Royalty Trust Picks

Proven outperformance through cycles…mitigated risk...direct ownership in some of North America’s best plays…natural inflation hedges.

These are among the reasons investors are giving a warm welcome to the recent spate of royalty trusts, according to a mid-June report by Morgan Stanley Research. Analysts Todd Firestone and Evan Calio initiated coverage of seven royalty trusts: Sand - Ridge Mississippian Trust 1 (SDT) and II (SDR); ECA Marcellus Trust I (ECT); SandRidge Permian Trust (PER); Chesapeake Granite Wash Trust (CHKR); VOC Energy Trust (VOC); and Whiting USA Trust II (WHZ).

Their rationale: “We would invest in trusts over the long term because we think they offer unitholders better, lower-risk returns relative to the rest of energy and the broader market.”

A trust’s portfolio is made up of producing wells and planned drilling locations, and just like oil and gas wells, its output diminishes over time, and thus, its value. The assets produce pre-designated volumes of oil and gas, and each distribution to investors is a return of and on capital, according to the report. In picking the trusts they think offer the best returns, the analysts valued them using a “total” return framework, with internal rate of return (IRR) as the metric.

Trusts can be structured as a royalty, a net profits or a production payment vehicle with varying amounts of undeveloped locations. Older trusts typically involved royalty or profits interests and included existing producing wells with minimal drilling. Some of the more recent trusts launched, however, are structured as royalty interests but with large drilling programs. “This adds a new dynamic both to valuation and to risk. Investor acceptance has been high,” the analysts note.

Trusts are similar to master limited partnerships (MLPs) in tax treatment but are not “going concerns.” They have both equity and debt characteristics and are more like bonds, but involve a fluctuating commodity. “A trust must distribute virtually all of its distributable cash flow, similar to REITs and MLPs, to receive pass-through treatment (CHKR, SDR, SDT, ECT and PER) or as a loan for profits interests trusts and volumetric production payments (VOC, WHZ),” according to the report. The analysts characterize trusts as “variable” income securities whose prices and yield-to-maturities (IRRs) discount a market-assumed commodity deck.

Firestone and Calio examined each trust’s yield-to-maturity and compared similar-duration fixed-income instruments. They then ranked each based on exposure to commodity, geological risk and spreads on similar investments.

Upside for trusts resides in long-term commodity price increases and production growth from larger type well estimates. The caveats are material shifts in commodity fundamentals, causing a supply shift that keeps crude above $120 per barrel for a sustained period and natural gas above $5 per MMBtu; geological variability; and sponsor liquidity default and operations concerns regarding underlying properties, the analysts say.

“We think 8% is an appropriate IRR for the ‘drilling’ trusts (CHKR, ECT, PER, SDR and SDT) and would apply lower assumptions for WHZ and VOC,” they say. Commodity price is the major driver of value under the IRR approach; based on this factor, the analysts favor SDR, ECT and PER.

There are five play-focused trusts. SandRidge Mississippian Trust II is the second generation of SandRidge Mississippian Trust I, with all production coming from the Mississippian Lime region. These trusts will benefit as the play is further de-risked, the analysts note. SD will complete 300-plus horizontals in the Mississippian in 2012, and estimated ultimate recoveries have risen to 456 thousand barrels of oil equivalent (MBOE) in 2012 from 410 MBOE in 2011.

ECA Marcellus Trust 1 is a 100% gas-levered, 20-year royalty trust near and within the southwest Marcellus’ liquids-rich fairway in Green County, Pennsylvania. There is no development risk and production has been better than expected, the authors note. All development wells have been completed, but a number await connection to gathering systems.

SandRidge Permian Trust is focused on assets in the Permian Basin’s Central Basin Platform. It is the most liquids-exposed trust in Morgan Stan-ley’s coverage, at 96% liquids, 88% crude oil. The large development program involves 88 gross vertical wells with drilling and completion taking only about five days. The analysts like its 96% liquids cut and fast, relatively easy drilling in an established onshore play.

CHKR’s current and future production stems from the Colony Granite Wash, which Chesapeake Energy terms its “best” field. The analysts note two particular strengths of this trust: Chesapeake helped pioneer horizontal completions in the Anadarko Basin, including the Granite Wash; and the type curve inspires confidence, with 172 horizontals drilled into the formation since 2007.Net profits interest trust, VOC has 84% proved developed reserves, with upwards of 90% liquids. Production is from established fields in Kansas and East Texas with upside from Woodbine horizontal completions. “Unitholders (are) protected to (the) downside as VOC must produce the later of 20 years of 8.5 million BOE of cumulative production,” the report notes.

WHZ offers a contrast in exposure. The 10-year profits interest trust produces from 390 net wells in 41 different fields in 10 states. Some 99% of its holdings are proved developed assets that will produce liquids-rich volumes over a 10-year period.