Royalty Trust Investing: The Gigantic Risk

At the conceptual level, the idea of investing in a royalty trust sounds like a simple straightforward way to earn income because there is no actual asset that you are operating, but rather, you are sitting on your rear and collecting a portion of the profits or sales from a business enterprise.

Typically, royalties (when present) are a component of start-up funding. Imagine if you wanted to begin a brewery, but did not have the resources to buy commercial brewery equipment. The traditional ways that you would raise funds is by either borrowing money from a bank (and giving them a secured interest in the equipment, and possibly a personal guaranty as well). The other way is that you might give up an equity stake to an investor as a capital raise.

Over the past generation, as wealthy Americans have become flush with capital and have relied upon their advisors to pursue creative investing options, royalties (once the exclusive domain of the entertainment industry) came to consider royalties as an easy way to collect a passive income stream from the projects that they fund.

In this scenario, the investor creates a company whose sole asset is a royalty indenture (either of a fixed or perpetual duration). A fixed royalty might be something like “Royalty Co. shall collect a 5% royalty on all revenues of Brewery Co. until January 1, 2028” whereas a perpetual royalty will entitle Royalty Co. to a certain percentage of Brewery Co.’s sales or profits forever unless a termination is later negotiated (the most legendary royalty I ever encountered was negotiated by the owners of the old St. Louis Hawks basketball franchise, who negotiated a royalty with the NBA for 1/8th of the NBA’s TV revenue into perpetuity though it was terminated after their death).

Royalty trusts are an incredibly delightful investment when the business from which you are collecting a royalty stream is growing or at least remaining stagnant.

In the United States, nearly all royalty trusts that have become publicly traded are oil and natural gas royalty trusts that only have an ownership stake in an asset that depletes a fixed amount of energy resources over time. The gigantic risk of royalty trust investing is that, in the United States, nearly all publicly traded royalty trusts are energy-industry liquidation trusts that make royalty payments on the production of oil and natural gas but will end up with no value leftover at the end of the trust’s duration.

For instance, the message board communities concerning the San Juan Royalty Basin Trust (SJT) get excited about the monthly dividend in the amount of 5-8% that they receive each year. This is not a traditional corporation that will exist in perpetuity. It is a royalty trust with an interest that entitles it to the operational income of 75% of certain natural gas production in New Mexico, and it is expected to run out by 2033. It has 97 MMCF of natural gas, with royalties giving you 75% of the 4 MMCF that is produced each year. When that 97 MMCF is fully produced, there is no more San Juan Royalty Basin Trust. Actually, to be more specific, the indenture that creates the royalty states that the royalty will terminate when less than $1 million per year in proceeds is harvested, and whatever is left shall be sold, and then liquidated to shareholders.

I don’t like energy royalty trusts for the same reason I don’t want to buy musical rights on the website Royalty Exchange. It is a depreciating asset that approaches zero over time, rather than a sustainable business capable of growth.

When esoteric investments raise in popularity, it can be helpful to perform a gut-check on what you’re dealing with. Royalties, per se, are intriguing because they grant you a percentage of the proceeds without having to do anything. But, as practiced in the United States public stock market, the royalty trusts cover the production of assets that dwindle to nothing over time. With stocks, we model growth rates outward for a decade or two. With energy royalty trusts, you are comparing the the royalty income generated over the dwindling asset and discounting it back to the present. It is a different game. I’ve never been intrigued by it. Businesses that try to grow run into enough troubles; I’ve never been drawn to assets that are structured to be worth zero. The only exception would be in a Great Recession type of scenario in which the projected cash flows over the duration of the holding are something like 10x of the trust’s stock price, but even then, I would imagine such an environment would offer better deals in the traditional markets.