Sandridge Mississippian Trust 2 Proving to be Trustworthy

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If you are an investor who enjoys dividends, big dividends, and lots of dividends, then no doubt you have glanced once or twice towards royalty trusts.  Royalty trusts are an interesting concept.  In the case of oil and gas, the investor is basically investing directly in the oil itself, and is able to get in on the profits.  These trusts are set up to give their shareholders a set percentage (a very high percentage) of the net income from the wells by way of dividends.

The Catch

There's always a catch, isn't there?  In the case of an oil royalty trust, the stock has a limited lifespan.  The trust itself is tied to specific wells, and therefore when the wells dry up, so do the profits.  So, how do investors know when the well is going to dry up?  They don't.  Investors have a pretty good guess based on the "proven reserves" (which are basically conservative estimates and fluctuate) and also based on "probable reserves," but technically no one knows how much oil or gas is down there until it is physically pumped out.

Even before a well runs out, production can start to decrease significantly, leaving shareholders with not quite the same dividends that they had before.  Decreasing dividends naturally leads to a slump in stock price.  

There are also some tax concerns one would want to look into before considering an investment in a royalty trust, but that's for another article.

Old Faithful

BP Prudhoe Bay Royalty Trust (NYSE: BPT)  is the ruler by which all other royalty trusts are measured.  It is a huge oil reserve, they have had fantastic dividends, and they've been going strong now for over 20 years.

Perhaps you were surprised, as I was, to see the stock price for this trust down nearly 30% from Agust 26-29.  My first thought was "I didn't know that Prudhoe Bay was already running out."  But after doing a little digging (no pun intended), this isn't what sent investors running.  Even the pessimists have Prudhoe Bay producing oil through 2025.  It seems that investors are being influenced by an article that came out in the Wall Street Journal, that claimed the trust's market cap (at that moment) was higher than the cash they have available for distributions. Whether or not it is true, it has adversely effected stock price.  Is this a buying opportunity?

Falling Dividends

Prudhoe Bay isn't the only royalty trust seeing some action.  Royalty trusts are relatively non-volatile, but the sector has seen some volatility of late.  San Juan Basin Royalty Trust (NYSE: SJT) is down around 10% over the last couple of days.  Permian Basin Royalty Trust (NYSE: PBT) is down nearly 30% from it's highs six months ago.  The reason for the decline in share price is that both these trusts have been steadily declining in their respective dividends.

This isn't management being stingy with their money.  Royalty trusts are required to return a certain amount of money to shareholders in the form of dividends.  Management can't just decide to "hoard" money and buy a new oil well or something.  The money that is there has to be returned to "unit" holders.  What percentage of money gets paid out doesn't fluctuate.  What does fluctuate is the amount of oil being pumped, the price of oil, and the expenses related to pumping it.  Any of those things can eat into dividends, causing them to decrease.  But has the fall in stock price presented us with a value investment?

A Trustworthy Trust

While the trusts mentioned up to this point in the article might be an investment opportunity for some, I would like another option.  Prudhoe Bay is good, but all trusts have a limited life.  We don't know when the end is, but we know that we are 23 years closer to the end than when this trust was started.  San Juan and Permian have declining dividends.  There might be reasons to believe that they'll go back up.  But rather than worry about whether or not these previously mentioned trusts present buying opportunities, I would just prefer to find a young royalty trust with a stellar dividend that could serve as an alternative.  My find is Sandridge Mississippian Trust 2 (NYSE: SDR)

This stock debuted earlier this year at about $21/share.  The share price is down over its short five month life, but not significantly.  This is a trust based on various wells, with a near equal exposure to natural gas and oil.  Production is expected to continue increasing through 2015.  They claim at least 20 years of proved reserves.

In the trust's prospectus, they outlined several intended payouts based on their estimates of how much oil and gas they would produce, and how much that oil and gas would be worth at the time they got it out of the ground.  In order to do a good estimate, you have to take a lot into consideration, and it's normally good to err on the cautious side.  For the first two payouts, Mississippi 2 was hoping for dividends of $0.26 and $0.46.

They are proving that they can be trusted.  The first two payments were $0.2677 and $0.4972, both of which beat out the trust's estimates.  This has me excited.  The next two payments are expected to be $0.56 and $0.60.  If the trust continues to hit estimates, that would bring the total for the first year to $1.92, or just around 9% based on the current share price.  

Conclusion

I'm not saying that Prudhoe Bay or Permian Basin are bad investments.  That's for you to decide.  But with Sandridge Mississippian Trust 2, I believe I can have my cake and eat it too.  I don't have to worry right now about the limited lifespan of the trust; it just started.  And so far, this trust is proving that I don't have to worry about declining dividends either.  


thequast owns share of Sandridge Mississippian Trust II. The Motley Fool owns shares of SANDRIDGE MISSISSIPPIAN TR II COM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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