Royalty trusts typically own oil or natural gas wells, the mineral rights of wells, or mineral rights on other types of properties. An outside company must perform the actual operation of the oil or gas field, or mine, and the trust itself, in the United States, may have no employees. Royalty trusts, like MLPs, generally invest in energy sector assets. Unlike the steady cash flows at MLPs, royalty trusts generate income from the production of natural resources such as coal,
oil, and natural gas. These cash flows are subject to swings in commodity prices and production levels, which can cause them to be very inconsistent from year to year. The trusts have no physical operations of their own and have no management or employees. Rather, they are merely financing vehicles that are run by banks, and they trade like stocks. Other companies mine the resources and pay royalties on those resources to the trust.
Royalty trusts attract investors with their relatively high yields. Royalty trusts in the United States and Canada usually involve oil and gas fields or mines which are at or past their production peak, and will gradually decline in output as well as revenue; however, the infrastructure to develop them has already been built, so that an investor can expect a reasonably steady income stream.
Royalty trusts own numerous individual wells, oil fields, or mines, they represent a convenient way for the average investor to diversify investments across a number of properties. Also, since commodities are considered a hedge against inflation, the popularity of royalty trusts as investments rises as interest rates rise, and their shares often rise as a result. Royalty trusts allow investors to speculate directly on commodities such as gas, oil, or iron ore without having to buy futures contracts, or use the other investment vehicles traditionally associated with commodities—since the trusts trade like stocks.
Due to depreciation and depletion, distributions from most trusts are not considered income in the eyes of the IRS. Rather, these nontaxable income distributions are used to reduce an owner’s cost basis in the stock, which is then taxed at the lower capital gains rate and is deferred until an owner sells.
A financial advisor can review your current holdings and determine the appropriate investment allocations in this sub-asset class based on an Investment Policy Statement designed to reach your True North.
