Unlike corporations or master limited partnerships, oil and gas royalty trusts aren’t operating businesses, usually have no employees, and can’t make acquisitions, take on additional commodity-price hedges or invest in new growth projects. The sponsor contributes all of a trust’s assets, from oil- and gas-producing acreage to hedges against fluctuating commodity prices. These investment vehicles also have a finite lifespan and will liquidate their assets at a predetermined point in the future.

Investing in a publicly traded royalty trusts is akin to buying an interest in a series of oil and/or natural gas wells; you will receive a share of the proceeds from the hydrocarbons produced from these wells throughout the trust’s life. The best royalty trusts offer double-digit yields and the potential for near-term growth in quarterly distributions.

But be forewarned that every trust has a unique structure: You shouldn’t focus on yield alone when making your investment decision. Some trusts have outsized exposure to depressed natural gas prices; other high-yielders are slated to terminate in a few years and are suffering from declining production and distributions.

Investors should consider several factors when evaluating an oil and gas royalty trust, including the potential for near-term output growth, the trust’s production mix, the amount of time remaining in its life span and the quality of its underlying assets. Furthermore, the buy target on every royalty trust in the model Portfolios reflects the results of a valuation model that I run after these holdings report quarterly results.

Our strategy for profiting from oil and gas royalty trusts remains unchanged: Buy the stocks when they trade below our buy target to lock in an above average yield; and take profits when the unit price appreciates to frothy levels–usually when commodity prices are on the rise.

Investors who have followed this strategy have been well-rewarded. For example, we added SandRidge Mississippian Trust I (NYSE: SDT) and Chesapeake Granite Wash Trust (NYSE: CHKR) to the Growth Portfolio in late 2011, when the units traded at favorable prices. When these valuations became stretched in February 2012, we took profits and avoided the subsequent downside when commodity prices weakened.

Now marks another buying opportunity to buy some of our favorite royalty trusts, especially names that will benefit from a potential increase in oil prices in the back half of 2012 and early 2013.

With this strategy in mind, here’s a review of how the oil and gas trusts in our model Portfolios fared in the second quarter and an update to our valuations.

SandRidge Permian Trust (NYSE: PER) will pay a quarterly distribution of $0.574232 per unit on Aug. 29, 2012, to unitholders of record on Aug. 14, 2012. This disbursement represents investors’ share of the proceeds from the trust’s production in March, April and May; the distribution covering June, July and August will be paid on Nov. 30, 2012.

Source: Bloomberg, SandRidge Permian Trust S-1

SandRidge Permian Trust has exceeded the target distributions laid out in its S-1 registration statement with the Securities and Exchange Commission in every quarter since going public. In the most recent quarter, the trust exceeded this target by 4 percent, largely because higher-than-expected production offset lower-than-expected commodity prices.

At the time of SandRidge Permian Trust’s initial public offering (IPO), the S-1 estimated that the underlying wells would produce 351,000 barrels of oil equivalent per day in the three months ended June 30, 2012. In actuality, these wells flowed 386,000 barrels of oil equivalent per day–10 percent greater than the target level. Oil output exceeded expectations by 8 percent, while the trust’s sponsor lifted 30 percent more natural gas and 19 percent more natural gas liquids (NGL) than outlined in the S-1 form.

This upside stemmed from SandRidge Energy (NYSE: SD) drilling the trust’s developmental wells at a faster rate than initially planned. As of March 31, 2011, the area of mutual interest (AMI) included 509 producing wells on 16,800 gross acres of land in the Permian Basin. SandRidge Energy, the trust’s sponsor, had committed to drill an additional 888 developmental wells in the AMI by March 31, 2016, at the latest. In the S-1 registration statement, management estimated that the parent company would fulfill this obligation by March 31, 2015, implying a drilling schedule of 18 wells per month.

But between March 31, 2011 and May 31, 2012, SandRidge Energy had drilled 300.9 developmental wells, receiving fractional credit for some wells depending on its ownership interest and certain technical specifications. In other words, the trust’s sponsor has drilled an average of 21.5 developmental wells per month. In the three months ended May 31, 2012, the firm drilled and completed an average of 27 wells per month.

Lower-than-expected commodity prices offset this accelerated drilling program, though the trust’s oil-heavy production mix provided a degree of protection against these challenges. In the three months ended May 31, 2012, crude oil represented almost 86 percent of output attributable to the trust, with NGLs accounting for 9.8 percent and natural gas making up the balance.

More important, oil accounted for 94 percent of the trust’s total revenue over this period. Despite dramatic declines in the price of NGLs and natural gas, these headwinds had a negligible impact on the trust’s revenue and quarterly distribution.

Although the price of West Texas Intermediate (WTI) crude oil tumbled precipitously over this three-month period, the trust hedged 88 percent of its production at an average price of $102.20 per barrel, ensuring that its price realizations fell short of expectations by only 1 percent.

These hedges should likewise cushion the trust’s revenue and distribution against recent weakness in the price of WTI, which has averaged $87.25 per barrel since June 1. In its S-1 registration statement, the trust had targeted a distribution of $0.58 per unit for the three months ended Aug. 31. This forecast assumes an oil price of $101.50 per barrel, about 15 percent above the average price of WTI since June 1. Investors shouldn’t fret about weak oil prices eating into the trust’s distribution: Management estimates that WTI prices that are 15 percent lower than the forecast outlined in the prospectus would reduce the payout by less than $0.01 per unit.

Meanwhile, NGL prices have rebounded sharply since late June, and natural gas prices have recovered to $2.82 per million British thermal units from less than $2 per million British thermal units at the end of April 2012.

We expect SandRidge energy to continue drilling wells at an accelerated pace in the short term, a strategy which should ensure that quarterly output exceeds management’s production targets. At the end of May, the trust had more than 18 developmental well that were awaiting completion.

Higher production should more than offset any shortfall in commodity prices. At the time of the trust’s IPO, management estimated that a 10 percent increase in production relative to the targets laid out in the prospectus would add $0.05 to $0.06 per unit to the quarterly distribution.

The trust doesn’t foot the bill for drilling or completion but does bear its share of post-production expenses, including the cost of gathering and transporting gas. These expenses exceeded management’s forecast, largely because higher-than-expected output entails additional post-production costs.

We expect SandRidge Permian Trust’s distributions in coming quarters to surpass the targets set out in the prospectus by about 5 percent, implying a payout of $2.50 to $2.63 per unit over the next 12 months. Moreover, we remain bullish on oil prices over the long term; when the trust’s hedges expire on March 31, 2015, higher-than-forecast oil prices could result in quarterly disbursements that exceed estimates outlined in the prospectus.

As I explained at length in Trust Exercise, I use a variation of the dividend discount model (DDM) for valuing royalty trusts. Based on SandRidge Permian Trust’s recent results, I’ve updated my valuation model to reflect eight quarters of distributions that are 5 percent higher than targeted levels and 10 percent above target from mid-2015 through trust termination date in 2031. Accordingly, SandRidge Permian Trust rates a buy under $24 per unit and maintains its position on my Best Buys List.

SandRidge Mississippian Trust II (NYSE: SDR) declared a quarterly distribution of $0.4972 per unit covering the months of March, April and May. The trust had targeted a payout of $0.46 per unit.

SandRidge Mississippian II’s acreage produces a combination of oil, NGLs and natural gas. In the March-May period, the wells in the trust’s AMI flowed 490,000 barrels of oil equivalent per day, with liquids accounting for almost half of this output.

Depressed natural gas prices are less of a concern in this case because the trust went public in April 2012, when the commodity traded near a multiyear low after the no-show winter of 2011-12 swelled inventories. Management already baked low natural-gas prices into its distribution forecast. In addition, oil sales made up more than 84 percent of the trust’s revenue in its most recent reporting period.

SandRidge Mississippian Trust II’s declared distribution surpassed the targeted payout because total production beat management’s expectations by 15 percent, with oil volumes surprising to the upside by 12 percent and natural gas output by 17 percent.

Like SandRidge Energy’s other trusts, SandRidge Mississippian Trust II’s prospectus calls for the parent to drill a series of development wells in the AMI. In this case, the sponsor will sink total of 206 development wells by Dec. 31, 2016, though the trust has targeted Dec. 31, 2015, to fulfill this obligation.

As of the end of May, SandRidge Energy had drilled 40.2 these developmental wells and brought 33 new development wells into production in its most recent fiscal quarter. If the sponsor maintains this accelerated drilling program, the 206 wells would be completed by fall 2013, more than two years prior to the targeted completion date.

However, during a conference call to discuss quarterly results, SandRidge Energy sought to temper expectations and emphasized that investors shouldn’t assume that the firm will continue to drill 30 wells per month. Whereas the prospectus assumed that four rigs would work the play, the sponsor has run five to six rigs running in the AMI. Management hinted that some of these rigs would relocate to other basins in coming quarters, slowing the pace of development.

We still expect SandRidge Energy to complete its drilling obligations ahead of schedule and for production to generally exceed expectations over the next two years.

Commodity prices were a headwind for SandRidge Mississippian II, with oil and NGL realizations averaging $93.64 per barrel in the three months ended May 31 and natural gas prices averaging $2.34 per million British thermal units. Although the trust doesn’t break out its NGL price realizations from its average oil prices, the average price of $93.64 suggests that weak NGL prices won’t have an outsized effect on revenue in coming quarters. With about two-third of its expected oil output hedged at prices as high as $107 per barrel, the trust is well-equipped to weather any price fluctuations in this commodity.

My valuation model assumes that the trust’s quarterly distributions will exceed the target level by 7 percent over the next two years and by 10 percent thereafter. This outlook translates to a total distribution of about $2.65 per unit over the next four quarters, equivalent to a yield of 13 percent at the stock’s current quote. Based on these assumptions, SandRidge Mississippian Trust II rates a buy under $24.50 and maintains its position on my Best Buys List.

Units of Chesapeake Granite Wash Trust (NYSE: CHKR) pulled back more than its peers when commodity prices weakened in the spring and early summer, largely because of the negative headlines surrounding the royalty trust’s sponsor, Chesapeake Energy Corp (NYSE: CHK).

At the time, we argued that the selloff in Chesapeake Granite Wash Trust and the concerns about Chesapeake Energy’s leadership and financial health were overblown.

In this instance, the only risk was that the bankruptcy of the parent–always a remote possibility–would affect the schedule for drilling wells in the trust’s AMI. Although Chesapeake Energy continues to outspend its cash flow on new drilling, the firm has an impressive portfolio of assets that it can monetize in a variety of transactions, from outright sales to joint ventures and spin-offs.

Moreover, CEO Aubrey McClendon’s history of controversial moves has made him an easy target for the mainstream media. Although I don’t agree with every strategic decision McClendon has made as the head of Chesapeake Energy, the CEO had the foresight to snap up shale oil and gas acreage before many of his peers and has built one of the largest independent exploration and production companies in the US.

Units of Chesapeake Granite Wash Trust have recovered since their May lows; investors who opted to take advantage of the selloff locked in above-average yields and are sitting on impressive gains.

Investors should be more concerned about Chesapeake Granite Wash Trust’s exposure to NGL prices than its sponsor’s CEO. In its most recent fiscal quarter, the wells in the trust’s AMI flowed about 1 million barrels of oil equivalent per day, about 16.5 percent of which was crude oil, 32 percent of which were NGLs and the remainder of which was natural gas.

Although the trust’s average oil price realizations surpassed expectations laid out in the prospectus, NGL prices averaged only $32.83 per barrel–significantly less than the assumptions on which management based its distribution forecast.

The trust faced the same headwinds that last quarter afflicted Linn Energy LLC’s (NSDQ: LINE) operations in the Granite Wash. (See the Aug. 2 issue, Learning from Earnings.)   Output from this basin contains large volumes of ethane, an NGL whose price declined significantly because of rising production and an oversupply at the trading hub in Conway, Ks. A lack of liquidity in the futures market for NGLs forces producers to purchase oil futures as a hedge against declining NGL prices. This strategy didn’t work in the most recent quarter because these hedges failed to protect against the full decline in NGL prices.

As a result, Chesapeake Granite Wash Trust only generated enough cash flow to disburse $0.58 per unit, a distribution that was less than the trust’s subordination threshold 0f $0.61 per unit. Chesapeake Energy owns subordinated trust units that will convert to common stock a year after the sponsor completes its drilling obligations. Until then, the parent company has agreed to forego a portion of the distributions from its subordinated units to ensure that holders of the common units receive a quarterly payout that’s equal to the subordination threshold.

In addition to this welcome protection, NGL prices have rallied since early June, and Chesapeake Granite Wash Trust’s management has noted that price realizations had improved significantly in early August. If this rebound proves sustainable, this development would boost the trust’s distribution for the three months ending Nov. 30, 2012.

My valuation model for Chesapeake Granite Wash Trust assumes that the distribution will remain at the subordinated level for the next two quarters and recover to the targeted level in early 2013. The model factors in distributions that exceed the targeted levels by 10 percent from 2015 onward. These conservative assumptions yield a valuation of $21.50 per unit. If my forecast pans out, the trust yields about 15 percent at its current stock price. Buy Chesapeake Granite Wash Trust up to $22 per unit.