San Juan Basin Royalty Trust (SJT) has a high dividend yield over 7%, based on its distributions over the past 12 months. It is one of 416 stocks with a 5%+ dividend yield. This is a very enticing payout, considering the S&P 500 Index has a 2% dividend yield right now. This means SJT offers more than three times as much dividend income as the average stock in the S&P 500.

SJT also pays its dividend each month, rather than each quarter like most other stocks. This gives investors the benefit of slightly faster compounding, for those who reinvest dividends. SJT is one of only 29 stocks with a monthly dividend. However, SJT’s dividend may not be as attractive as it seems.

This article will discuss why investors should view royalty trusts like SJT with a fair dose of skepticism.

Business Overview

SJT is a royalty trust. It was established in November 1980. The trust is entitled to a 75% royalty interest in various oil and gas properties across 151,900 gross acres, in the San Juan Basin of northwestern New Mexico.

Burlington Resources Oil & Gas Company LP, a subsidiary of ConocoPhillips (COP), owns and operates the properties. More than 90% of the trust’s production is comprised of gas, with the remainder consisting of oil.

Source: Investor Relations

The trust does not have a specified termination date. It will terminate if royalty income falls below $1,000,000 per year over any consecutive two-year period. 2016 was a very difficult year for SJT. Not surprisingly, this was due to lower oil and gas prices.

Natural gas fell from an average of $2.60 per Mcf in 2015, to $1.89 per Mcf in 2016. The average price for oil declined from an average of $47.00 per barrel in 2015, to just $30.01 per barrel in 2016. In addition, natural gas production declined by 3.9% in 2016, due to field declines. At the end of 2016, proved reserves were estimated at 78,739 MMcf of natural gas, and approximately 188 million barrels of oil.

Source: 2016 Annual Report, page 6

Collapsing commodity prices wreaked havoc on SJT’s financial performance. In 2016, royalty income declined by 14%, to $16.79 million. From 2014-2016, royalty income fell 73%. SJT estimates, using a 10% discount rate, that the net present value of future cash flows is $93.5 million.

Growth Prospects

There are only two significant growth catalysts for SJT moving forward. The first is higher commodity prices, which would help SJT generate higher cash flows. Specifically, higher gas prices would be a huge boost for SJT, since gas accounts for the vast majority of production. The other major growth catalyst for SJT would be, if the trust’s oil and gas properties produced for longer than is currently expected. SJT is not exactly sure of the lifespan of the trust.

It has hired independent petroleum engineers, which conservatively estimated that the trust is likely to continue to produce for least another 10-15 years. These two factors will determine whether SJT is a good investment. The trust is not permitted to engage in any business activity, which includes using any portion of the trust estate to acquire additional properties. If the trust lasts 10-15 years, at the 2016 distribution rate, investors would receive approximately $2.99-$4.48 per unit in distributions.

On June 19th, SJT shares closed at a unit price of $6.93 per unit. However, higher distributions could significantly improve SJT’s investment prospects. Conditions have improved considerably to start 2017. SJT’s first-quarter gas prices rose 63% from the same quarter last year. Average oil prices increased 30% year-over-year.

This more than offset the impact of a continued decline in production. Royalty income distributed to the trust nearly tripled, to $8.61 million. Aside from higher commodity prices, SJT could receive a boost if it receives a favorable outcome from its July 2014 lawsuit against Burlington. SJT is claiming breach of contract, and is seeking in excess of $12 million. SJT claims Burlington failed to pay certain royalty interests to the trust. A non-jury trial date was moved out to January 16th, 2018, to give the companies an opportunity to settle. Discussions are ongoing, and is something investors should keep an eye on moving forward.

Higher commodity prices to start 2017 led to significant improvement last quarter, which resulted in higher dividends as well.

Dividend Analysis

As a trust, SJT’s dividends are classified as royalty income. Distributions are considered ordinary income, and are taxed at the individual’s marginal tax rate.

Since oil prices are so important to royalty trusts’ cash flow, it is no surprise that SJT’s dividends have declined substantially in the past two years.

SJT made the following distributions from 2012-2016:

• 2012 distributions-per-share of $0.718358
• 2013 distributions-per-share of $0.782955
• 2014 distributions-per-share of $1.284587
• 2015 distributions-per-share of $0.364745
• 2016 distributions-per-share of $0.298851

Declining commodity prices caused SJT’s fundamentals to deteriorate since 2014. This, in turn, led to lower dividend payments. The good news, is that distributions have increased so far in 2017. Through the first five months of the year, SJT distributed $0.264194 per unit. At this rate, SJT would pay out approximately $0.634 per unit. This payout level would represent a yield of 9.2% based on the current unit price. As a result, if oil and gas prices can maintain current levels or continue to recover, SJT’s dividends could increase to a level that makes the stock attractive.

For example, if the trust lasts another 10 years, investors will want a dividend yield well in excess of 10% annually, to make SJT a successful investment.

Final Thoughts

Investing in SJT right now is essentially making a bet on two things—higher oil prices, and a longer-than-expected lifespan of the trust.

Royalty trusts can be a good source of dividend income because of their high yields. But investors need to make sure the trust’s assets will not run out before the initial investment is paid back.

It appears that SJT investors will need a significantly higher price of natural gas and oil in order to make the stock a good investment.

• For an example of a royalty trust whose assets have far outlived its initial projected lifespan, click here.