From a tax and cash distribution perspective, royalty trusts are similar to an upstream master limited partnership. However, unlike an MLP, a royalty trust does not have employees, operate its properties, make acquisitions, incur debt, or operate in perpetuity.
Upstream royalty trusts are experiencing a renewed interest as demonstrated by the recent $182 million IPO of ECA Marcellus Trust I (NYSE: ECT) on July 1, which was sponsored by Energy Corporation of America (ECA).
Essentially, a trust is formed by a sponsor conveying mineral interests to the trust and retaining operations of the assets conveyed. Royalty trusts are an attractive vehicle for sponsors to raise capital as a trust can be strategically structured to fit a sponsor's assets and desired amount of capital to be raised; a common theme of recent royalty trusts is the ability for both public and private sponsor companies to monetize proved reserves, including non-producing reserves, at an attractive valuation typically exceeding valuations generated as a public c-corporation, joint venture, or in the acquisition and divestiture market.
From a tax and quarterly cash distribution point of view, a royalty trust has similarities to an upstream master limited partnership (MLP). However, a royalty trust is structurally different from an MLP in that a royalty does not have employees, operate its properties, make acquisitions, incur debt, or operate in perpetuity. Another key difference is a trust should be valued based on its expected internal rate of return (IRR) generated by forecasted distributions over the life of the trust compared to an MLP that is largely valued off its current annualized yield.
An MLP must continue to drill and make acquisitions to maintain its yield over the long term. At formation, a trust's assets are fixed. Modern day trusts typically have terms of 15 to 20 years or terminate after certain volume of hydrocarbons are produced.
Since the last royalty trust IPO in 1999, the IPO market for royalty trusts was dormant until the $230 million IPO of MVO Oil Trust (NYSE: MVO) on January 19, 2007, which was sponsored by a private company. Shortly thereafter, Whiting Petroleum Corporation (NYSE: WLL) formed Whiting USA Trust I (NYSE: WHX) in a $277 million IPO on April 24, 2008. Mike Ames, a managing director at Raymond James & Associates, noted, "Both sponsors selected mature, predominantly producing assets to contribute to their respective trusts, which were ideal given the assets' predictable production profiles used to forecast distributions over the life of the trust and both received attractive valuations." At IPO, WHX was able to monetize its reserves at $33.80 per boe and redeploy the proceeds into other areas of operations.
Shortly after the IPO of WHX, the public equity markets collapsed with the subprime mortgage fallout in 2008 essentially shutting down the IPO market. The first royalty trust to go public since the severe market disruption was ECA Marcellus Trust I with a $182 million IPO on July 1, 2010. ECT is a 20-year royalty trust with 14 gross proved developed wells (12.6 net wells) and 52 gross proved undeveloped wells (26 net wells) on 9,300 acres in Greene County, Pennsylvania.
ECA retained operations and the remainder of the working interests in the wells as well and owned approximately 50% of ECT's units. At IPO, ECT had a $352 million market capitalization.
ECT is a unique trust in that it is the first modern trust to have such a large portion of the reserves classified as proved undeveloped, thus, requiring a sizeable drilling program. With the advent of shale drilling, the risk of drilling PUD wells had significantly decreased compared to drilling conventional PUD wells. As a result, the decreased risk of drilling Marcellus Shale PUDs made the PUDs appropriate for a trust. Furthermore, retail investors have the possibility of distributions exceeding the targeted distributions if the PUD wells outperform the Ryder Scott reserve report, which was used to forecast target distributions.
ECA was looking to raise capital to accelerate its drilling on its one million net acres in the Appalachian Basin. ECA also wanted to be able to continue to run as a private company. The company favored raising the capital via a royalty trust over a JV as a JV invites competition into a company's operating area, requires a significant portion of the property to be sold to a JV partner and typically receives a valuation inferior to a royalty trust.
ECA underwent the process of filing an S-1 registration statement with the Securities and Exchange Commission and marketing the trust via a road show, but once the trust was public, ECA no longer had any public company responsibilities or costs. The ECT trust was structured so that at expiration of the 20-year term of the trust, half of the remaining reserves will revert automatically to ECA and the other half will be sold via a competitive bid process with ECA having the right of first refusal.
Howard House, co-head of energy banking and managing director at Raymond James commented, "I have been structuring royalty trusts since the early 1990s, and I believe the royalty trust vehicle has never had more application than it does today with the amount of capital needed to drill the multiple shale plays in the US and the number of retail investors demanding yield type of securities."
ECT and other modern-day trusts are attractive to retail investors due to these trusts' quarterly cash distributions with estimated IRRs that are forecasted at IPO to match or exceed current annualized yields of upstream MLPs. In addition, trusts have no management risk, meaning the assets and hedges contributed to the trust are fixed at formation of the trust.
Trusts do not and cannot make any additional acquisitions or divestitures or layer in additional hedges after formation. Realized distributions and IRRs are predominantly generated by actual quarterly production and realized commodity prices. The production targets are usually generated from production assumptions from a third-party engineer, and the commodity price is typically based off some variation of consensus Wall Street commodity prices and the NYMEX strip net of the impact of commodity hedges in place.
Two key structural items of a trust are the decision to form the trust as a Net Profits Interests (NPI) versus a pure Royalty Interest (RI) and perpetual trust versus a term structure trust. In an NPI, the trust receives a set percentage of the net profits from the sale of production. The trust unitholders and sponsor would typically share all capital costs, operating costs, and workover expenses. Due to the sharing of costs, unitholders would receive tax shield from intangible drilling costs when the trust is structured as a perpetual trust.
The advantage of an NPI to the sponsor is that the unitholders share all operating and capital costs with the sponsor. However, due to the sharing of costs, the up-front proceeds to the sponsor are lower than with a RI trust. In an RI trust, the trust receives a set percentage of the net proceeds from the sale of the production and the sponsor bears all capital costs, operating costs, and workover expenses.
The advantage of an RI trust to the sponsor is there are greater upfront proceeds than an NPI trust and somewhat improved marketability given that unitholders are not burdened by operating or capital costs. The disadvantage is that the sponsor bears all operating and capital costs. Recently formed trusts have been structured as both NPI and RI trusts.
An NPI trust is appropriate when predominantly older producing assets are being contributed to the trust and little to no drilling is required. An RI trust is more appropriate for a trust that will have a significant amount of very low-risk PUD drilling, such as drilling Marcellus Shale PUDs.
To make a low-risk PUD royalty trust marketable to retail investors and provide the proper amount of investor protection, the sponsor must have the requisite creditworthiness, an established long history of operating in the area, and be willing to take 100% of the drilling cost risks via a RI trust structure.
Another key structural issue is making a trust perpetual, term, or a combination of both. The term structure trust effectively means that at the end of the trust life the properties automatically revert back to the sponsor. In addition, a term trust is treated as a deferred gain on sale. The deferred gain on sale is booked as a liability on the sponsor's balance sheet, which is amortized into income on a units-of-production basis over the life of the trust. The trust is treated as a debt instrument for federal income tax purposes.
Essentially a perpetual trust means that when the trust ends, the properties are sold with the proceeds distributed to unitholders on a pro-rata basis. A perpetual trust is treated as a gain on sale. Balance sheet and income statement items are proportionately reduced and transferred to the trust. The perpetual trust has a marketing advantage over a term trust in that the distributable income payable to the unitholder is subject to depletion allowances.
According to Jimmy Murchison, a vice president at Raymond James, "The formation of a royalty trust starts off with a brainstorming session between the sponsor company and the bankers to create a security that offers an attractive IRR and the proper amount of protection to retail investors and appropriate amount of capital to the sponsor." Raymond James has structured and been the physical bookrunner on the last three royalty trust IPOs.
With the successful IPO of ECT, a PUD-heavy royalty trust, interest in royalty trusts has never been higher due to the large amount of capital needed to develop the US shale plays.
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