The Trouble With Trusts

The trouble with writing about investments is that you almost never hear about your big winners.

We have heard plenty of concern about the SandRidge trusts, and if you’ve read the story above you’ll know that these are now Sells, and why.

How we got here, though, says something about who I am and how I can best help you going forward.

I am, as described in greater detail in October, a highly successful energy investor, industry expert and chemical engineer.  

When I came on board last fall, I eliminated some portfolios (e.g., Field Bets) and began to sell off underperformers. I recommended refiners and companies involved in natural gas infrastructure, but the general direction was toward a smaller, more focused portfolio. I did not want to shake things up too quickly and possibly generate short-term capital gain consequences for investors, but was slowly making the various portfolios my own.

I was not especially bullish on the oil and gas trusts, but they provided no compelling reason to sell, either. That recently changed along with their long-term outlook.

And as the great investor John Maynard Keynes observed, “When the facts change, I change my mind. What do you do, sir?”

What we won’t do is make knee-jerk reactions without carrying out a thorough analysis, nor will we attempt to time short-term market moves.  

If I feel a company has a compelling story, I am not going to sell solely because the share price falls. In fact, Chevron (NYSE: CVX), one of our Conservative Portfolio holdings, saw its share price decline by 14 percent during October and November. But its outlook remained bright and I suggested buying if the share price fell below $105. It did, and investors who bought in have seen a rally of 11 percent in just a couple of months.

However, our risk tolerances may differ. If you simply can’t afford the notion of a 15 percent decline, please reconsider the risk factors inherent in stocks.

I have heard from a couple of people who said that the drop in the value of the trusts was more than they could bear as conservative investors. That tells me two things.

First, many investors didn’t really appreciate the inherent riskiness of these trusts.

Second, it’s important to understand your personal risk tolerance–and that of anyone making picks and pans. For me, a 15 percent decline in a stock with strong fundamentals will often spell opportunity. But if that is an unacceptable level of volatility for you, you need to have your own exit strategy.

Now about those trusts. Royalty production trusts are investment vehicles that are used to finance development of natural resources like oil and natural gas. After each quarter the trusts pay distributions to investors based on oil and gas sales in the quarter. The distributions decline over time as the properties are depleted. Most trusts have a specific termination date, at which point the remaining assets are distributed to investors.

There is a number of risk factors with these. The major ones are the price of the commodity and the production volumes. The latter will be influenced by the level of drilling activity, the level of depletion and the split between the production of oil and natural gas. A trust that is expected to produce primarily oil could see shares drop sharply if the mix turns out to have less oil and more natural gas (based on current prices for oil and natural gas.)      

Tax policy is another serious consideration. The trusts pass profits through to shareholders, who then pay ordinary income taxes on part of the distributions (part is considered a return of capital). As a result, royalty trusts in the US are not presently subject to corporate income taxes and avoid the problem of double taxation at the corporate and individual level. A change in tax policy such as a decision to assess corporate taxes on the profits would obviously diminish the trusts’ appeal.

But it was the more routine production shortfall that recently tripped up the Sandridge Mississippian Trust II (NYSE: SDR), resulting in a disappointing quarterly distribution. Sandridge will pay 53 cents a share to shareholders, but analysts had expected the distribution of 71 cents a share,  on average.

The market reacted swiftly. SDR shares opened 15% lower the next day and kept dropping after a Raymond James analyst downgraded the trust from Outperform to Underperform. Others soon piled on. Raymond James noted that production fell despite a big increase in drilling by Sandridge.

Most investors are attracted to these trusts for the high yields, which often run in the range of 10 to 15 percent. But note that many investors have been attracted to junk bonds on that same basis — and at times have absorbed much larger capital losses. In both cases, those high yields come with risks that are too high for many conservative investors.   

In the specific case of SDR, the lower distribution was a result of two factors. First, production was lower than expected. Second, there was reportedly a higher fraction of natural gas than expected. Because natural gas prices are presently depressed, this weighed upon the shares.

But the more worrisome aspect was that the lower production occurred in spite of increased drilling by Sandridge. Production could be lower due to unplanned maintenance and it wouldn’t necessarily signal a long-term concern for the trust. In this case where drilling increased and production still declined more than expected, the market immediately lowered the value of the trust.

These trusts should be recognized as speculative investment vehicles despite the lure of a regular and lofty yield. It doesn’t mean that all such trusts are bad investments. But we’re not going to be counting on SandRidge’s projections in making such decisions..

My experiences in energy is hands-on. I view the refining sector as someone who has worked in refineries. I view oil and gas production as someone who managed a team of engineers in the North Sea oil and gas fields. If I don’t understand the core business of a company, I will not invest in it. I buy stocks whose long-term outlook I deem positive, and sell those when that outlook changes, or when a stock becomes expensive relative to its peers. This is an approach that’s worked for me and I believe that it can work for you as long as we understand how each of us handles risk.

Stock Talk

Guest One

Mark Dirstine

I like what I’m hearing so I will give you more time since you are a newby to this publication. I was thinking about cancelling as I did the Canadian Edge. Roger gave us great stats but never had the blank to cut a loser loose until it was at the bottom and I road several Canadian stocks to far down. What you are doing with this energy sector is encouraging so for now count me in and I’m selling PER.

Guest One


I on the other hand am not pleased with your analysis at all. I feel this is a cop out! I would have liked to have seen you give hard numbers based on your analysis instead of just saying the parent companies are over leveraged and cannot be trusted with their initial claims (an oxymoron). These trusts should not be that hard to comprehend, especially for someone with your expertise! Very disappointing! Elliott Gue gave hard numbers on these Trusts based on the target distribution numbers, hedges, threshold, and mix of oil and gas in the wells. Yes, these certainly can change based on new information, but to just let go of them without giving hard numbers when they have been obliterated is ridiculous in my opinion. There are subordination guarantees with hedges on the newer Trusts and the mix of oil and gas are very different. To just throw SDR and PER in the same salad bowl leaves a bad taste in my mouth!

I guess what really bothers me about you just dumping these Trusts is the fact that the cash distribution number analysts were expecting for SDR of .71 were ridiculous! That was at the top of the target incentive cash distribution and certainly not achievable with the price of nat gas from Sept through Nov. Furthermore, to speculate on what the distributions, mix of oil and gas, depletion rates, and prices of the commodities are going to be moving forward without factual information is providing a disservice to long time subscribers of this newsletter who invested in these Trusts based on completely different information. It seems to me these are investments that you did not like in the first place and have found a great opportunity to let them go! You could have at least lowered your target and buy numbers based on recalculating what the Trusts worst case scenarios could be. I realize there is reasonable risk involved with these Trusts, but not nearly as much as you are suggesting. I believe there is less risk the lower the price becomes also and would have appreciated you addressing that too! Common sense should have prevailed here with a better analysis of the reasons to sell them, or at least give alternatives to just dumping them like with a worst case scenario! Unless there is absolute fraud regarding the wells that the parent companies sold off to the Trusts, which I hope you are not suggesting unless you can back that up with facts, I would have appreciated a more thorough analysis.

Guest One


True Trusts do pass along profits to shareholders but if in an IRA the shareholder won’t have to pay any tax until he takes a distribution, which in any case he would pay anyhow if in a traditional IRA, but only once. If you are going to change all your recommendations when you have a change of personnell, I believe you owe subscribers a warning and a more gradual and well documented discussion as to the corporate fundamentals of each. In general, I agree with Anonyomus above.

Guest One

stanley zalewski

I get the impression the reason Mr. Elliot Gue left was because of his poor selection of SDR,PER and CHKR which were all strongly suggested as buys when they came out. I personally have owned all 3 of these trusts.
and as we know they all have been loosers big time. Again when your paying $400 a year for the subscription you just might want to start researching other subscription,s. Again is that one of the reasons he left.
Thank You – Stan Zalewski (

Guest One

Tom de

Robert. Not sure how to react to the comments you have rec’d so far. I see change as a good thing. The bad news about SDR and others that you are now listing as SELLs has been a shock but these things occur in the investment world, just like they do in the sports world, and, unfortunately, in our own families from time to time.

Cleaning house and offering new opportunities is a welcome activity. I’m looking forward to new ideas and analyses. THANKS

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