Cash-strapped natural gas producers, grappling with plummeting prices and rising drilling costs, are looking to raise funds by selling investors access to some of their wells through a financial structure that pays little or no tax.
These structures, called Royalty Trusts, are similar to master limited partnerships (MLPs) that are used extensively in the energy industry to cut taxes.
However, trusts appear to be gaining popularity with companies because they are not obligated to raise payouts like MLPs. Investors, meanwhile, are lapping them up for guaranteed upfront income.
"You would get more upfront and less in the back end in a royalty trust versus an MLP, which is a more steady deal," Raymond James analyst Kevin Smith said.
Companies assign a slice of their future income as royalties to a trust. As trusts usually hold mature assets, production is more or less determined, giving investors a "fixed" income and access to gains from any upswing in commodity prices.
"In a very low interest environment, investors are very thirsty for yield products," Smith added.
Units of trusts such as Whiting Petroleum's Whiting USA Trust I and SandRidge Energy's SandRidge Mississippian Trust I have outperformed their so-called sponsors till now.
"A royalty trust is very defined. From an investor standpoint, it is extremely rare to have something you can know so well," said Ashton Lee, portfolio manager of Lucas Energy Total Return Fund, which invests in royalty trusts.
As most exploration and production companies outspend cashflow due to expensive drilling processes, weak price for their produce further strains their balance sheet.
Natural gas prices have hit decade-lows as output has soared due to the advent of hydraulic fracturing, which has opened up previously untapped but vast shale fields.
"The question facing the sponsor is: do I have access to capital or do I need to do a trust to fill in those capital needs?" said Judd Cryer, senior vice president at Swank Capital, which invests in royalty trusts.
Trusts have so far achieved good market valuations, emerging as a viable funding option for debt-laden oil and gas explorers.
"For a company like ours, which has more drilling projects than we have available capital to spend on those projects, royalty trusts are a good vehicle to bring in some additional outside capital," said Kevin White, a vice president at SandRidge Energy.
Last April, the IPO of SandRidge Mississippian Trust I raised $315 million, selling more units than expected and at the top of the proposed price range.
The trust holds interests in 37 oil and gas wells operating in Oklahoma and another 123 Sandridge is expected to drill.
"The biggest driver is the way these trusts have been structured, they get very good valuations at IPOs," said Swank Capital's Cryer.
There were five IPOs of oil and gas trusts last year.
Analysts reckon other gas producers such as Southwestern Energy Co, Ultra Petroleum, Exco Resources Inc and Quicksilver Resources Inc could also look at royalty trusts.
SandRidge, one of the most active sponsors of royalty trusts with SandRidge Permian Trust being its second, is hoping to raise $603.75 million through its latest offering, SandRidge Mississippian Trust II.
George Young, a co-portfolio manager of the 5-Star Villere Balanced Fund that owns 6 million SandRidge shares, said the trusts have "been additive."
"Each time they have done one of these royalty trusts, they have provided liquidity to go out and buy more assets," he said in a telephone interview, adding that he would like to see more such trusts.
Craig Hodges, portfolio manager of the Hodges Small Cap Fund that holds 1.5 million SandRidge shares, said the company was maximizing shareholders value by leveraging low-risk wells.
Young's and Hodges' funds do not hold units of Sandridge's royalty trusts.
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