Closely monitoring the schedule of master limited partnerships (MLP) and US oil and gas royalty trusts slated for initial public offering (IPO) can pay off handsomely for income-seeking investors. Financial websites routinely miscalculate the yields offered by these securities until the fledgling stock has paid a full year of distributions. This oversight means that these high-yielding gems often don’t appear on investors’ radar screens for at least six months after going public.

Few investors bother to read the lengthy S-1 registration statements that sponsors file with the Securities and Exchange Commission prior to the IPO. These documents outline the MLP or royalty trust’s asset base, their exposure to commodity prices and management’s assessment of how quickly the distribution will grow during the first few years as a publicly traded entity.

If you take the time to cull through these statements and identify the likely winners, you can get in before the herd notices the trust’s rapidly growing quarterly payout and piles into the stock.

Looking Good

SandRidge Mississippian Trust II (NYSE: SDR) filed its first S-1 registration statement with the SEC on Jan. 5, 2012. Although this initial filing often lacks certain details, the document often contains enough information for you to ascertain whether the proposed IPO warrants further monitoring. This first glimpse into the structure and growth potential of SandRidge Mississippian Trust II, a spin-off of independent producer SandRidge Energy (NYSE: SD), suggests that the latest offering could be a winner–provided that the price is right.

SandRidge Energy’s first royalty trust, SandRidge Mississippian Trust I (NYSE: SDT), amended its S-1 form six times during the three months that transpired between the initial filing and the security’s first day of trading. Based on this precedent, SandRidge Mississippian Trust II’s IPO would likely occur in April.

SandRidge Mississippian Trust II represents a royalty interest in a series of existing and planned oil and gas wells in northern Oklahoma and southern Kansas. The 81,200 gross acres covered by the royalty interest, or area of mutual interest (AMI), are located in the Anadarko Basin, a mature oil- and gas-producing region where SandRidge Energy has amassed 1.5 million net acres.

These royalties entitle unitholders to 80 percent of the proceeds from 67 existing wells within the AMI and 70 percent of the proceeds generated by 206 developmental wells that SandRidge Energy will drill before the end of 2015. These wells will target the Mississippian formation, an oil-bearing deposit that’s been in production since the 1940s. Decades’ worth of geologic data and production records dramatically reduce drilling risk in the region.

Much like the Permian Basin of south Texas, portions of the the Anadarko Basin have recently enjoyed a renaissance, thanks to hydraulic fracturing and horizontal drilling.

Directional drilling enables producers to target a field’s most productive portions by carving out a well that branches off horizontally from the vertical shaft. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks.

Producers have drilled about 400 horizontal wells targeting the Anadarko’s Mississippian formation since 2007. With 19 horizontal drilling rigs, SandRidge Energy is one of the play’s most active operators.

Although crude oil accounts for slightly more than half the output from the AMI, elevated oil prices and depressed natural gas prices should ensure that more than three-quarters of the trust’s total revenue will come from oil sales.

SandRidge Mississippian Trust II won’t be responsible for the costs associated with drilling the 206 developmental wells outlined in the S-1 registration statement, though the trust will pay its share of post-production expenses. Investors will receive virtually all revenue net of expenses in a quarterly distribution. The trust will disburse these payouts about 60 days after the end of each quarter; unitholders will likely receive their distributions at the end of February, May, August and November.

The trust officially launched on Jan. 1, 2012, and will disburse its first payout (covering royalties from January and February) on May 30. Future distributions will cover three-month periods. Investors should note that the quarterly payouts will vary based on prevailing commodity prices, though SandRidge Mississippian Trust II will include two features that mitigate the effect any fluctuation in oil and gas prices have on the trust’s cash flow.

First, SandRidge Energy will hedge a portion of the trust’s oil and gas output. Amendments to the trust’s initial S-1 filing should outline the extent to which these hedges will cover estimated production, the commodity prices locked in by these hedges, and when these contracts will expire.

For a time, the trust’s subordinated units will also insulate the quarterly distribution from volatile commodity prices. SandRidge Energy will own about half the trust’s units after the IPO, including subordinated units that will account for 25 percent of the total outstanding units.

As long as the quarterly distribution received by individual investors exceeds 80 percent of the targeted payout, SandRidge Energy’s subordinated units will entitle the firm to the same payout. However, if the trust fails to generate sufficient cash flow to meet the minimum payout to all unitholders, SandRidge Energy would forego some of the distribution from its subordinated units to ensure that investors are made whole. As compensation for this risk, SandRidge Energy will receive a bonus payout on its subordinated shares if the quarterly distribution exceeds 120 percent of the targeted distribution.

Four quarters after SandRidge Energy completes the 206 developmental wells outlined in the prospectus, the subordinated units will automatically convert to common units. That is, if SandRidge Energy completes the 206 development wells as scheduled on Dec. 31, 2015, the subordinated structure will remain in place until Dec. 31, 2016. After this point, unitholders will have less protection against volatile commodity prices.

The subordinated and incentive thresholds established in the S-1 statement are based on targeted distributions; whether the trust’s cash flow enables its quarterly payout to meet these estimates hinges primarily on how much oil and gas SandRidge Energy lifts during the quarter and the prevailing prices for these commodities.

With years of experience operating in the AMI and decades of data, SandRidge Energy should have a good handle on oil output from the existing 67 wells and likely production rates from the 206 planned wells. SandRidge Energy likely erred on the side of conservatism when estimating quarterly production from the trust’s underlying wells; the subordinated units incentivize the sponsor to under promise and over deliver.

Check out this graph of the projected output from the trust’s producing wells and proven undeveloped (PUD) and probable reserves. The producing category comprises the trust’s 67 existing wells, while the other two categories estimate production from the 206 developmental wells. Output from PUD wells is less subject to risk, while those categorized as probable entail a bit more drilling risk.

Source: SandRidge Mississippian Trust II S-1

The forecast calls for output to increase through 2015 and taper off once SandRidge Energy completes its drilling program. Although production tends to decline quickly in the first few years after a well’s peak, this deterioration tends to stabilize at a slow-but-predictable pace thereafter. These wells won’t become uneconomic for some time and should have a relatively long life.

In fact, SandRidge Energy estimates that the trust’s assets could fetch about $185 million–more than $3.50 per unit–upon termination in 2031. In the interim, the trust will continue to generate quarterly income, albeit at a diminishing rate. Oil and gas trusts usually don’t suddenly crater in value once the underlying wells hit their peak production. However, rising output and distributions will attract income-seeking investors and send the stock price higher in the trust’s early years.

The commodity price assumptions underlying SandRidge Mississippian Trust II’s targeted distributions also appear reasonable.

Through 2014, SandRidge’s forecast calls for oil and natural gas prices to correspond to futures contracts on Jan. 3, 2012, a time when gas declined to a record low because of glutted inventories. Beginning in 2015, the company projects that commodity prices will increase 2.5 percent annually, with oil capped at $120 per barrel and natural gas capped at $7 per million British thermal units. Check out this graph depicting the firm’s forecast for natural gas prices.   

Source: SandRidge Mississippian Trust II S-1

The trust’s underlying commodity price assumptions call for natural gas to average less than $3.50 per million British thermal units in 2012 and to increase gradually to $4.50 per million British thermal units by mid-decade. According to this forecast, US natural gas wouldn’t hit $7 per million British thermal units until 2031. Although US natural gas prices should remain depressed for at least the next two to three years, the commodity’s long-term prospects are brighter. Despite my bearish near-term outlook for natural gas prices, SandRidge’s long-term projections could prove conservative.

Meanwhile, SandRidge Mississippian Trust II’s targeted distributions reflect oil prices that average $102.50 per barrel in 2012, $99 per barrel in 2013 and $95 per barrel in 2014. This forecast calls for oil to trade for less than $120 per barrel throughout next 20 years–an extraordinarily cautious outlook. I expect oil to eclipse $120 per barrel with increasing frequency in coming years.

The short distribution history of SandRidge Mississippian Trust I likewise suggests that SandRidge Mississippian Trust II’s targeted distributions (depicted below) will prove somewhat conservative.

Source: SandRidge Mississippian Trust II S-1

SandRidge Mississippian Trust I has paid two quarterly distributions since going public on April 1, 2011. The first of these payouts exceeded the target but not the incentive threshold, while the second topped the incentive level by a considerable amount. This admittedly brief distribution history suggests that SandRidge Energy may have under promised on its initial distribution targets.

My previous articles on US oil and gas royalty trusts elicited a number of questions about the tax implications of investing in these pass-through entities.

This particular trust has elected to be taxed as a publicly traded partnership and will issue a K-1 form to investors. Investors usually receive the K-1 in March of each year. The document will detail exactly how your distributions will be taxed.

As a pass-through entity, SandRidge Mississippian Trust II won’t pay corporate taxes; instead, each unitholder will pay tax on their share of the partnership’s profits, eliminating the double taxation that occurs on most corporate dividends.

Even better, noncash accounting charges such as depletion and depreciation mean that the Internal Revenue Service (IRS) will consider a portion of your distributions as a return of capital, deferring your tax liability until you sell the trust’s units.

SandRidge Mississippian Trust II’s initial S-1 statement omitted an estimate of what percentage of the trust’s payout would be tax-deferred; amended registration statements will likely contain this information.

In general, investors should steer clear of holding pass-through entities such as MLPs and US royalty trusts in an IRA and other tax-advantaged accounts.

For one, holding pass-through securities makes their tax advantages redundant. Also, publicly traded partnerships generate unrelated business taxable income (UBTI), which can trigger taxes in a tax-advantaged account. You’re exempt from paying tax on up to $1,000 in total UBTI; after that, you can actually owe some taxes on UBTI payments.

Some investors make far too much of the potential tax liability associated with UBTI. Often, you would have to have a large amount invested in MLPs and other pass-through entities before exceeding the $1,000 threshold. In addition, the individual taxpayer is not the one who pays UBTI-related taxes; the IRA’s administrator muyst file a tax return and claim the UBTI (on IRS form 990). These taxes are owed by the IRA or 401(k) itself. Presumably, the administrator would then pass along any tax charges to you.

But SandRidge Mississippian Trust II’s S-1 statement indicates that the trust’s structure will avoid UBTI-related complications:

Tax-Exempt Organizations. Employee benefit plans and most other organizations exempt from U.S. federal income tax including IRAs and other retirement plans are subject to U.S. federal income tax on unrelated business taxable income. Because all of the income of the trust is expected to be royalty income, interest income, hedging income and gain from the sale of real property, none of which is unrelated business taxable income, any such organization exempt from U.S. federal income tax is not expected to be taxable on income generated by ownership of trust units so long as neither the property held by the trust nor the trust units are debt-financed property within the meaning of Section 514(b) of the Internal Revenue Code. In general, trust property would be debt-financed if the trust incurs debt to acquire the property or otherwise incurs or maintains a debt that would not have been incurred or maintained if the property had not been acquired and a trust unit would be debt-financed if the trust unitholder incurs debt to acquire the trust unit or otherwise incurs or maintains a debt that would not have been incurred or maintained if the trust unit had not been acquired.

This passage indicates that payments made by SandRidge Mississippian Trust II could be held in an IRA without incurring UBTI tax.

A British reader also asked about his tax liability on distributions paid by US royalty trusts. In this instance, SandRidge Mississippian Trust II’s S-1 indicates that “non-US” investors will have a portion of their distributions withheld; the US government routinely withholds taxes paid on dividends at different rates for investors who live in other countries. In most cases, treaties between the US and foreign tax authorities allow you to reclaim any taxes withheld as a credit against your foreign tax liability.

At this early stage in the security registration process, SandRidge Mississippian Trust II’s tax advantages, exposure to oil prices and potential for distribution growth make the stock worthy of consideration. However, much of this depends on the price at which the trust debuts; no stock is a buy at any price.

Based on the current distribution estimates and the yields of other, similar trusts I would regard SandRidge Mississippian Trust II as a buy under $24 per unit and a steal at less than $20.50 per unit. I will continue to track the trust’s IPO process in upcoming issues of The Energy Strategist.

Partner Up

Energy-focused MLPs have grown increasingly popular since I added a handful of these securities to The Energy Strategist’s model Portfolios in 2006. Investors seeking expanded coverage of the MLP universe should sign up for MLP Investment Insider, a free e-zine authored by Peter Staas, a regular contributor to The Energy Strategist and The Energy Letter. Register for your free subscription today to keep abreast of the latest MLP news and trends.

Around the Portfolios

Fourth-quarter earnings season is under way. Here are the reporting dates for our Portfolio holdings.

Growth Portfolio

BG Group (LSE: BG/, OTC: BRGYY)–Feb. 9, 2012
Cameron International (NYSE: CAM)–Feb. 2, 2012
Core Laboratories (NYSE: CLB)–Feb. 1, 2012
Dresser-Rand Group (NYSE: DRC)–Feb. 24, 2012
Eagle Rock Energy Partners LP (NSDQ: EROC)–March 9, 2012
EOG Resources (NYSE: EOG)–Feb. 17, 2012
Linn Energy LLC (NSDQ: LINE)–Feb. 24, 2012
Nordic America Tanker Shipping (NYSE: NAT)–Feb. 13, 2012
Occidental Petroleum Corp (NYSE: OXY)–Jan. 25, 2012
Petrobras (NYSE: PBR A)–Feb. 24, 2012
Suncor Energy (TSX: SU, NYSE: SU)–Feb. 2, 2012
Weatherford International (NYSE: WFT)–Feb. 21, 2012
World Fuel Services Corp (NYSE: INT)–Feb. 24, 2012

Conservative Portfolio

Chevron Corp (NYSE: CVX)–Jan. 27, 2012
Eni (Milan: ENI, NYSE: E)–Feb. 15, 2012
Enterprise Products Partners LP (NYSE: EPD)–Feb. 1, 2012
Natural Resource Partners LP (NYSE: NRP)–Feb. 14, 2012
NuStar Energy LP (NYSE: NS)–Jan. 27, 2012
Penn Virginia Resource Partners LP (NYSE: PVR)–Feb.  9, 2012
Sunoco Logistics Partners LP (NYSE: SXL)–Jan. 26, 2012
Teekay LNG Partners LP (NYSE: TGP)–Feb. 24, 2012

Aggressive Portfolio

Afren (LSE: AFR)–March 27, 2012
Alliance Holdings GP LP (NSDQ: AHGP)–Jan. 27, 2012
GeoResources (NSDQ: GEOI)–March 13, 2012
Joy Global (NYSE: JOY)–March 2, 2012
Knightsbridge Tankers (NSDQ: VLCCF)–Feb. 8, 2012
Macmahon Holdings (ASX: MAH, OTC: MCHHF)–Feb. 21, 2012
Nabors Industries (NYSE: NBG)–Feb. 21, 2012
Oasis Petroleum (NYSE: OAS)–March 8, 2012
Oil Search (ASX: OSH, OTC: OISHF)–Feb. 21, 2012
Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY)–Feb. 20, 2012
SeaDrill (NYSE: SDRL)–Feb. 29, 2012
Tenaris (NYSE: TS)–Feb. 23, 2012