In Royalties We Trust
Some investors prefer royalty trusts. "We're respectful of MLPs and we own them in a balanced way," says Russell Lucas, co-founder and portfolio manager at Lucas Capital Management, an RIA in Red Bank, N.J., that runs energy-focused hedge funds and private equity funds. "But we've always felt that royalty trusts are a better core investment and MLPs more of a short-term bond alternative."
One of the knocks against royalty trusts is that they're depleting assets that one day will turn into useless dry holes. It's a greater risk for U.S. royalty trusts, which by law can't make acquisitions after they're created.
Canadian trusts, on the other hand, are actively managed businesses that can buy other properties, raise and borrow money, and manage their own resources.
One of the key factors to consider with oil and gas royalty trusts is their depletion rates, Lucas says. He cites new technologies that have boosted production and extended the life of wells. Seismic studies have improved, gas shales can be "fraced" (or fractured) and wells can be flooded with water that helps float the oil or wash it from adhering to the rocks.
"The hidden secret is understanding the opportunity of each trust and looking for the catalyst enabling for a longer-than-expected life span," Lucas says.
One of Lucas' top picks is Enterplus, a Canadian trust with a history of paying attractive yields and which currently pays about 10%. "Reinvestment of dividends can provide an attractive total return in periods of flat commodity pricing," he says.
Lucas says that even after two or three rounds of distribution cuts due to falling oil prices, most trusts are still paying distribution yields in the 10% to 15% range.
Either, Or
Royalty trusts are viewed more as a pure commodity play because they're more closely tied to the price of their underlying assets. But rather than trying to guess market prices, some advisors use both MLPs and royalty trusts to cover their bases. "We're using MLPs and royalty trusts together as a diversification tool," says Ling. "We're not trying to time one or the other."
Ling says his firm places great emphasis on cash flow when constructing portfolios. He says that with dividend flows not as prevalent as they once were, MLPs and royalty trusts allow you to increase cash flows in your portfolios while at the same time helping you curb volatility.
But sometimes Ling has to do a little explaining to get people comfortable with investing in MLPs. "The first thing they focus on about MLPs is the limited partnership component," he says. "They might have a problem with that." That's because older investors might remember the troubles associated with various partnerships during the 1980s-specifically the tax-shelter partnerships that lost investors money after the IRS cracked down on them.