U.S. Royalty Trusts

The sun rises over Whiting's Siberia Ridge Field in Sweetwater County, Wyoming.

?Oil and gas royalty trusts have been around for decades. But with today’s high energy prices, it is worth taking another look at this type of business structure, which is being revived. Two oil trusts went public in 2007.

A royalty trust refers to a statutory trust formed with specific oil and gas interests from a sponsor company. Sponsors view these vehicles as a tax-efficient way to monetize producing assets at attractive valuations. Investors are attracted to these high-yield instruments, and their exposure to oil and gas assets and respective commodity prices.

Although royalty trusts can be finely tuned to include different income, cost and termination-point options and strategies, there are several key characteristics required to enable any trust to perform well for both sponsors and unit-holders.

One of the key components is to have a financially and operationally strong E&P sponsor. The sponsor should have previously demonstrated its ability to operate in the same type of area and play as the assets that are held in trust. It is also important to have a strong alignment of interests between the sponsor and the unit-holders. The sponsor should have a significant working interest in the underlying properties and should also own trust units.

Another key component is commodity-price protection. The trust is prohibited from maintaining an actively managed hedging program, but the sponsor can put hedges in place at the time of the trust’s formation. The sponsor’s initial hedging program provides unit-holders downside protection from a drop in commodity prices and allows the sponsor to realize a higher valuation for its IPO units. Once the hedges roll off, the production is sold at market prices. Wall Street-consensus pricing and Wall Street-accepted gross domestic product deflators are used for unhedged volumes.

Royalty trusts differ from master limited partnerships (MLPs) in that there is no general partner, no incentive distribution rights, no unrelated business taxable income and no asset-acquisition or drop-down program, according to Howard House, managing director and co-head of energy investment banking for Houston-based Raymond James & Associates. Unlike an MLP, royalty trusts are prohibited from making future acquisitions, offering additional primary units or actively managing a hedging program, he says.

A term royalty trust is somewhat similar to a volumetric production payment (VPP) structure, often offered by banks. But a VPP simply advances the producer a finite amount of cash for a finite amount of production. There is no way for the producer to be protected against rising operating costs, as it can be with a net-profits-interest royalty trust.

Whiting USA Trust I's assets are in the Williston, Green River, Piceance and Permian basins, the Hingeline play and onshore the Gulf Coast

In the 1980s, a number of energy companies spun off royalty trusts directly to shareholders and many of those are still around today. In the 1990s, about eight E&P trusts were formed to capture value for Section 29 tax credits on gas production before they expired. However, producers were not generating much taxable income at the time, so the tax credits didn’t do them any good. Also, access to public capital was limited, so the structure fell out of favor.

Today, the appeal to royalty-trust sponsors is the ability to monetize mature reserves at attractive prices in a tax-efficient manner, avoid the headaches of actively managing a publicly traded entity, retain control of operations and avoid the taxable event of an outright asset sale. Aside from the disclosure made at the time of the IPO, the sponsor is not burdened by future ongoing public filings. In fact, the trust’s trustee is responsible for maintaining regulatory statements and public communications, as well as ongoing Sarbanes-Oxley mandates. Set-up costs, including SEC filings and reserve reports, are about the same as that involved in other public entities.

“To our knowledge, we are the only U.S. firm that has structured any royalty trusts since the 1990s,” says House. “We’ve done three of them.”

New trusts
The first was Appalachian Gas Royalty Trust, formed by Denver-based Energy Corp. of America, and filed with the SEC in 2005. Before the trust could be IPO’d, Blackstone Minerals Co. LP of Houston bought the entire deal for $155 million.

In 2006, Raymond James advised MV Partners, a privately held limited liability company based in Wichita, Kansas, on the formation of MV Oil Trust, which subsequently went public in January 2007 as MVO on the New York Stock Exchange. Raymond James was lead manager of the $173-million offering.

Also in 2007, Raymond James advised Denver-based Whiting Petroleum Corp. on the formation of Whiting USA Trust I (NYSE: WHX), which IPO’d in April 2008. Again, Raymond James was lead manager, this time on a $234-million offering.

“Our job, as an investment bank, is to work with a sponsor to come up with a structure that accomplishes the company’s objectives while forming a marketable entity as a good investment,” says House.

“These trusts are different from Canadian royalty trusts,” he says. “U.S. royalty trusts are fixed, passive entities as opposed to Canadian royalty trusts that are active entities that function more like U.S. E&P MLPs.”

Once constructed and put in place, a trust does not make acquisitions nor have an active management. It is managed by a trustee, usually a bank, which is responsible for quarterly and annual public disclosures and paying distributions to unit-holders.

In the 1980's, a number of energy companies spun off royalty trusts directly to shareholders and many of those are still around today.

The assets are similar for royalty trusts and MLPs, both requiring mature, long-lived, proven reserves with a high component of proved developed producing (PDP). A trust investor receives quarterly or monthly distributions and receives a 1099 form instead of a K-1. Furthermore, there is no unrelated business taxable income.

There are two main factors to consider when forming a trust. The sponsor must decide whether to convey a net-profits interest or an overriding-royalty interest into the trust, and must decide whether to structure the trust as perpetual or with a termination feature.

In a net-profits-interest trust, the trust receives a set percentage of net profits from the sale of production. The sponsor and unit-holders share in the capital costs, operating costs and workover expenses. To the extent there are proved undeveloped reserves (PUD) to be drilled, they share those costs as well.

From a sponsor’s standpoint, the advantage is that the unit-holders bear their proportionate share of the costs. The disadvantage is that the up-front proceeds are smaller because projected cash distributions used to value the trust are reduced by those costs.

The overriding-royalty-interest trust receives a set percentage of the net proceeds from the sale of production, but the sponsor bears all operating and capital costs. The up-front proceeds are greater because the cash-flow stream is not burdened by costs and expenses. The disadvantage for the sponsor is that, by bearing all future operating and capital costs, it is at the mercy of rising service costs. If such costs are not material to the asset base or if the sponsor has long-term visibility of the cost structure, this type of structure may be preferable.

The other key factor is whether to structure the trust as perpetual or with a termination feature. A term trust has a defined termination point, similar to a VPP. One of the benefits to the sponsor is that, at the end of the term, the properties revert back to it. Most significantly, because it is not in an outright sale, monetizing assets through a term trust is tax-deferred to the sponsor.

“This is an opportunity for the company to monetize the reserves at very attractive levels with a deferred capital gain,” says House. “As production takes place, the liability that sits on the balance sheet is amortized over the life of the trust. From the unit-holder’s standpoint, for federal tax purposes, it is as if they have invested in a debt instrument. The distributable income is split between principal amortization and interest income.”

A perpetual trust is a conveyance of actual mineral interests to a trust. The balance sheet and income statement items are proportionately reduced and directly transferred to the trust. For tax purposes, the distributable income payable to the unit-holder is subject to depletion allowances, which are calculated using the greater of cost or percentage of depletion.

Whiting’s trust
In April, Whiting Petroleum Corp. sold 11,677,500 units at $20 each, out of a total 13,863,889 units issued by the newly formed Whiting USA Trust I, a net-profits-interest trust, through its IPO.

The units were purchased by retail (90%) and institutional (10%) investors. “That’s about what we anticipated. It’s primarily a retail product and gives unit-holders direct exposure to commodity prices,” says John Kelso, Whiting Petroleum director of investor relations.

The Whiting trust’s assets are conventional oil (62%) and gas (38%), from 3,051 gross wells in 172 fields spread over 14 states throughout the Rocky Mountains, Midcontinent, Gulf Coast and Permian Basin regions, with an average 10.5% projected annual decline rate. The 90% net profits interest was conveyed to the trust by Whiting Petroleum Corp., which received net proceeds from the offering of some $215.4 million.

It also retained a 14.2% net profits interest in the assets through its ownership of 15.8% of the trust units, as well as the remaining 10% interest, for an overall 24.2% retained ownership of the net proceeds. The company used the offering proceeds to pay some of its bank debt.

“Ours is a very unique structure. It’s one of a kind at this point. In ours, the unit-holders pay lease operating expenses and such,” he says. Because Whiting Petroleum Corp. currently retains 24.2% of the net proceeds from the underlying properties, it has a vested interest in holding down costs, so “that takes some of the unknowns out of the equation for the investors,” says Kelso.

“We made the trust’s first distribution on May 30, representing first-quarter production of 335,000 barrels of oil equivalent,” he says.

There is no minimum amount of units each investor can buy, but on average, individual investors acquired about 1,400 units each. Underwriters included Raymond James, Wachovia Securities, RBC Capital Markets, Oppenheimer & Co. and Stifel Nicolaus & Co. Inc.

While Whiting Petroleum may pursue activities such as in-fill drilling, recompletions and workovers on behalf of the trust, there is a predetermined end to the trust’s life. Once 8.2 million barrels of oil equivalent (BOE) attributable to the trust have been produced and sold, the trust will terminate, and the properties will revert back to Whiting Petroleum.

The company estimates the 8.2 million BOE will be produced, without additional investment, by year-end 2017. The total reserves attributed to the properties are 13.85 million BOE. Accordingly, the unit-holders have a cushion in that 90% of the total reserves attributable to the underlying properties, or 12.47 million BOE, are available to satisfy the 8.2 million BOE in production that is attributable to the trust. Whiting Petroleum pays 100% of capex costs.

“These are fairly mature properties,” Kelso says. “One of the reasons we wanted to put mature properties in the trust was that they would have predictable production profiles. The estimates we had for the first quarter were in line with actual production numbers.” The assets in the trust were properties that Whiting Petroleum Corp. had either drilled or acquired.

“In the prospectus, we estimated the total of the first four distributions would be $5 per unit. Of that $5, about $3.84 would be considered a return of principal and the remaining $1.16 would be considered interest income. Unit-holders will receive a tax form 1099, instead of a K-1. So from a tax standpoint, it’s a lot simpler than an MLP.”

Whiting chose a trust structure as opposed to an MLP for several other reasons as well. “It seems that MLPs have fallen out of favor. Also, we thought we could get a more attractive price for the reserves. As it turns out, we got $31.18 per BOE, which we feel is a premium valuation,” he says.

Vess-Murfin’s trust
“When contrasting the various opportunities of capital structures such as MLPs, VPPs and others, the net-profits-interest, term royalty trust structure appealed to us,” says Mike Vess, president of Wichita, Kansas-based Vess Oil Corp. and co-chief executive of MV Partners LLC, the trust’s sponsor.

“MV Oil Trust allows us to focus on the acquisition and exploitation of oil and gas reserves. We wanted to avoid the disruption of the SEC and Sarbanes-Oxley requirements of other structures.”

MV Oil Trust was formed by MV Partners. The sponsor conveyed a net profits interest to the trust that represents the right to receive 80% of the net proceeds from all of MV Partners’ interests in oil and gas properties. The assets, in Kansas and Colorado, are operated by Vess Oil and Murfin Drilling Inc., the largest and third-largest operators, respectively, in Kansas. Some of the fields date back to 1915.

As of year-end 2007, the trust owned 994 long-lived producing wells (98% oil) with an annual decline rate of about 4%. The termination point is June 30, 2026, or when 11.5 million BOE attributable to the trust have been produced and sold. Affiliates of MV Partners own 25% of the units, initially offered at $20 each, and have a 45% economic interest in the properties.

“We expect MVO to continue to pay one of the highest distributions among all E&P yield securities,” says John Kang, vice president of equity research for RBC Capital Markets. “The higher distribution is a direct byproduct of the company’s 20-year limited structure, coupled with their production capabilities.”

Kang estimates that the trust will reach the 11.5-million-BOE hurdle well before the 20-year termination date.

In 2005, while management of Vess Oil was forming the strategy to launch a royalty trust, it wanted to give Vess Oil the ability to privately pursue acquisitions because “it made more sense to us,” says Vess. “We can pace ourselves, use our own timing, and have more optionality with our finance structures. An MLP structure exerts pressure to do acquisitions relatively quickly.”

Today, the royalty trust is a stronger vehicle than MLPs, but it shouldn’t be that way, he says. MLPs provide the option to buy assets, borrow money, and have an active E&P presence with an ability to grow. In theory, they should command a stronger value than a royalty trust. But that is not the case.

“In 2009, I think it would be prudent for anyone contemplating a public transaction to look at a royalty trust as a viable option, if the circumstances and assets fit,” Vess says.

Related Document: MV Oil Trust Annual Report

Related Document: Whiting USA Trust I Quarterly Report