Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Oil and Gas Royalty Trusts for Income
Transcript
- Lucas: So let's talk about something I've been seeing more of in family office portfolios lately — oil and gas royalty trusts. Luna: I've noticed that too. At a time when bonds are yielding maybe four and a half percent and equities are expensive, these trusts can throw off seven, eight, even ten percent distributions. Lucas: Right. And the real kicker is the tax treatment. Because the trust owns mineral rights — not operating companies — most of the distribution is classified as return of capital, not ordinary income. Specifically, it's the depletion allowance. Luna: So you're not paying your full marginal rate on that income. In some cases, upwards of 85 percent of the distribution can be tax-deferred. Lucas: Exactly. Let's make it concrete. The Permian Basin Royalty Trust — ticker P-B-T — is one of the oldest and most liquid. It owns a perpetual overriding royalty interest in about 80,000 acres in West Texas. The trust doesn't drill wells, doesn't hire roughnecks. It just collects a percentage of the revenue from whoever does. Luna: And because it's structured as a grantor trust, the tax attributes flow through to the unitholders. So you get your K-1, and a big chunk of that distribution is sheltered by cost depletion. Lucas: Right. For a high-net-worth client in the top federal bracket — thirty-seven percent — plus the net investment income tax, that's a huge difference. If the trust distributes a hundred thousand dollars and eighty percent is a return of capital, you're only paying tax on twenty thousand dollars that year. Luna: But the trade-off is that the asset is literally depleting. Every barrel of oil pulled out of the ground reduces the remaining reserves. So over time, distributions tend to decline unless commodity prices keep rising. Lucas: That's the critical point. This isn't a perpetual income stream like a dividend from a diversified company. It's a liquidating asset. The trust has a finite life. The Permian trust has been around since the 1980s, but production from those wells is naturally declining. Luna: So you need to model the decline rate. And also remember that these are volatile. The distribution depends on oil and gas prices, which can swing fifty percent in a year. Lucas: Which is exactly why you'd only allocate a small piece of a portfolio — say two to five percent — as an income diversifier. But for a client who already has a concentrated energy position from a business exit or inherited mineral rights, it might not make sense. Luna: Speaking of which, I've worked with families who inherited actual mineral rights — not units in a trust. The trust format actually solves a problem there. It provides liquidity and diversification. You can buy and sell units on the NYSE. Lucas: Yeah, that's a huge advantage. If you own a direct working interest in a well, you're stuck with cash calls, liability exposure, and a very illiquid asset. A royalty trust gives you a passive, marketable security. You can exit in a day. Luna: And the tax treatment is similar, but the trust handles the accounting. You get one K-1 instead of a stack of well statements. Lucas: Now, let's talk about how advisors are using these in 2026. With interest rates still relatively high and the equity market looking stretched, a lot of family offices are looking for yield without taking on credit risk. These trusts are not corporate bonds — they're commodity-linked. Luna: Right, so you need to believe that oil prices will at least hold. But the breakeven for most Permian production is around forty dollars a barrel. We're at seventy-five today. So there's a cushion. Lucas: And the depletion allowance means the after-tax yield can be much more attractive than a municipal bond for someone in a high bracket. A muni yielding four percent is tax-free, but a royalty trust yielding eight percent with seventy percent return of capital can have an equivalent taxable yield north of fifteen percent. Luna: But you're comparing apples and oranges in terms of risk. Munis are backed by tax revenue. These are backed by depleting physical assets and volatile commodity prices. The risk profile is completely different. Lucas: Absolutely. I'm not saying it's a replacement. It's a sleeve. But for a client who already has significant wealth and wants to generate income in a tax-efficient way, it's worth a conversation. Luna: And if today's conversation gave you a new idea or helped you think about your portfolio differently, that's exactly why we do this show. We keep it ad-free and listener-supported. If you found value, you can buy us a coffee at buy me a coffee dot com slash fexingo. Lucas: Yeah, that's the only way this stays on the air without annoying commercial breaks. Every little bit helps us keep digging into these niche strategies. Luna: So back to the mechanics — one thing that trips people up is the K-1. It arrives later than a 1099, typically in March or April. If you're using these in a taxable account, you need to plan for that. Lucas: And you can't hold them in an IRA easily because of unrelated business taxable income — UBTI. At least not in a standard IRA. Some self-directed IRAs can handle it, but it's complicated. Luna: So really, these are best in a taxable brokerage account for a high-net-worth individual who has room for a non-correlated income stream. Lucas: Let's also differentiate between royalty trusts and the more common MLPs — master limited partnerships. MLPs also have tax advantages, but they often involve operating businesses. The K-1 can be even more complex, and they may generate unrelated business taxable income. Luna: Royalty trusts are simpler. They don't have employees, they don't operate. It's just a passive interest in production revenue. So the K-1 is typically straightforward. Lucas: And because they're structured as trusts, not partnerships, they avoid some of the filing headaches. But you still need a tax advisor who understands depletion. Luna: One more risk: these trusts can be terminated early if production drops below a certain level. The Permian trust has a clause that if annual revenue falls below one million dollars for two consecutive years, the trustee can liquidate. Lucas: So you're not only betting on oil prices, but also on the operator's willingness to keep drilling. If the operator stops infill drilling, production declines faster. Luna: But for someone who's comfortable with that risk and wants current income with a tax deferral, it's a vehicle worth knowing about. I'm not saying run out and buy it tomorrow, but understand how it works. Lucas: And if you're advising ultra-high-net-worth families, this is a tool in the toolbox. Not for everyone, but for the right client at the right time, it can be a powerful part of an income strategy. Luna: Especially in an environment where traditional fixed income doesn't offer much after-tax yield. The depletion allowance gives you a built-in tax shield that bonds just can't match. Lucas: Right. So the takeaway: oil and gas royalty trusts offer high current income, significant tax deferral through depletion, and liquidity via public markets. But they come with commodity price risk, reserve depletion risk, and a finite life. A small allocation can boost after-tax yield, but you have to monitor the underlying production. Luna: And that's the kind of nuance that makes wealth management interesting. It's not just about picking stocks — it's about knowing which structures fit which situation. Lucas: Exactly. Next time, maybe we'll talk about another niche structure that's been getting attention: private real estate debt funds.