The 2 Worst High-Yield Ways to Invest in Oil's Eventual Recovery and 2 Excellent Alternatives

By Markets Fool.com

With oil prices crashing to their lowest levels in six years, income investors might be tempted to take advantage of an eventual oil recovery by locking in sky-high yields such as those offered by oil and gas royalty trusts SandRidge Mississippian Trust I (NYSE: SDT), and SandRidge Mississippian Trust II (NYSE: SDR), which appear to be yielding 37%, and 34.6% respectively.

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However, there are three reasons these two oil and gas investments represent the worst way to profit from oil's eventual recovery. Luckily there are two far superior high-yield alternatives you can take advantage of.

The high-yield is a lie
First let's make clear that royalty trusts are not permanent ownership stakes in companies, as are stocks. Rather they represent the rights to royalty payments from fixed and declining assets that are guaranteed to run out and result in consistently lower payouts over time and the eventual liquidation of the trust itself. Thus the reason that the yield appears so high is because it is based on the past 12 month's distributions, which are likely to actually be significantly lower -- both due to sharply falling oil and gas production and lower energy prices.

Production is falling off a cliff
The only way that quarterly distributions can increase is if the sponsor of the trust -- in this case SandRidge Energy -- invests in drilling new wells or the price of oil increases. In the case of the Mississippian Trusts I SandRidge has completed its obligation for drilling new wells and will finish drilling the last new well for Mississippian Trust II by the end of Q1 2015.

Without new wells the production for these trusts is likely to plunge. For example, here is the latest quarterly production data for these trusts, compared to the same quarter in 2013.

  • Mississippian Trust I: oil production down 61%, natural gas production down 46%
  • Mississippian Trust II: oil production down 49%, natural gas production down 31%

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The reason that the Mississippian Trust II's production is falling at a slower -- though still frighteningly high -- rate is because of the drilling of new wells, which will soon come to an end resulting in the likely acceleration of the Mississippian II's production decline rate.

Oil and gas hedges expire by end of 2015 or sooner
The third reason I am so bearish on these trusts is because their production is protected by hedges that only cover a fraction of their production or run out in less than a year.

For example the Mississippian Trust II has only 85,000 barrels of oil hedged at $99 per barrel for all of 2015. Even with its large decline rate, that hedging will likely only cover one quarter's worth of oil production, after which the Mississippian Trust II's oil production will be fully exposed to much lower oil prices.Worse yet is the fact that the Mississippian Trust II has no natural gas hedges, a truly baffling fact given that 55% of the trust's production is natural gas.

Meanwhile the Mississippian Trust I's hedging position is much better, with close to 100% of its likely annual oil and gas production hedged at $101.7 per barrel and $4 to $8.55 per thousand cubic feet of gas.

But given the Mississippian Trust I's high decline rate, investors can expect the distribution to continue to decline quickly, as the most recent quarter's $0.305/unit distribution -- down 39% from the previous year's payout -- illustrates.

Linn Energy: a far superior alternative
In my opinion long-term income investors would be far better off investing in oil and gas producing master limited partnership Linn Energy , or its non-MLP holding company LinnCo , for three main reasons. Note that because LinnCo is a holding company whose sole assets are units of Linn Energy, any references to Linn Energy applies equally to both investments.

The first reason that Linn Energy is a great long-term investment in oil's eventual recovery is that management has the ability to use the recent oil crash to acquire additional low-decline assets at fire sale prices. Towards this effect Linn Energy recently filed with the SEC to allow it to raise $1 billion in new equity capital, and the MLP is considering partnering with private equity to set up joint ventures that would allow it to potentially further leverage that cash in order to acquire large amounts of oil and gas assets without the need to take on additional debt.

Add to this the recent private equity DrillCo joint venture with The Blackstone Group's GSO Capital -- which will allow Linn Energy to drill $500 million in new wells with no capital risk of its own -- and you can see why I'm impressed with Linn Energy management's skill at increasing production at minimal cost.

Don't get me wrong, I'm not saying that the oil crash won't hurt Linn Energy in the short-term, as it already has. Plunging oil prices have forced it toslash its payout and 2015's capital spending budget by 56% and 53% respectively. However, the difference between Linn Energy and the SandRidge Mississippian Trusts is that Linn Energy will be able to use this oil crash to increase its market share and asset base. Thus, when oil prices do eventually recover, the chances of Linn's payout growing is far greater than that of the Mississippian Trusts, whose production will continue to fall over time due to lack of new investment by its sponsor.

Takeaway: Don't fall into the high-yield trap that is the SandRidge Mississippian Trusts. Consider quality MLPs like Linn Energy instead
With oil prices down over 50% in just the last eight months, long-term income investors are right to be searching for high-yield oil and gas investments that are likely to recover along with oil prices. However, in my opinion, royalty trusts, especially SandRidge Mississippian Trusts I and II, represent the two worst ways you can go about achieving that goal. High quality, high-yield oil and gas MLPs such as Linn Energy and its c-Corp alternative, LinnCo, offer far more sustainable investment choices -- ones that have a far greater chance of growing your income and wealth over the long-term.

The article The 2 Worst High-Yield Ways to Invest in Oil's Eventual Recovery and 2 Excellent Alternatives originally appeared on Fool.com.

Adam Galas has no position in any stocks mentioned. The Motley Fool owns shares of The Blackstone Group L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.