Investors continue to fixate on the latest developments in Europe’s ongoing sovereign-debt crisis, leading to jagged volatility in global equity markets. As we experienced in October, any hint of good news sends the major stock indexes sharply higher, while even the slightest disappointment produces equally breathtaking selloffs. 

The good news: Volatile markets are scary, but they also offer the best opportunities for investors with a longer time horizon. Investors should pursue a three-pronged strategy in these trying times:

• Buy high-yielding safe havens. With the yields on high-quality corporate and government bonds near record lows, investors are starved for income. Focus on our favorite US oil and gas trusts and master limited partnerships (MLP). These high-yield securities have held up remarkably well, as investors appear to regard any dips as an opportunity to buy.

• Buy cheap growth. In a market where stocks are highly correlated, investors are throwing out the baby with the bathwater. Oil services names and other growth-oriented stocks trade at bargain prices when you consider that global drilling activity remains strong and oil prices remain elevated. (See The Outlook for Oil Services Stocks from Oct. 4, 2011).

• Consider some shorts and hedges. I’ve written about some of my least favorite sectors in recent issues of The Energy Letter. I explained why many alternative-energy stocks are dead on arrival in Popping the Green Bubble and my negative near-term outlook for US natural gas prices in Bearish on US Natural Gas, Bullish on International LNG. Investors should consider extablishing short positions beased on these trends.

US income trusts fit into the first category of this three-pronged strategy. The best US oil and gas trusts offer relatively safe yields of 14 percent or more and the potential for significant capital gains. Better still, a number of high-quality trusts that had their initial public offerings (IPO) this year have yet to garner substantial attending from income-seeking investors.

However, not every recently listed income trust is a potential winner. Each trust is structured differently, with some offering rising distributions and significant protection against falling commodity prices. But investors who chase the highest yielders with little regard to the trust’s structure or the quality of its underlying assets tread on dangerous ground.

When most investors think of oil and gas trusts, Canadian royalty trusts come to mind. High-yielding Canadian royalty trusts have generated substantial wealth for investors, though most converted to corporations because of a change to the tax code that went into effect at the beginning of 2011. Even after these conversions, many of these former trusts still offer high yields and significant growth potential.

The structure of US oil and gas trusts differs considerably from the trusts listed north of the border and offers substantial tax advantages to individual investors.

US-listed royalty trusts aren’t subject to corporate taxes. The trusts pass through the income and profits earned to individual unitholders who pay tax on their share of the income. This prevents the double taxation that occurs when the Internal Revenue Service (IRS) taxes dividends at the corporate and individual level.

Like MLPs, trusts incur significant depreciation and depletion charges that provide a tax shield. The IRS considers part of the distribution you receive as a return of capital. You won’t be taxed on that portion of your distributions until you sell your units.

In contrast to operating companies such as MLPs and Canadian royalty trusts, US-listed oil and natural-gas trusts are finite entities that convey the right to unitholders to collect royalties from a specific group of wells, fields or geologic formations. A US oil and gas trust can’t acquire additional acreage over time or expand its drilling program.

As the trust’s underlying wells mature, declining oil and gas output will reduce the size of the distributions. Most trusts terminate on a predetermined date, at which point the assets are liquidated and the proceeds distributed to investors.

I’ve profiled a number of US oil and gas trusts–my favorites and some that investors would do well to avoid–in The Energy Strategist. Here’s a look at another US trust I’m often asked about.

ECA Marcellus Trust I (NYSE: ECT) went public in July 2010, closing at around $20 per unit on its first full day of trading. Since then, the trust has paid a total of $2.978 per unit in distributions and currently fetches about $25 per unit–a total return of about 40 percent when you include reinvested distributions.

The trust was formed by Energy Corp of America (ECA), a privately held oil and gas producer with operations in Appalachia, the Rockies and the Gulf Coast.

The properties and wells held by a US trust are often called an area of mutual interest (AMI). That’s because the profits from oil and natural gas produced and sold in the AMI are usually split according to a particular formula between the sponsoring company and the trust itself. In this case, the AMI is a roughly 9,600 acres of leased land in Greene County, Pa.

Source: ECA Marcellus Trust I S-1/A

Greene County is located in southwest Pennsylvania, not far from the border with West Virginia. This area is in the heart of the Marcellus Shale, an unconventional natural-gas field where drilling activity has picked up dramatically in recent years.

Readers of The Energy Letter should be familiar with the rapidly growing oil and gas output from unconventional plays such as the Bakken Shale in North Dakota and the Eagle Ford Shale in south Texas. To liberate hydrocarbons trapped in shale and other tight reservoir rocks, producers use two key innovations: horizontal drilling and hydraulic fracturing.

Horizontal drilling involves drilling laterally off of a traditional vertical shaft to increase the well’s exposure to the productive portion of the formation. Hydraulic fracturing involves pumping a liquid into a well to crack the reservoir rock and facilitate the flow of oil and gas through the field and into the well. In the nation’s most prolific shale plays, producers are drilling incredibly complex wells that can involve 30 or more fracturing stages and lateral segments that measure more than 12,000 feet in length.

Horizontal drilling and hydraulic fracturing can also enhance the output from mature fields. For example, producers have used these methods with great success in the Permian Basin of west Texas, an area that’s been in production for more than 50 years.

Drilling activity in the Marcellus Shale has accelerated rapidly because production costs are low and the formation is located close in the Northeast, one of the largest and most important consumption centers for natural gas. In addition, parts of the Marcellus also contain substantial volumes of natural gas liquids (NGL) such as propane and butane, higher-priced commodities that improve wellhead economics.

When ECA Marcellus Trust I was formed, the AMI included eight producing horizontal gas wells drilled into the Marcellus Shale formation and six wells that had been drilled but hadn’t gone into production. At this time, ECA agreed to drill an additional 52 horizontal wells in the AMI targeting the Marcellus Shale. The drilling on these wells continues, and ECA is obligated to complete all drilling by March 31, 2013, or on year later in the event of any unforeseen delays. These 66 wells represent the trust’s underlying assets; no additional wells will be drilled, nor will any additional acreage be added to the AMI.

Investors who buy ECA Marcellus Trust I will receive the following royalty interests:

• Ninety percent of the proceeds from the sale of gas and NGLs produced by the 14 wells that ECA has already drilled;
• Fifty percent of all proceeds from the sale of gas and NGLs produced by the 52 new horizontal gas wells due to be drilled and put into production by the end of the first quarter of 2013.

ECA Marcellus Trust I will terminate on March 30, 2030, and cease to exist. At this point, unitholders will retain perpetual royalties, equivalent to a roughly 45 percent interest in the 15 producing wells and a 25 percent interest in the 52 wells to be drilled. These assets will be sold at the time of the termination, and any remaining proceeds will be distributed to the unitholders as a final payout. The sponsor company, ECA, also has the right of first refusal to buy these perpetual royalties at the time of termination.

Unitholders aren’t responsible for the costs associated with drilling the 52 new wells or operating expenses to keep the wells in working order, all of which will be borne by ECA. The trust is responsible for post-production costs such as the expenses associated with compressing and transporting the gas.

The basic terms of the trust appear attractive to investors. Greene County is in a known and productive part of the Marcellus Shale, and there’s little risk that horizontal wells completed in this region will turn out to be economically unproductive. The trust also has two additional advantages I look for:

• It’s a relatively new offering and won’t terminate soon. Most trusts come with either a fixed termination date or automatically terminate based on specific production-related conditions. In this case, the trust has been around for about a year and a half, and investors can look forward to more than 18 years of distributions and a final payoff at termination.
  
  
• Built-in Growth. US oil and gas trusts can’t make acquisitions; rising production or commodity prices are the only way a trust can grow the distribution paid to investors. In the case of ECA, rising production is locked in for the next two years or so because the sponsor company has committed to drilling 52 new wells in the AMI.

However, two factors give me pause. First, the sponsor of this trust is a privately held company rather than a large, independent producer. Although ECA appears to be a well-run company that has sponsored successful trusts in the past, I tend to prefer trusts backed by Chesapeake Energy Corp (NYSE: CHK) and other established players.

Second, longtime readers know that I am bearish on the prospects for US natural gas prices over the next few years. Although demand growth will be solid, the supply of gas from new shale plays is just too high. ECA Marcellus Trust I has the advantage of relatively low costs, proximity to key end-markets and some modest liquids output. Nevertheless, depressed gas prices are a significant headwind.

Fortunately, the trust has significant built-in hedges that protect investors from commodity price volatility. Roughly 50 percent of the projected natural-gas output from the trust’s wells is hedged through March 31, 2014, using collars that provide a ceiling and a floor for gas prices. Meanwhile, there’s a good chance that the supply-demand balance will improve by mid-2014.

Demand for natural gas should strengthen, soaking up some excess supply. Producers will also slow their drilling activity in dry-gas fields and focus their efforts on oil- and NGL-rich plays. By then, Congress may have passed a bill to encourage the use of gas as a transport fuel. I don’t expect the price of natural gas to stage a substantial rally by 2014; however, the market should be healthier three years down the line.

ECA Marcellus Trust I will not take on additional hedges. At the end of the first quarter of 2014, no more hedges will be in place.

Even more important is the subordination clause that’s part of this trust. At the time of their formation, trusts often publish specific distribution targets for the first five years or so of their existence. In the case of ECA, the trust published a distribution target, an incentive distribution level and a subordination threshold.

Source: ECA Marcellus Trust I S-1/A

Through the end of the first quarter of 2015, the subordination threshold is 80 percent of the target distribution and the incentive threshold is to 120 percent of the target.

At the subordination threshold, ECA will step in to support the quarterly distributions. The sponsor retained about a 50 percent ownership stake in the trust after its initial public offering. The company also subordinated half its stake in the trust, or 25 percent of total outstanding units.

When the distributable cash flow drops below the subordination threshold, ECA will reduce the distributions it’s entitled to receive on its subordinated units until other unitholders (public investors) receive at least the subordinated distribution rate. In other words, if conditions deteriorate, the parent reduces its own distribution to preserve the payouts disbursed to public shareholders. This is an important guarantee that means ECA Marcellus Trust I is unlikely to pay out less than its subordination threshold over the next few years, even if gas prices remain depressed.

In exchange for the downside protection offered by ECA’s subordinated units, the company receives an incentive distribution in good times. When the trust’s distributions exceed that incentive threshold depicted on the graph, ECA will receive a bonus incentive payout on all payments in excess of the incentive distribution level. Although this structure limits distribution upside in strong commodity markets, that’s a small price to pay for downside protection.

Trusts usually err on the conservative side when setting their distribution targets in an effort to under-promise and over-deliver on their yield. In addition, the parent would like to hit the incentive threshold as often as possible to maximize its distribution bonus. ECA Marcellus Trust I has paid quarterly distributions that are a little less than or a little more than the target level since the trust formed. In total, distributions paid thus far have amounted to about 98 percent of the target rate.

One key consideration is that all subordinated units will convert to normal units one year after the ECA finishes drilling the last of the 52 wells in the AMI. As early as the end of March in 2014, unitholders in the ECA Marcellus will lose their downside protection on distributions.

Assuming that ECA Marcellus Trust I in 2012 pays distributions that amount to 95 percent of the targeted disbursement, the trust would yield 11.3 percent at current levels.

All told, I prefer trusts that focus more on oil and NGL production. That being said, ECA Marcellus Trust I offers an attractive value proposition: Near-term protection against low gas prices, coupled with longer-term exposure to a potential improvement in North American gas prices.

Meet Me at the Summit

Don’t miss out on this unique opportunity to hear me, Roger Conrad, Yiannis Mostrous, Benjamin Shepherd, David Dittman and Jim Fink share their latest insights on the markets and economy. Join us at Investing Daily’s 2012 Wealth Summit at the luxurious Four Seasons Hotel in Palm Beach, FL on May 4-5, 2012.

With the US economy likely to grow at a lackluster pace over the next few years, expect the stock market to suffer through a period of extreme volatility as investors adjust to the new normal. The EU’s ongoing sovereign-debt crisis will also continue to enervate investors. Throw in “Black Swan” events such as the civil war in Libya, and it’s easy to see why investors are on edge. A fearmongering media that focuses on worst-case scenarios rather than the likely outcomes doesn’t help matters.

But Investing Daily’s 2012 Wealth Summit will give you the edge in these uncertain times. This year’s event will focus on winning investment strategies that generate profits in both up and down markets. To learn more about this must-attend Wealth Summit, go to InvestingSummit.com or call 1-800-832-2330 for more details.