of natural gas, compared to $4.2 million from crude oil. Even if oil prices were to triple, the trust’s distributable cash flow would have only modest upside.
In addition, San Juan Basin Royalty trust has no hedges in place to offset depressed natural gas prices. Accordingly, the trust’s quarterly distribution tends to fluctuate with natural gas prices. As you can see in this graph, the trust’s payout soared in mid-2008 and plummeted in 2009. We expect these disbursements to remain on the low side, as a persistent supply glut should keep domestic natural-gas prices near record lows for some time.
Fuel-switching among power utilities should improve the demand side of the equation slightly in coming years, and sustainably low prices inevitably will stimulate demand in other sectors. Meanwhile, producers have scaled back production in the Haynesville Shale, Canada’s Montney Shale and other dry-gas basins. At these levels, drilling in these fields doesn’t offer the best economics; however, if natural gas rallies to more than $5 per million British thermal units, production from these fields will surge once again.
In short, we expect gas prices to remain weak for the next two to three years. Although this balance will eventually tighten, San Juan Basin Royalty Trust’s distribution offers little upside in the near to intermediate term.
We also prefer oil and gas royalty trusts that are earlier in their life cycles. Newly listed trusts are often structured to grow their hydrocarbon production and distribution in the first three to five years after their initial public offering. Typically, new trusts are granted a certain number of producing wells at the time of their formation and include a commitment from their parent company to drill a pre-arranged number of new wells in a certain time frame. As these new wells are drilled and begin production, the trust’s payout to unitholders rises.
In addition, many new trusts use a subordinated unit structure to guarantee minimum target payouts to unitholders. With this structure, the trust’s sponsor forgoes a portion of its distribution when the disbursement to public unitholders falls short of a predetermined threshold.
Formed more than 30 years ago, San Juan Basin Royalty Trust lacks these advantages. That the trust has maintained its distribution despite weak gas prices is a testament to its low production costs and savvy management.
A number of newer trusts I’ve detailed in my coverage universe offer superior growth potential, hedges against commodity price volatility, more exposure to oil prices and yields that are almost two times that of San Juan Basin Royalty Trust. Unless natural-gas prices suddenly improve, we will continue to rate San Juan Basin Royalty Trust a sell.