SBR - Sabine Royalty Trust: An Intriguing Business Model Within Current Context

Summary

• Given growing expectations of high global energy prices headed perhaps even higher next year, the immediate & obvious investment strategy response is to invest in producers.
• Sabine Royalty Trust is an intriguing alternative, with its strategy focused on acquiring royalty rights, instead of production facilities.
• In the event that the current global commodities price boom will continue, commodities producers may find themselves squeezed by higher input prices.
• Sabine Royalty Trust could benefit from higher prices, without the risk of higher input costs associated with those higher prices.

Investment thesis

Sabine Royalty Trust (SBR) is a trust entity that specializes in turning royalty obligations into assets and distributions to investors. The net effect is that its performance tends to follow oil & gas prices, similar to what one might expect to see from a mining company. The one major difference is that it does not have to contend with the input cost factor, which often tends to follow commodity bull runs, since drilling for oil & gas does require a large volume of inputs, including energy, steel, and other commodities. While the risk of rising input costs is a non-issue in the case of SBR, the risk of sudden production declines that may deprive the company of the royalty income from its assets may be more pronounced than it might be the case with some oil & gas producers. It is therefore hard to gauge whether there is a net reduction in risk once both factors are taken into account. It is nevertheless an intriguing alternative to investing in producers and there is also a very generous dividend to consider.

About SBR

The assets that SBR is sitting on consist of royalties agreements on current & future oil & gas production assets. Current production from those assets seems to be on an expanding path.

As we can see, things are headed in the right direction for the company on account of higher production as well as much higher realized prices on that production. The higher the price of the product sold, the higher the royalty payout per unit sold.

The rise in royalty income that we see for the latest reported quarter of this year, versus the same quarter from last year translates into higher distributable income, as we can see at the bottom of the statement, thus it tends to push its shares higher in response.

Oil & gas market outlook, and implications for SBR investors

Given SBR's business model, it goes without saying that both its price outlook and its disbursements to investors are highly dependent on the price of oil & gas, particularly in the US. My view on the outlook for natural gas is that with the growing LNG connection of the North American market to the European market, there will be a steady trend of price convergence, not so much with European prices headed down but US prices headed up. The EU gas market is in permanent distress for the foreseeable future, due to the loss of approximately 4.7 trillion cubic feet of natural gas supplies from Russia per year. As of November demand was down 24% compared with the same month from a year earlier. In other words, the EU economy is no longer functioning normally, which will become more obvious in economic data points starting late this year and going into next year. This means that there will not be a slack in demand for US LNG for the foreseeable future. The net effect will be a constant upward momentum for US natural gas prices, with the weather being the only short-term wildcard.

As far as oil goes, it is a truly global commodity. It does not depend so much on the US supply/demand situation, but rather on the global picture. As far as I can tell, next year we are looking at subdued global demand, mostly due to the Ukraine war. On the other side of the equation, we have supply constraints ranging from slower-than-expected US production growth to OPEC's unwillingness and inability to produce more, to be topped off by a likely drop in Russian exports, mostly on the back of the oil price cap scheme. In balance, I expect oil prices to be on the high end despite a slow economic growth environment, for most of next year, as well as beyond.

For SBR, the most likely outcome is an oil & gas price environment that will trend mostly higher from current levels, with a lot of volatility, given that next year, the market will have a hard time deciding whether to trade on supply shortfalls or demand weakness forecasts. While I expect oil & gas prices to be volatile most of next year and beyond, they will be higher, which will help SBR to perform overall decent going forward in terms of its royalty intake, as well as outgoing investor compensation.

Investment implications

While I expect SBR's price to move steadily up going forward, I also think that it will face much trading volatility, together with increasingly volatile oil & gas prices. With the very generous dividend in the 10% range, this is definitely an intriguing investment opportunity, worth keeping an eye on for a more favorable entry point.

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