SandRidge Mississippian Trust I is a statutory trust that holds royalty interests in oil and gas properties. SandRidge Mississippian Trust I (NYSE: SDT) receives its royalties from properties in the Mississippian formation in Alfalfa, Garfield, Grant and Woods counties in Oklahoma. There is also a SandRidge Mississippian Trust II (NYSE: SDR) that receives royalties from properties in the same counties as well as Kay County in Oklahoma and Barber, Comanche, Harper and Sumner counties in southern Kansas. Both trusts have very high distributions, which may attract investors. However, the payment of these distributions is anything but certain.

How the SandRidge Trusts Work

In oil and gas trusts, investors purchase the rights to future net profits from a set of oil and gas wells. SandRidge Energy Inc. (OTC: SDOCQ) created SandRidge Mississippian Trust I as a way to own royalty interests in 37 producing and 123 horizontal development wells in the Mississippian formation in Oklahoma. Essentially, the value of the trust is the net present value (NPV) of the distribution stream of profits from the wells. The trust receives the remaining profits after all the other parties that have an interest in the wells, including the well proprietor and the trust administrator, take their share of the profits.

Advantages for Investors

Investors in SandRidge Mississippian Trust I own an investment with a high but variable yield. In addition, the investment provides significant tax benefits. Since the trust passes profits directly to the holders, it is similar to a master limited partnership (MLP) and exempt from corporate income taxes. However, unlike an MLP, the distributions from SandRidge Mississippian Trust I are capital gains, not dividends and, therefore, investors pay a lower tax rate. In addition, as a part-owner of the wells, a trust holder can depreciate the assets and lower his or her cost basis in the investment.

The Problem With Trusts

SandRidge Mississippian Trust I and Trust II have payouts that fluctuate considerably from quarter to quarter. The reason for the volatility is that the amount of oil and gas that the well produces fluctuates as the price of oil and gas rises and falls. Most importantly, however, the assets in the two trusts can't grow. They are limited to the wells, which are depreciating assets. Eventually, the wells dry up and the payment stream ends.

Dividend Stream Is Inconsistent

The fall in oil and gas prices has had a significant impact on the distribution stream of the trust. SandRidge Mississippian Trust I paid more than 30 cents in distributions in each of the four quarters of 2015. However, in 2016, the trust paid 31.1 cents on Feb. 10, 2016, 13.84 cents on May 11, 2016, and only 4.12 cents on Aug. 10, 2016. The sum of the last four quarters of distributions totals 79.52 cents, which equates to a yield of 51.3% based on the $1.55 closing price for the trust on Aug. 22, 2016. However, if the company continues to pay 4.12 cents for each of the next three quarters, the annual yield would be 10.6%. Furthermore, the lower distributions have occurred as the value of the trust has declined. The trust traded for $2.70 on Aug. 25, 2015, which is almost 75% higher than its closing price on Aug. 22, 2016. In other words, the decline in distributions occurred as the value of the wells declined.

The Bottom Line

Oil and gas trusts such as the two SandRidge Mississippian Trusts are volatile investments and decaying assets. Unlike an oil company, which can acquire more properties and see its stock price rise, the trusts are likely to appreciate only if the price of oil and gas rises significantly and production increases. In addition, most companies' dividends are much more stable than the distributions from an oil and gas trust. Finally, large distributions occur when oil prices are high, while small distributions occur when oil prices are low. In other words, when the price of oil is high, oil producers increase production. Eventually supply outstrips demand, and prices fall. Therefore, oil and gas trusts like the SandRidge Mississippian Trusts are subject to the boom and bust cycles of commodities investing.