November 2010 SG&A Resource Report Oil and Gas Royalties Stansberry & Associates investment ResearchOil and Gas Royalties The Real Secret to Generating Huge Returns in America’s Petroleum Market By Matt Badiali Virvually every industry has a “backdoor” way to get paid over and over again for a single idea or prop- ery. In the drug business, the big money is in patents Afterall the work is done developing a new drug, a scientist can partner up with a larger company o handle the expenses and risks of testing, marketing, and distribution. ‘Then, the patent holder is paid for every filled prescription. The guy who developed the popular pain, medication Lyrica, for instance, shares in more than $2 million per month because he owns the patents. ‘The women who owned the patents on the antifungal medicine Nystatin share more than $50,000 per month for 20 years, In the publishing business, the big money is in royalties. ‘Once you do all the work to write a book, you just sit back and collect your share of the profits. Ex President Bill Clinton, for example, makes more than $84,000 per month from sales of his best seller, My Life. This is why we've nicknamed collecting lucrative royalties the “Mainz” income stream secret. ‘The printing press, which was invented in Johannes Gutenberg of Mainz, Germany, is generally con- sidered the invention that first made collecting regular royalties possible, by allowing book publishers and authors to make a fortune reproducing valuable pieces of work. Prior to the printing press, reproducing a book was neatly as arduous as writing it. The Gutenberg press made it possible co write the book and crank ‘our copies fast and cheap. The Mainz secret remains one of the great low-risk ways to get rich in America You make just one investment... or control one valuable asset... and then get paid over and over again, while somebody ele takes the risk of marketing, development, and distribution. Inside this report, youll find the details of some incredible ways to use this secret as an investor. In short, you avoid all the normal risks of doing business... and simply collect incredible streams of income for owning a valuable asset For our purposes as resource investors, we want to use this Mainz secret to collect royalties on one of the world’s most vital energy commodities. As you'll soon learn, you can regularly collect 89-10% annual payments on some of the richest land in America ‘And if you follow my advice, your long-term gains could reach the thousands of percent,SS —_———— Let's get started. The Secrets to Royalty Success Royalty trusts are simple businesses that own the rights to some oil and gas reserves. They don't explore, drill, cransport, refine, or anything else involved in producing or selling oil and gas. They simply own the asset and collect steady payments when some other company pulls the oil and gas out of the ground. “Typically, a larger “sponsor” packages up a set of assets and spins them off as a royalty trust to generate capital up front for its long-lived assets AND keep receiving income from the production. They also receive tax benefits from adopting the royalty trust structure ‘What's important for us as investors is this: In exchange for tax advantages, royalty trusts distribute vir- tually all of their earnings to shareholders through regular dividends. In our case, we're interested in trusts formed by oil and gas sponsors. In addition to the high yield, oil and gas trusts offer the potential for big gains if resource prices soar like they did from 2006 to 2008. Were interested in wusts with a couple of key characteristis. First, we want trusts affiliated with strong sponsors and operators. Remember, royalty trusts are paid when the reserves they hold are being pro- duced... ifthe assets sit idle, then they don't add to the bottom line. We want partners strong enough and committed to producing those assets Second, we want “mineral rights.” That means our royalty is on production from an area, rather than a fixed pool of oil. Let me explain. ‘There are «wo kinds of oil and gas royalty companies. One owns rights to a finite pool of oil and gas ‘These are called “term trusts.” The other owns mineral rights to an oil field. These are called “perpetual uusts,” The difference ean cost you a whole lot of money. ‘One unique feature of royalty trusts is they are legally prohibited from acquiring assets and growing. Since they must pass their earnings through to unit-holders, there's nothing left to expand their holdings. ‘They must sit on a winnowing asset base. That's why you want to make sure that asset has a long enough lifespan to keep paying you. Owning a pool of oil is like owning a loaf of bread. Every day, you eat a slice of the bread. Eventually, its all gone. ‘Owning the mineral rights to a field is different. When you hold mineral rights, the actual amount of oil and gas you control can grow as drilling results increase the size of a deposit's known reserves. It's natu- ral that as an operating company works on a property, it discovers more oil than it first estimated. Trusts with mineral rights have a claim on those reserves... Term trusts dont. For example, Whiting USA ‘Trust (NYSE: WHX) is a term trust, It receives 90% net profits interest from 9.11 million bartels of oil equivalent. The 9.11 million barrels of oil equivalent should be hit by the end of the year 2021. At that point, shares of the trust will be worthless. That’s about 10.5 years from now. Let's do a little math,Today, Whiting USA costs around $19 per share and pays $2.96 per share in dividends. At $2.96 per year, itll take 6.4 years to pay us for our share. That leaves us about four years ($12.66 total per sharc) worth of dividends as upside. ‘That's why we don't want to invest in a commod- ity stock with a capped upside, it’s just too risky. Now look at the BP Prudhoe Bay perpetual trust. This trust owns a piece of Prudhoe Bay in Alaska ‘That's North America’ largest oil field. You could hhave bought shares of this trust in 1990 for about $30 per share, Since then, you made $83 per share in dividend payments alone and the share trade for $90. A $10,000 investment in 1990 would be worth $49,000 today. In total, you made 490% in 20 years. Believe it ‘or not, that’s just 9% per year. That's the power of compounding your returns over a long period of time. It’s why we want trusts that can crank out pay- ments over two decades ~ like BP Prudhoe Bay. Mote important, that’s the kind of royalty trust we want. We wane the possibility of both commodity Do You Take Your Cut from the Top Line or from the Bottom Line? ‘There are two other designations you'll run into when researching trusts: net-profits trust and over-riding trusts, A net profits trust gets a cut of the net profit from produced oil and gas. Buc the trust must kick in its shares of capital costs. These trusts act more like passive oil companies. ‘The second kind of trust is the over-riding royalty wust. This version gets a cut of the net profit from oil and gas production, The net is calculated after capital expenses. This kind of trust is lide more than a bank and a lawyer. upside and long life. If we can do that, welll make a fortune, without doing another thing, Get Tax-Free Money From Royalty Trusts Like I said, royalty trusts enjoy tax advantages by passing on their income. Sharcholders also enjoy tax perks. Shareholders do pay tax on the money they receive. But due to the depreciation and depletion of the trusts assets, these distributions are not subject to the current 15% tax rate on passive income. the IRS treats the distributions you receive differently than the dividends you get from most high- income stocks or bonds. Instead, it subsracts the distributions from the original cost of your shares and defers the taxes on until you sell the stock, when you pay the capital-gains tax rate. That's why I prefer readers hold trusts in their tax-advantaged IRAs. Also, for some of these trusts if you file a Form 1040, you get to deduct the depletion, severance tax, and administration expense from the gross royalty income. Irs not hard to do, and many of the companies publish “How to File” tax guides every year. ‘Thanks to those tax breaks, the yields on these companies can be much higher than other companies, which only pay part of their profits as dividends.Le The Field of Royalty Trusts Let’ look at the field of royalty trusts. Just because one of these companies isn't a buy today doesn't mean it won't be a deal later on. If you are a serious income investor, then these tables are money in the bank. First, let's look some of the net-profits crusts Net Profits Enterprise Premium or Interest Trusts Symbol Market Cap Value iscount to NPV. Cross Timbers cRT $210,780,000 _ $209,460,000 3% Permian Basin PBT $868,790,000 $862,900,000 4% Sabine Royalty Trust SBR $736,400,000 $730,820,000 12% Dorchester Minerals DMLP ——$751,550,000 _ $737,440,000 -9% As we discussed earlier, net profits rusts must kick in for capital costs. You can also see by the difference beoween the market value and the enterprise value that these trusts usually hold cash and have no debt. Now, here’ a list of che over-riding trusts: Net Profits Enterprise Premium or Interest Trusts Symbol Market Cap Value Discount to NPV San Juan Basin Trust SJT __$1,040,770,000 _$1,040,000,000 -3% Hugoton Royalty Trust HGT $745,600,000 $740,500,000 “11% Mesa Royalty Trus MTR $81,070,000 $79,080,000 -9% BP Prudhoe Bay Trust. BPT —_$2,020,000,000 _ $1,990,000,000 4% As we discussed earlier, these trusts usually cake their cash payments from the bottom line. As you can sce, four of these trusts are selling at a discount to net present value. Those are primarily gas trusts. Those are the ones that we're going to buy. Back in Bargain Territory ‘The natural gas price fell Notural Gas Pace is Back in Bargain Tero 29% since June 21. That means o Yt the commodity is getting back to ** “cheap.” se We use “natty” as the fuel for home heating and cooling, gag and for electricity generation. I like it as a government-approved long-term alternative to coal %6 ‘Over the past few years, o { horizontal drilling and hydraulic fracturing techniques dramatical- Bargain Tertory ly shifted the natural gas sup- : 2005 2008 2007 2008 2008 200ply/demand situation. /pShale rock is often loaded with natural gas. The problem is the rock is packed tighs, like pages in a book, Picture a book lying on your desk. Imagine the natural gas rests in the space beoween the pages and cant flow. Shale is just like that. Cracks in the shale run horizontally. A single verti- cal well can only tap a small percentage of the gas caught beeween the pages. However, if you turn that well horizontally, to run along the page, you hie a lor more. In addition, we figured out that if you could somehow prop the pages of the book open, even more gas would flow out. That’s why we blast the cracks in the shale with water. We put sand or ceramic spheres in the water to prop them open, and voila... huge gas production. /pln just the last decade, we've figured out how to do those things... and its caused gas supplies to swell. In 1984, U.S. natural gas pro- duction was 18.5 illion cubic feet, In 2009, we produced 26.3 uillion cubic feet...thanks to horizontal drilling and hydraulic fracturing. /pHowever, the demand for gas hasn't kept up. In 1984, we consumed 17.9 uillion cubic feet. In 2009, we consumed 22.8 uillion cubic feet, So while we added 42% to our production capacity, we only added 27% on the demand side./pThis surge of production, coupled with only a creeping increase in usage, has caused a crash in natural gas prices. Just a few yeats ago, $7-S8 per MCE (thousand cubic feet) was a normal price. Nowadays, $4-$5 is a normal price./pAnd as the natural gas chart above shows, $3 0 $3.50 is the new “cheap.” Along with all commodities, natural gas suffered a crash in late 2008. The glut has kept the price depressed... The new range is between $6.50 on the high side and down around the $3.25-$3.75 on the low side. This is the level where most industry insiders and power-plant operators consider the fuel a great bargain./pToday, the price of natural gas is around $3.70 per MCE. ..in the cheap range ‘Also placing natural gas in the “bargain bin’ is the oil-to-gas ratio. Oil and natural gas are energy cousins. They tend to trade in a rough “energy equivalent” band. Sometimes oil gets cheap relative to natu ral gas; sometimes natural gas gets cheap relative to oil Back before the current gas glus, the market considered natural gas cheap when the oil-to-gas ratio was 12:1 or 14:1 - meaning 12,000 or 14,000 cubic feet of gas sold for as much as a barrel of oil. Today, we can say natural gas is cheap only when that ratio spikes to 20:1 or 24:1. This ratio reached 24:1 in the fall of last year. Today, che oil-to-gas ratio is 20:1 and rising. Natyy is heading back into “super-cheap” territory. Keep in mind, we do face some risk in buying these trusts. Ifoil and gas prices nosedive, the market will punish shares. Consider, if you bought BP Prudhoe Bay Trust in 1990, when oil prices were high, you suffered a 85% decline when oil prices dropped. T think chat risk is remote right now... Today, natural gas is 45% below its five-year average. That ‘means natural gas prices would have ¢o rise 83%, just for us to hit the average. ‘The second risk to our investment worth noting is a potential market crash. ‘There remains the risk of a huge marke sell-off like the one we saw in 2008. The stock market is floating on a sea of Fed-created liq- uidity We can’t know when the big surge in stocks will fates, but we can limit our risk with a 25% stop loss.SS —_———— Royalty Stream No. 1: Hugoton Royalty Trust (NYSE: HGT) Hugoton’s corporate structure is basically a lawyer and a bank. The trust formed in 1998 when XTO Energy spun out 80% net profits interest on assets in the Hugonton basin of Oklahoma and Kansas, the Anadarko Basin in Oklahoma, and the Green River Basin of Wyoming, Ic produces 90% gas, 10% oil, has no debt, and pays a 7% annual dividend. Its market cap is $800 million, XTO was the operator. It is now being acquired by ExxonMobil, probably the best operator you can have. The trust's assets are in fantastic locations. Hugoton current reserves are 117 million MCF of natural gas and 1.1 million barrels of oil ‘The trust owns 79,500 net acres in the Hugoton. Natural gas drilling began in Hugoton back in 1922. Ik covers more than 5 million acres. This is one of the largest regions of natural gas production in the U.S. In 2009, the trust's assets produced 19,200 MCF and 50 barrels of oil per day. Those Hugoton acres became more valuable to us because XTO found four more productive rock lay- cers nearby. Depending on XTO's success in those neighboring formations, we should sce Hugoton’s reserve life extended. ‘An important risk: Hugoton’s oil and gas is completely unhedged, which means it gets paid the spot price. That's why we see a huge amount of variability in revenue. Average Dividends. _—_ Dividend Year Revenue Gas Price _Per Share Yield 2007 $70 million $6.11 $1.72 7.3% 2008 $117 million $8.28 $2.57 8.3% 2009 $30 million $3.48 $1.20 8.6% 2010" $36 million $4.67 $1.48 8.0% “results through August 2010 Were buying at a good time. If the trust produces the same amount of gas this year and gas prices stay flat, we'll make at least $1.48 in dividends. That’ 8% if we pay less chan $18.50 per share Reserve Inform: Gas 12/30/2006 2.2 million barrels 230 million MCI 12/30/2007 2.1 million barrels 225 million MC 12/30/2008 1.6 million barrels 178 million MCF 12/30/2009 1.1 million barrels 117 million MCF In 2009, Hugoton produced 8.3 million MCF of natural gas and 90,000 barrels of oil. Ac that rate, the trust will be around between 12 and 14 years, However, a bump in gas prices will boost reserves, as we discussed above. Action to take: Buy Hugoton Royalty Trust (NYSE: HGT) up to $22 per share and use a 25% trailing stop loss, adjusted for dividends.Royalty Stream No. 2: San Juan Basin Trust (NYSE: SJT) San Juan, like Hugoton, is basically a lawyer and a bank that collects royalty interest on about 1,137 wells and 119,000 acres in the San Juan Basin of northwestern New Mexico. San Juan doesn't do the dirty work of exploring, it just collects checks... and passes the cash along to us. Tes neatly 100% gas focused, no debt, and pays an 6.5% annual dividend, Its market cap is $1.15 billion San Juan Trusts reserves are healthy. ConocoPhillips became the operator after it acquired the former operator. In fact, it revised its reserve life from nine years as of 2009 to nearly 15 years this year. That reflects horizontal drilling and reduced well spacing performed by Burlington Oil and Gas (now a sub- sidiary of ConocoPhillips). Also, Burlington had spaced its wells at 160-acre intervals. lfs now shifting to a much denser plan. It drilled several wels in 2008 at 40-acre spacing. In other words, it can get four extra wells in an area where it had only one before. That is significantly increasing San Juan Trusts reserves. Depending on how Burlington’ drilling progresses in 2010, we could see a further increase next year as well An important risk: San Juan Basin’s gas is completely unhedged, which means it gets paid the spot price. Take a look at the table of results (below), and you'll see what happens when a company is fully exposed to the spot price. That's a huge amount of variability in revenue. Average Dividends __ Dividend Year Revenue Gas Price Per Share Yield 2007 $115 million $6.11 $2.35 7.5% 2008 $145 million $8.28 $2.45 6.6% 2009 $32 million $3.48 $2.72 18.7% 2010" $43 million $4.67 31.83 8.1% “results through August 2010 If the trust produces the same amount of gas this year and gas prices stay flat, we'll make atleast $2.72 in dividends again. Thaes 10.9% this yea, if we pay $25 per share. Reserve Information Oil Gas 12/30/2006 400,000 barrels 220 million MCF 12/30/2007 388,000 barrels 195 million MCF 12/30/2008 249,000 barrels 156 million MCF 12/30/2009 207,000 barrels 133 million MCF In 2009, San Juan produced 9.8 million MCF of natural gas and 15,000 barrels of oil. At that rate, the ‘rust will be around another 13 years. However as with its peers, a bump in gas prices will boost reserves, as we discussed above. Normally, shares of royalty trusts rise and fall in conjunction with the price of their underlying com- modity. If gas prices rise a bit, we should see a capital gain as the shate price rises to reflect the increase in revenueSS —_———— Action to take: Buy San Juan Basin (NYSE: SJT) up to $25 and use a 25% trailing stop loss, adjusted for dividends. Dont pay a penny more. Don't worry if the price temporarily spikes after this rec- ‘ommendation. It will come down, and you'll have time to build your position. The longer you wait for a good price under $23, the higher your distribution yield will be. Royalty Stream No. 3: Dorchester Minerals (Nasdaq: DMLP) If you go to its website www.dmlp.net, the header says Vanillal. That really says it all. The site is noth- ing more than proxy materials and a link to Dorchester's vitals at Nasdaq. But flashy marketing is beside the point. Ids the assets that matter most...and these are great assets Dorchestor was founded in 2003 through the combination of Dorchester Hugoton, a public oil and gas company, with two private companies: Republic Royalty Co. and Spinnaker Royalty Co. The resulting company owns both net profits interest and royalty properties ‘The royalty properties consist of producing and nonproducing properties in 574 counties and parishes in 25 states. ‘Mineral Net Overriding Profits Interest Royalty Royalty Leasehold ‘Number of States 25 7 7 8 Gross Acres 2,308,263 617,081 208,755 37,338 Dorchester’ proven reserves are 60 million MCF of natural gas and 3.2 million barrels of oil. The company has a $825 million market value, no debt, and pays 7.1% dividend, ‘The company earned $663,000 in 2009 in “lease bonuses”. That's the initial price an oil company pays pper acre just to get access to the mineral right. That's in addition to the royalty interest if anything of value is discovered, Every discovery adds more oil and gas to Dorchester’s proven reserves. ‘That's an important distinction. Unlike our other royalty companies, Dorchestor gets paid whether those actes produce oil and gas or not. That only represents about 1.5% of 2009 revenue... but it is an additional source of revenue. Because Dorchester has such a large and varied array of property, it has many operators. Those notable companies are Comstock Oil and Gas, Chesapeake Energy, Continental Resources, Hess Corporation, Marathon Oil, EOG Resources, and Cimarex Energy. Dorchester had 353 new wells drilled on its properties in 2009, with another 10 near completion at the end of the yeat: These wels are in some of the best new oil and gas plays in the U.S, About 166 of those wells are in the Fayetteville Shale of Arkansas. Dorchester owns 11,464 net acres in this tremendous unconventional natural gas shale play. Another 60 wells were drilled on Dorchester’s 7,600 net acres in the Bakken Shale in North Dakota. In addition, the trust owns 22,000 acres in New York and Pennsylvania that may contain Marcellus shaleAverage Dividends __ Dividend Year Revenue Gas Price Per Share Yield 2007 $65 million $6.11 $1.97 9.5% 2008 $90 million $8.28 $2.80 8.6% 2009 $44 million $3.48 $1.50 9.6% 2010" $43 million $4.67 $1.56 65% “results through August 2010 Reserve Information Oil Gas 12/30/2006 46,000 barrels 0.5 million MCE 12/30/2007 34,000 barrels 1.4 million MCE 12/30/2008 65,000 barrels 2.0 million MCF 12/30/2009 (66,000 barrels 3.2 million MCE In 2009, San Juan produced 0.6 MCF of natural gas and 21,000 barrels of oil. At that rate, the trust will be around another five years. However, as you can sec in the table above, che trust’ reserves actually grew over the last four years! ‘That trend should continue, thanks to its high quality acreage positions. This trust should continue to grow for several more years as more of its actes are exploited. Unlike the other trusts we discuss here, Dorchester pays its sharcholders quarterly, rather than month ly. You get fewer checks, but they are bigger. Action to take: Buy Dorchester Minerals (Nasdaq: DMLP) up to $28 and use a 25% trailing stop loss, adjusted for dividends. Don't pay a penny more. Don't worry if the price temporarily spikes after this recommendation. It will come down, and you'll have time to build your position. The longer you wait for a good price under $25, the higher your distribution yield will be. Royalty Stream No. 4: Mesa Royalty Trust (NYSE: MTR) Mesa Royalty Trust is actually the remnant of a legendary ‘Texas oilman’s company. He founded Mesa Petroleum in 1956. In Mesa Petroleum, Thomas Boone Pickens, (known as T. Boone) created the largest independent oil and gas company in the world. He achieved unparalleled success in 1962, when his team drilled 98 successful oil wells. The two-per: son company made more than $750,000 in profit that year (about $4.2 million in today’s money) “Today, the resulting trust has acreage in two excellent U.S, basins, the Hugoton in Kansas and the San Juan in Colorado and New Mexico. It also has two excellent operators in those basins, BP Amoco operates the 468 wells in the Hugoton fields, ConocoPhillips operates the 466 wells in the San Juan Basin. The trust holds 99,413 net acres in the Hugoton and 31,328 net acres in the San Juan. ‘The interesting growth potential is actually in coal bed methane. Methane, the simplest form of natu- ral gas, often fills coal seams. The Fruitland coal field in New Mexico is one of the largest sources of coalbed methane reserves in the United States. Mesa Trust owns 25,400 net acres with Fruitland potentialSS —_———— The operator of those acres drilled 50 Fruitland coalbed methane wells subject to royalty payments. In all, the trust owns 485,000 barrels of oil and 6.9 million mef of natural gas proven reserves. Year Revenue 2007 $12 million 2008 $14 million 2009 $4 million 2010" $4 million Average Dividends Dividend Gas Price Per Share $6.11 $6.55 $8.28 $7.38 $3.48 $2.06 $4.67 $3.31 “results through first six months 2010 The trust is 75% navural gas, 25% oil, has no debs, and pays a 6.2% annual dividend. Its market cap is small, just $87 million. Reserve Information 12/30/2006 12/30/2007 12/30/2008 12/30/2009 Oil 2.5 million barrels 909,000 barrels 609,000 barrels 485,000 barrels Gas 33.5 million MCE 17.4 million MCE 9.5 million MCF 6.9 million MCF In 2009, Mesa produced 0.8 million MCF of natural gas and 56,000 barrels of oil. At that rate, the ‘rust will be around another 8.5 years. However, as with all the other trusts, its reserves will grow when the price of gas rebounds./pAction to take: Buy Mesa Royalty Trust (NYSE: MTR) up to $46 per share and use a 25% trailing stop loss, adjusted for dividends. All you have to do to start collecting your paychecks is to put in your bids for these stocks. Then just sit back and watch the checks start rolling in month] This is a fantastic way to collect income from safe energy supplies right here in the United States, You own the royalties, and the oil companies have to pay you... by law. 10Psd by Sansbeny &Asoetes estan ase, Sastry Asscalswoeames crus o sugesns 2 tnebaksunsbemueseach com. This aes is fr ledbck cob Forqumsions aya accu o to spak ‘wih eistower src, cal 84261268 (U8) cr 104057964 tertona Nerdapde 8 um. pm. ase tive, Or etal BOSSuRSar eer Pst ete To i rons us Pe gg pesnain sent abi. (©2010 Stars & Assocs ivestmet Resta Al gts rst. Ary repre. cov of itv, whl or ais prahbed wiht wile pemision ar ‘Snatory&asseste, 1257 San ut Sa Baler, MO 2208 or atures ay bolas tone cna slat ale rok ai ar ourlrnatn ol, Sabery & Asal ep acorn or near rok, el, inmsnet ater Stastny & Assocs ois wets rom nang ane stn any tury ty eared ocr sbscras, Aap of Sirsa & Asis an stad mpi) ust wat hur ara invesmas coma spblses ane ofThaurs ae aet mal pein Ser ble algo ha recantation. ‘Tes wor ibn a SC Soe curet ns, ns, ope re se, nd wht wee hare 8 aril cama, Km eatin ara, are yu sho make tay nese desir Bse sly on wt oa edt Jou ae oe ou apes, uR3B350R0299B0 S&A Resource Report 1217 St. Paul Street Baltimore, MD 21202 1-888-261-2693,