US oil and gas trusts have become popular investments for two primary reasons: high yields and tax advantages.

Trusts aren’t subject to corporate taxes; instead these entities pass through their net income to individual unitholders who pay tax on their share of these earnings. This structure eliminates the double taxation that occurs when the Internal Revenue Service (IRS) taxes earnings at the corporate level and dividends at the individual level.

Like master limited partnerships (MLP), 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 MLPs, US-listed oil and gas trusts are finite entities that convey the right to unitholders to collect royalties from a specific group of wells, fields or geologic formations. The trust can’t add to these properties over time by acquisition or expansion.

As these wells mature, declining oil and gas output will force the trust to reduce the amount it disburses to investors. Most trusts are set up with a predetermined termination date, at which point the assets will be liquidated and the proceeds distributed to investors.

We favor recently launched trusts, as they tend to have a longer life span ahead of them and often grow their payouts rapidly in the early years. Newer trusts also featured hedges and other safeguards that reduce immediate exposure to commodity prices and facilitate reliable distribution growth.

Because trusts have a limited life span, it’s particularly important that investors not overpay for these securities. With yields on most traditional income-oriented investments near multi-decade lows, it’s easy to get carried away by the double-digit yields offered by some of the US trusts and overpay for the stock.

In late February and early March 2012, we suggested that investors take profits in a number of oil and gas trusts in the model Portfolios, as these names were wildly overvalued.

But the recent pullback in oil prices has deflated valuations, giving savvy investors an opportunity to by these stocks at favorable investors. However, investors should adhere to our buy targets when adding these positions to their portfolios.

I explained my valuation methodology for oil and gas trusts at some length in Trust Exercise. These models proved their worth in the ensuing three months: The two trusts we took profits on in that issue have given up an average of 20 percent in the ensuing months.

In this issue, I’ll use the same technique and update my valuation model for the oil and gas trusts in the model Portfolios.

I use a form of the dividend discount model (DDM) to value trusts. The DDM is one of the simplest ways to gauge a security’s value and reflects one of finance’s core principles: the time value of money, or the idea that $1 today is worth more than a $1 in the future.

Even in today’s environment, some inflationary pressure exists, albeit dramatically less than in the 1970s, ‘80s and ‘90s. This general increase in the price of goods and services means that rational investors would regard $1 paid a year later as less valuable than $1 received today.

Opportunity cost also factors in to the equation. That is, if I lend someone $100 today, I give up the opportunity to invest that $100 in a portfolio of stocks or bonds or to put that $100 in a savings account. To compensate, I would seek some sort of return on the loan.

The DDM assumes that a stock is worth the net present value (NPV) of its future dividend payments to shareholders. This approach requires the analyst to estimate how much a company will pay in dividends over the holding period and discount the total based on desired annualized rate of return determine what these disbursements are worth in today’s dollars. The sum of all these discounted payments represents the security’s current value.

The best way to illustrate the technique is with an example. Let’s start with Growth Portfolio holding SandRidge Mississippian Trust II (NYSE: SDR).

If you type the ticker into your broker’s website or Yahoo! Finance, you’ll see that the stock yields about 5.4 percent. SandRidge Mississippian Trust II went public on April 18, 2012, and on May 11 paid a single distribution of $0.267726. To calculate yield, most financial websites simply assume that this initial payment is the quarterly distribution, multiply it by four and divide by the price of the trust.

But this bogus calculation overlooks a number of salient factors. First, the first quarterly payment made by the trust relates to production from the trust’s wells between Jan. 1, 2012, and Feb. 29, 2012; this disbursement doesn’t represent a full quarter’s worth of output from the trust’s underlying acreage.

Future payouts, which will be based on a full quarter, would be considerably higher. In this case, a $0.267726 distribution for two months equates to a payout of more than $0.40 for three months, or $1.60 annualized. Based on a $1.60 annualized distribution, units of SandRidge Mississippian Trust II yield almost 8 percent.

But this current yield of 8 percent omits several important factors. SandRidge Mississippian Trust II is set up to grow its production and distributions in its first few years as a publicly traded entity.

The trust 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 the trust’s parent SandRidge Energy (NYSE: SD) 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.

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 at work, 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.

As of the end of February, the date of the trusts’ most recent quarterly report, SandRidge Mississippian Trust II was entitled to the proceeds from the original 67 wells and the eight of its sponsor’s planned 206 developmental wells. The remainder of these developmental wells is slated to be completed by the end of 2015. As SandRidge completes these wells, the production attributable to the trust will rise, along with the quarterly payout.

Like most trusts, SandRidge Mississippian Trust II provided target distributions for each quarter through its termination date in 2031.

SandRidge Mississippian Trust II projected that its inaugural disbursement to investors would amount to $0.26 per unit. Unitholders actually received $0.267726, or roughly 3 percent more than the target.

The trust pays distributions in August, November, February and May and expects to disburse $2.27 per unit over the next four quarters, equating to a yield of 11.5 percent at current prices. In the subsequent 12 months, the trust’s estimates call for the payout to reach $2.79 per unit, equivalent to a distribution yield of about 14 percent at the current quote.

In short, units of SandRidge Mississippian Trust II will likely yield about 11 percent in the next four quarters, almost double the yield quoted on most financial websites.

These target distributions are also a good starting point for valuing a trust using the DDM.  I typically value trusts by looking at three different sets of assumptions: a conservative case, a base case and an aggressive case.

My conservative DDM model for SandRidge Mississippian II assumes a 7.5 percent required rate of return and distributions that average 10 percent below the targeted level for the life of the trust. In this scenario, SandRidge Mississippian Trust II is worth $20.00 per unit at the current time, slightly above the trust’s current unit price.

My base case assumption assumes a 7.5 percent discount rate and that the trust meets its distribution targets throughout its life span. In this case, the trust is worth $23 per unit.

Finally, my aggressive valuation assumes that the trust’s distributions exceed management’s targets by 10 percent throughout the trust’s life. The model assumes a 7.5 percent discount rate. On that basis, the trust is worth around $25 per unit.

To put these valuations into perspective, SandRidge Mississippian Trust I (NYSE: SDT) has been public for more than a year and its four quarterly distributions have exceeded management’s targeted payouts by an average of more than 18 percent. This track record suggests that the parameters of my aggressive valuation for SandRidge Mississippian Trust II could prove overly conservative.

Of course, these targeted distributions reflect prevailing crude oil and gas prices at the time the trust files its initial registration statement with the Securities and Exchange Commission. The recent dip in oil prices means that the commodity price assumptions underlying SandRidge Mississippian Trust II’s target distributions are a touch higher than prevailing prices.

The trust’s hedge book somewhat mitigates this discrepancy. SandRidge Mississippian Trust II has hedged about 80 percent of its targeted revenue for 2012, 75 percent for 2013 and 56 percent for 2014. Nevertheless, SandRidge Mississippian Trust II’s next quarterly distribution could be close to or even slightly below its targeted level.

We regard the current dip in oil prices as a temporary blip, which suggests that my base scenario still holds. SandRidge Mississippian Trust II rates a buy up to 23, but investors shouldn’t chase the stock higher.

Investors should also remember that the valuations generated by the DDM serve as a guidepost only. Despite the math involved and pat explanation, these valuation models aren’t an exact science. However, the DDM can give us an idea of when a trust is extremely cheap or extraordinarily overvalued. In general, the value of these trusts will fluctuate around these fair values over time.

Famed value investor Benjamin Graham once described the stock market as a voting machine in the short term and a weighing machine in the long term. That is, investors’ emotion and sentiment tends to drive stock price in the near term. If oil prices rally in the second half, units of SandRidge Mississippian Trust II and the other trusts in our model portfolios could eclipse even our aggressive valuations. The stocks will also gain momentum once financial websites accurately depict their yield.

Our investment strategy for the trusts in our mode Portfolios is simple: Buy the stocks when they fetch less than our base valuations (i.e., our buy targets) and take profits when the unit price exceeds our aggressive valuations by 10 percent or more.

The table below includes buy targets for all the US royalty trusts in our Portfolios, as well as the conservative, aggressive and base case valuations. I will update these estimates periodically to reflect changes in market conditions and my commodity price assumptions.

Source: Bloomberg, The Energy Strategist