WHAT IS 'Royalty Units'

Royalty units are ownership shares in a royalty income trust, which owns the income rights to oil and gas wells or coal mines. A royalty unit gives the holder a stake in the income generated by the energy holdings of the trust. The royalty trust receives the income or cash flow that the energy extraction generates, then passes this income on to the royalty unit holders of that trust.

BREAKING DOWN 'Royalty Units'

Royalty units are seen as an attractive investment for a number of reasons. Most importantly, in the U.S. as long as roughly 90 percent of the profits are distributed to the unit owners as dividends, there is no corporate tax on profits. The only tax is the relatively low individual income tax on dividends. Since most royalty trusts include many different wells or mines, royalty units are inherently diversified, at least within the mineral extraction sector. Another advantage of royalty units is that they allow an investor to participate in the oil and gas sector without buying an actual well or mine, or dealing in the complex futures commodity markets. In addition, like other commodities the trusts are considered a hedge against inflation. Finally, returns have been historically high, often double-digit, and are often up when financial instruments are down.

Royalty Units Are Managed by a Third Party

Royalty trusts have been around since the 1950s, but Texas oil baron T. Boone Pickens popularized them in the 1980s. The trusts themselves are always managed by a third party, such as a bank; the actual operator of the well or mine does not run the trust, and the bank trust officer may be the only employee. Royalty units are traded like stocks. Examples of public U.S. royalty trusts include BP Prudhoe Bay Royalty Trust, which is traded on the New York Stock Exchange (NYSE); and TEL Offshore Trust, which is traded on the NASDAQ exchange.

Risks associated with buying royalty units include the depletion of resources and the consequent reduction in income. As most oil and gas fields in North America are past peak production, this is not a theoretical risk. Moreover, in the U.S., royalty trusts cannot add new properties; once the existing properties are depleted of resources, the trust will wind down. By contrast, Canadian royalty trusts are allowed to be actively managed. However, that country’s recent Tax Fairness Plan has eliminated much of the tax advantage to royalty units. As a result, many Canadian trusts or CanRoys have converted to a conventional corporate structure.

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