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
Transcript
- Lucas: When you are managing a portfolio north of fifty million dollars, the search for predictable, tax-efficient income gets very specific. Equities pay dividends that get taxed as ordinary income or qualified rates, bonds throw off interest that is fully taxable at your top bracket, and real estate brings depreciation recapture headaches. So some ultra-wealthy families have been quietly rotating a slice of their fixed-income sleeve into something a bit more unexpected — oil and gas royalty trusts. Luna: Oil and gas royalty trusts. That sounds like something from the 1980s energy patch, not a modern portfolio. Lucas: And yet, they are very much alive, and for the right investor, they solve a few problems at once. A royalty trust is essentially a pass-through entity that holds a net profits interest in oil and gas properties. It pays no corporate income tax — all the income flows directly to the unitholders. And here is the tax kicker: a huge portion of those distributions is classified as return of capital, shielded by something called the depletion deduction. Luna: So you are not paying tax on the full distribution year one. That is a big deal for someone in the top marginal bracket. Lucas: Massive. And before we go deeper on the math, I want to mention something quick. Our listeners are the reason this podcast exists — we keep it ad-free, and we keep it focused on topics like this. A small group of listeners already chips in monthly through buy me a coffee dot com slash fexingo, and that support is literally what makes it possible to produce episodes like this one. So if our conversations have helped you think about a wealth decision differently, consider joining them. Luna: Yeah, it is a really low-key way to keep the show going. No ads, no sponsors — just listeners who find value here. Okay, back to royalty trusts. Lucas: Right. So let's look at a concrete example. The Permian Resources Royalty Trust — ticker symbol P-R-R-T — it was created a few years ago as a way for a private family to monetize their mineral rights in the Delaware Basin, which is a sub-basin of the Permian in West Texas. The trust holds a net profits interest in about thirty thousand net acres. Every quarter, the trust collects revenue from the operator, deducts operating expenses and a small overhead, and distributes the rest to unitholders. Luna: And the depletion deduction — how does that work in practice? Is it the same for every trust? Lucas: It varies, but generally it is either cost depletion or percentage depletion. For most trusts, you are looking at percentage depletion, which is currently fifteen percent of gross income from the property, capped at sixty-five percent of net income. So if the trust distributes one dollar per unit, maybe thirty to forty cents of that is tax-deferred return of capital, reducing your cost basis in the units. Eventually, when you sell, you pay capital gains on the difference, but you have deferred that tax for years — sometimes decades. Luna: That is essentially a tax deferral structure embedded in a commodity investment. And it is entirely passive — the unitholder does not sign any operating agreements or take on liability. Lucas: Exactly. That is the distinction from a direct working interest, where you are on the hook for drilling costs and environmental liability. With a royalty trust, you own a piece of the revenue stream, nothing more. The operator makes all the decisions. Your only job is to collect the distribution and fill out the K-1 at tax time. Luna: K-1s can be a pain, but for a family office with a dedicated tax team, that is a manageable cost. Lucas: Absolutely. And the returns can be compelling. Let's look at the numbers for the broader trust universe. Over the last five years, the Alerian MLP Index — which includes royalty trusts as well — has delivered a total return averaging around eight percent annually, but the yield component has been much higher, often in the six to nine percent range. Compare that to the ten-year Treasury, which as of this week is yielding around four and a quarter percent. You pick up several hundred basis points of yield, and a portion of it is tax deferred. Luna: But there is a catch, right? Oil prices go to zero, the trust stops paying. And there is the depletion issue — the assets are finite. Lucas: Two very real risks. Commodity price volatility is the big one. In early 2020, when oil briefly went negative, many trusts slashed distributions to zero. Unitholders got nothing for two quarters. And because the trust has no retained earnings, there is no cushion. You are living distribution to distribution. The second risk is reserve depletion. A royalty trust has a finite life — typically ten to twenty years, depending on the production profile. Once the wells are exhausted, the trust liquidates and unitholders get a final distribution, which is usually their remaining basis. So this is not a buy and forget forever position. You have to monitor production trends. Luna: So the family office or the wealthy individual needs to treat this like a bond that matures, but with variable coupons. And they need to be comfortable with the commodity cycle. Lucas: Exactly right. And that is why these are not core holdings for most families. They are a satellite allocation. Typically, we see allocations of five to ten percent of a fixed-income sleeve, or maybe two to five percent of total net worth. Enough to boost yield and get the tax deferral, but not so much that a bad year in oil derails the portfolio. Luna: Let's talk about the estate planning angle. I have heard that some families gift trust units to the next generation to shift the tax burden. Lucas: That is a very common strategy. Because the units have a low cost basis after years of depletion deductions, gifting them to a child or a trust for grandchildren can move future distributions into a lower tax bracket. And if the units are held until death, the heirs get a step-up in basis to the fair market value at the date of death, wiping out all that deferred gain. That is a powerful estate planning tool. Luna: So you get income deferral during life, a step-up at death, and a yield that is higher than comparably risky bonds. Why don't more people do this? Lucas: Complexity and liquidity. The K-1s are cumbersome, and the units trade on exchanges, but the volume can be thin. Some of the smaller trusts trade only a few thousand shares a day. So if you need to exit in a hurry, you might take a haircut on the bid-ask spread. And then there is the learning curve. Most advisors are not well versed in the tax nuances of depletion or the specific language of trust indentures. Luna: That is where a specialized family office or a wealth manager with energy expertise comes in. You really need someone who understands the mechanics. Lucas: Right. And I would add that not all trusts are created equal. Some are tied to a single basin, like the Permian. Others have exposure to the Gulf of Mexico or the Bakken. The quality of the operator matters enormously. You want an operator with a strong balance sheet and a history of prudent development. You also want to look at the trust's formation documents — some trusts have clauses that allow the operator to sell assets and wind down the trust earlier than expected. Luna: Any specific trusts you are watching right now? Not a recommendation, just for illustration. Lucas: Sure. Besides Permian Resources Royalty Trust, there is the Sabine Royalty Trust, ticker S-B-R-T, which holds interests in about nine hundred properties across the U.S., so it is more diversified. Its current yield is around seven percent, and it has been paying distributions for decades. Another is the San Juan Basin Royalty Trust, S-J-T, which focuses on natural gas in the San Juan Basin. Natural gas has its own dynamics, but the trust structure is the same. Both trade on the New York Stock Exchange. Luna: With natural gas, you get the additional risk of seasonal price swings and storage dynamics. But the tax benefits are the same. So a family that already owns energy stocks might use royalty trusts to get a different risk profile. Lucas: Exactly. Energy equities have operational risk, management risk, and they pay dividends that are fully taxable. Royalty trusts strip away the operational risk, give you a slightly higher yield, and defer taxes. They are a different tool for a different job. And I think as we head into a period where interest rates may stay higher for longer, and tax rates are a perennial topic in Washington, structures like this become more attractive. Luna: One last thought — do you see any risk of legislative change that could kill the depletion deduction or the pass-through status? Lucas: It is always a risk, but percentage depletion has been in the tax code for decades, and royalty trusts have survived multiple tax reforms. The pass-through structure is well established. I think the bigger risk is environmental regulation that could increase the cost of drilling on federal lands, since many trusts have exposure to federal leases. But that is a slow-burn risk, not a sudden change. For a family with a long time horizon, these trusts remain a viable piece of the puzzle. Luna: So for someone listening today — a family office, a high-net-worth individual — what is the one thing they should do if they want to explore this? Lucas: Talk to a tax advisor who has handled K-1s and depletion before. Then look at a trust like Sabine or Permian Resources, read the annual report, which is usually very transparent about production and reserves, and compare the current yield to what you are earning on your municipal bonds. If the after-tax yield after depletion is higher, and you are comfortable with the commodity exposure, it might be worth a small allocation. Start small. Maybe one or two percent of net worth. See how you feel about the quarterly distributions and the K-1 process. Then scale from there. Luna: Good actionable advice. And a reminder that sometimes the most effective wealth strategies come from corners of the market that most people overlook. Lucas: That is exactly the point. Thanks for listening — we will be back next week with another deep dive into a wealth strategy that most families have never considered.