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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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An Unnoticed Casualty of The Commodities Price Drop

An Unnoticed Casualty of The Commodities Price Drop

Royalty trusts have increasingly gained popularity in recent years as income focused investors have looked increasingly far afield for opportunities to earn an acceptable yield on their investments. Many of the existing royalty trusts pay high dividends and investors flocked to them as a result. Royalty trusts are a unique asset class for several reasons and the commodities price crash has dramatically impacted their business model in a way that investors need to understand.

Royalty trusts are unique in the investment field for a variety of reasons. First of all, royalty trusts do not pay taxes at the corporate level. Instead the tax burden gets passed to the investor which in turn enables investors to minimize total investment taxes (and maximize yield) by owning these investments in tax deferred accounts. Secondly, royalty trusts are depleting assets. Some trusts have rapid depletion rates, while others have slower depletion rates, but they all are based on a fixed asset which is being depleted over time such as a mine. Related: Shell Forced to Scale Back Ambitions

Royalty trusts compensate investors for this depletion through very high dividend yields. Some yields are as high as 15% or more. The key issues for investors when considering royalty trusts are two-fold: does the trust generate enough cash flow to consistently pay the dividend under a wide array of scenarios? And how much life is left on the trust itself?

Some trusts have stated end dates at which point they cease operations while others operate until the asset is totally depleted which occurs at an unspecified point in the future that depends on a variety of factors including the rate of use of the asset (which may vary from quarter to quarter). As a result, some well-known trusts end up being worth virtually nothing as they wind down operations, while others may end up operating for many years to come. Related: Oil Sands Producers Can Live With Alberta’s New Carbon Taxes

Among all the chaos in the space though, there may still be some good opportunities. One particular royalty trust that might be a good investment for long term investors is Mesabi Trust (MSB). Mesabi’s primary assets is the Peter Mitchell Mine which is operated by Cliff’s Natural Resources Northshore Mining subsidiary. The CLF subsidiary pays MSB base on the amount of iron ore it extracts from the mine and that income is passed on to MSB shareholders.

It has been a terrible couple of years for CLF and for MSB. Iron ore prices are at very low levels, demand across the space is moribund, and the entire sector has suffered as a result. Yet, MSB’s principle mine may still be a useful and important source of iron ore over the long-term for CLF. Related:This British Bank Is Backing The Bullish Case For Oil

The current issues in iron and steel are almost entirely China driven. These issues will pass eventually. In the meantime, the lower the level of ore extracted from MSB’s mine, the longer the mine’s life will be. As a result, while investors are surely unhappy with the poor current environment, it is not all that damaging to the intrinsic value of MSB or its assets.

Yet investors have hammered MSB mercilessly driving the stock down to multi-year lows. Part of that is probably because the trust pays variable dividends based on mined output and predictably that output has fallen considerably. While this creates a problem for short-term investors, it may create an opportunity for longer-term investors. In particular, for investors willing to buy MSB at the current depressed price and then wait for the macro-environment to revert to its historical norm, the current stock price swoon could be a significant opportunity.

By Michael McDonald of Oilprice.com

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