The best US oil and gas trusts offer investors high tax-advantaged yields, the promise of significant near-term distribution growth and potential upside from higher commodity prices.

Subscribers unfamiliar with these securities should consult my lengthy special report, Oil and Gas Trusts: Buys and Sells. I also explained the valuation models I use to evaluate oil and gas trusts in Trust Exercise, from the Feb. 23, 2012, issue of The Energy Strategist.

We pay close attention to newly listed oil and gas trusts, as these securities offer significant upside potential. Many financial and brokerage websites calculate a stock’s yield based on the company’s historical dividend payments; oftentimes, these sites indicate that shares of a recent initial public offering (IPO) yield zero percent.

In addition, a trust or MLP’s first distribution payment is often prorated. That is, if an MLP or trust goes public in mid-February, its first distribution covers only the portion of that quarter. Most websites annualize this prorated dividend, dramatically understating the stock’s yield potential.

When longtime Aggressive Portfolio holding SeaDrill (NYSE: SDRL) first listed on the New York Stock Exchange, we highlighted the stock’s 10 percent yield and strong growth potential. At the time, most financial websites indicated that SeaDrill’s stock offered only a negligible yield. Most financial websites also didn’t report the stock’s correct yield until 12 months later. Once income-seeking investors discovered the stock’s appeal, the influx of capital sent the share price soaring.

The same basic pattern played out with Chesapeake Granite Wash Trust (NYSE: CHKR), which we added to the Growth Portfolio on Nov. 24, 2011. The stock price began to take off after the trust disbursed its first payout to unitholders on Dec. 13, 2011, and ran up even more after its second distribution on Feb. 15, 2012. Until these payouts, many financial websites indicated that the stock yielded zero percent.

This anomaly offers savvy investors a window of opportunity to buy high-quality MLPs, royalty trusts and other income-oriented stocks well before the herd piles into these names. However, beating the rush requires reading the S-1 and S-1/A registration statements that companies considering an IPO file with the Securities and Exchange Commission (SEC). In these documents, management teams often outline the firm’s expected quarterly dividend or distribution. Of course, investors must also assess whether the underlying business will support the estimated payout.

I’m closely monitoring the IPOs of three new oil and gas trusts: SandRidge Mississippian Trust II (NYSE: SDR), Pacific Coast Oil Trust (NSDQ: ROYT) and Whiting USA Trust II (NYSE: WHZ). I will analyze Whiting USA Trust II at length in next week’s issue of The Energy Strategist Weekly.

SandRidge Mississippian Trust II (NYSE: SDR)

SandRidge Mississippian Trust II will feature a similar structure to its predecessor, SandRidge Mississippian Trust I (NYSE: SDT), which has returned more than 40 percent since we added the stock to the Growth Portfolio in early October 2011. We cut SandRidge Mississippian Trust I to a Hold on Feb. 23, 2012, because the stock appeared overbought. Investors who followed our lead and sold half their position in the trust took profits when the stock was up more than 60 percent.

I analyzed SandRidge Mississippian Trust II at great length in the Jan. 25, 2012, issue of The Energy Strategist Weekly, Energy Investing: Eagerly Awaiting the IPO of SandRidge Mississippian Trust II. Given the strong performance of SandRidge Mississippian Trust I, this new security could be a compelling investment–at the right price. This IPO should take place in early April, and I’ll offer an update take on the stock in a Flash Alert shortly thereafter.

In the meantime, here are a review of the trust’s basic features and my analysis of the updated S-1 registration statement that SandRidge Mississippian Trust II filed with the SEC on March 15, 2012.

The area of mutual interest (AMI) covered by the trust includes about 81,200 gross acres in northern Oklahoma and southern Kansas. Unitholders will receive 80 percent of net proceeds from oil and natural gas production from 67 producing wells in the AMI and 70 percent of the net proceeds 206 horizontal wells that the sponsor, SandRidge Energy (NYSE: SD), will drill in the area. These developmental wells will be completed by Dec. 31, 2015; rising production during this drilling program should generate substantial distribution growth during the trust’s first two to three years.

The net revenue from the sale of oil and natural gas production will vary with commodity prices. But SandRidge Mississippian Trust II includes two features that protect unitholders from volatile commodity prices in the intermediate term: extensive hedging and a subordinated-unit structure.

Although the trust will hedge its expected production in the first few years after the IPO, the recently amended prospectus didn’t include an estimate of the exact percentage of the expected oil and gas output that these hedges would cover.

The trust’s subordinated units will also insulate the quarterly distribution from volatile commodity prices for a time. SandRidge Energy will own a little less than half the trust’s units after the IPO, including subordinated units that will account for 25 percent of all 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.

In its most recent registration statement, SandRidge Mississippian Trust II updated its target distributions to reflect shifts in commodity prices since filing its initial S-1 form in January. These new estimates reflect prices in the oil and gas futures markets on March 5, 2012.

Oil accounts for just under half the reserves on the trust’s AMI, with natural gas accounting for the remainder. Although the outlook for oil prices remains sanguine, natural gas prices continue to hover near multiyear lows and should remain depressed for at least next two to three years.

Fortunately, gas futures near their nadir on March 5, suggesting that management didn’t factor in any significant upside for this commodity price when estimating the trust’s quarterly distributions. In fact, the trust assumes that US natural gas prices won’t eclipse $7 per million British thermal units between now and 2031–an extremely conservative outlook.

This graph tracks SandRidge Mississippian Trust II’s targeted distributions from its inception to its termination.

Source: SandRidge Mississippian II S-1/A, Amended March 15, 2012

The trust expects to increase its payout rapidly through 2016–when SandRidge Energy will drill actively in the AMI–with the estimated distribution topping out at $0.86 per unit in the first quarter of 2016. After this drilling program is completed, the trust’s quarterly disbursements will drop sharply before declining at a slow-but-steady pace until the trust terminates in 2031.

SandRidge Mississippian Trust II will also sell the AMI acreage at this end date and distribute the proceeds (an estimated $3.93 per unit) among investors.

Based on the structure and performance of SandRidge Mississippian Trust I, the trust’s distribution estimates will likely prove conservative. In particular, I suspect that SandRidge will sink the required 206 developmental wells more quickly than anticipated over the next two years.

Based on my updated valuation model, SandRidge Mississippian Trust II would be an excellent buy if the stock fetches less than $26 per unit. At this price, the units would yield less about 10 percent based on the trust’s projected payout for its first four quarters.

Pacific Coast Oil Trust (NYSE: ROYT)

Pacific Coast Oil Trust filed its first S-1/A registration statement on Jan. 6, 2012, suggesting that the IPO could occur within a similar time frame as SandRidge Mississippian Trust II.

Pacific Coast Oil Trust is entitled to receive royalties based on oil production from mature fields in the Santa Maria and Los Angeles Basins of California. Crude oil accounts for about 98 percent of the proved reserves on this property, limiting the trust’s exposure to depressed natural gas prices.

Unitholders are entitled to receive 80 percent of net profits from the sale of oil and gas production in “the developed properties,” which consist of the proved, developed reserves throughout the AMI. In addition, unitholders will receive 25 percent of the net profits from oil and gas production in “the remaining properties,” which comprise undeveloped reserves in the AMI.  

But there’s a catch: Producing oil from the trust’s undeveloped properties will require significant investment in drilling and production infrastructure. These high costs should prevent wells in the remaining properties from generating much in the way of actual profits during first few years of the trust’s existence.

To compensate, unitholders will receive 7.5 percent of the proceeds (free of development costs) from the sale of oil and gas from the remaining properties located on Pacific Coast Oil Trust’s Orcutt properties when developmental costs exceed the proceeds from oil and gas sales.

Pacific Coast Oil Trust will pay a monthly distribution, an attractive payment schedule for investors seeking a regular income stream.

A closer examination of the acreage underlying the AMI explains why the trust opted for this complicated distribution formula.

Wells in the AMI currently produce a total of 3,500 barrels of oil equivalent per day, about 2,100 barrels of oil equivalent per day of which comes from the conventional wells on the Orcutt properties. Most of the crude oil in this play comes from formations located between 1,700 and 2,700 feet underground that have been in continuous production for decades. Output from these mature wells declines at a steady but predictable pace, leaving little risk to wellhead economics; the operator knows how these wells behave, and the maintenance expenses are relatively minimal.

The majority of the oil lifted from these mature fields comes from secondary and tertiary recovery methods such as water-flooding, a production technique that involves pumping water into the reservoir to increase pressure and force oil into the well. Some developments also rely on electric submersible pumps and horse-head pumps to offset natural production declines. If you’ve ever flow into the Los Angeles airport, you’ve seen the horse-head pumps that dot the landscape.

The trust’s sponsor has a capital budget of $55.9 million for the Orcutt properties; about $6.4 million will be spent on the developed properties, with the rest funding drilling activity in the remaining properties.

Within the remaining properties, a shallow, highly porous Diatomite formation in the Orcutt field represents the biggest source of potential production upside. However, the hydrocarbons trapped in these pores require cyclic stream injection–a process that involves pumping hot stream into the reservoir rock to heat the oil–to enable the oil to flow to the surface for a period. This alternation between steam injection and extraction enables the operator to produce commercial quantities of oil. 

The sponsor plans to develop 38 wells using this technique for a cost of $16.3 million. Another $30 million will go to water-separation plants and other supporting infrastructure.

What does this mean for potential investors? Output from the mature wells should generate a stable base of cash flow that will support the distribution over the next few years, with the development of the remaining properties offering some upside. Management expects capital expenditures associated with the remaining properties to exceed net proceeds from the wells until 2050. In that scenario, unitholders will instead receive 7.5 percent of the proceeds from oil and gas flowed from wells in the Orcutt field. As development costs decline, the trust would pay 25 percent of net profits from the entire remaining properties.

Pacific Coast Oil Trust has hedged 70 percent of its oil output at a price of $115 per barrel, providing some shelter against fluctuations in commodity prices. Unlike the trusts created by SandRidge Energy, Pacific Coast Oil Trust lacks a fixed termination date and could produce oil for decades to come.

The current S-1/A statement includes cash flow estimates and projected distributions for the next few years, albeit not on a per-unit basis. As more details about the trust’s structure become available and the IPO approaches, I will keep subscribers apprised of my assessment of the stock.

Based on the current information, Pacific Coast Oil Trust appears riskier than the trusts created by SandRidge Energy because there are questions about how much oil the operator will be able to extract from the AMI. The trust’s structure also doesn’t commit the operator to drilling a specific number of wells or set a specific time frame for development, which could prompt the sponsor to delay development of the Diatomite formation if oil prices were to decline.