The North European Oil Royalty Trust Gives Investors More Certainty In A World Of Uncertainty

The North European Oil Royalty Trust (NYSE:NRT) is a very attractive investment bet. The business model is simple, almost guaranteeing profitability in my view, and providing enormous analytical certainty and clarity. The Trust has grown distributions to unitholders at over 20% a year in the last five years, and its free cash flow (FCF) yield is 22.95%. The business still appears undervalued, and in truth, its stock market performance has been terrible. It is the Trust’s ability to deliver distributions year-in and year-out that has made it a great investment. I believe the simplicity and clarity of the business gives investors certainty in a world defined by uncertainty.

A History of Stock Market Excellence

In the last five years, the Trust’s share price has gained over 49% while the SPDR S&P 500 ETF Trust (SPY), which tracks the S&P 500, has risen by more than 59%, the iShares Russell 2000 ETF (IWM), which tracks the Russell 2000, has gone up by over 11%, and the SPDR MSCI World Energy (WNRG), which tracks the MSCI World Energy Index, rose by more than 16%.

The Trust’s success on the market has been built on its distributions, with its total unitholder return (TUR) being over 166% in the past five years, compared to a total shareholder return (TSR) of over 74% for the SPDR S&P 500 ETF Trust , nearly 19% for the iShares Russell 2000 ETF, and nearly 15% for the SPDR MSCI World Energy.

In the year-to-date (YTD), the Trust remains a strong investment, with its share price up 1.5%, compared to nearly 13% for the SPDR S&P 500 ETF Trust, almost 4% for the iShares Russell 2000 ETF, and nearly -7% for the SPDR MSCI World Energy. The Trust’s TUR has been over 17% in that period, compared to a TSR of nearly 14% for the SPDR S&P 500 ETF Trust, over 4% for the iShares Russell 2000 ETF, and around -7% for the SPDR MSCI World Energy.

A Simple Business Model

Nearly all the Trust’s revenues stem from two royalty agreements: the Mobile Agreement and the OEG Agreement. The Mobil Agreement is a 4% royalty agreement covering gross sales of gas well gas, oil well gas, crude oil and condensate from the western half of the Oldenburg concession in Germany. The Trust also receives a 2% royalty on gross receipts from sulfur obtained as a by-product of sour gas produced in the western section of Oldenburg. The OEG Agreement is a 0.6667% royalty agreement covering gross sales of gas well gas, oil well gas, crude oil, condensate and sulfur from the entire Oldenburg concession, minus a certain allowed deduction of costs. The OEG Agreement also stipulates that half of the field handling and treatment costs are deducted from gross sales receipts before royalty calculation. The residual of the Trust’s income is derived from interest income.

The nature of the Trust confines activity to the 1.386 million acre Oldenburg concession, where natural gas, sulfur and oil are extracted by the operating companies. So, the Trust has no reason to acquire more land. The operating companies, Mobil Erdgas-Erdol GmbH, a German operating subsidiary of Exxon Mobil (XOM), and Oldenburgische Erdolgesellschaft, hold the concession, with BEB Erdgas und Erdol GmbH, a joint venture in which ExxonMobil and the Royal Dutch/Shell Group (SHEL) each own 50%, administers the concession held by OEG.

The Trust’s operating and related party expenses are a small fraction of its income. In the YTD, expenses were just 2.86% of income.

The reason that expenses are so low is because, as suggested in the discussion on income, it is the operating companies who are responsible for drilling, geological work and other such matters. The Trust thus avoids incurring the heavy capital investments needed to produce the gas, sulfur, and oil royalties the firm receives.

The Trust distributes its remaining net funds to its unit owners. In the last five years, distributions have grown from $0.70 per unit in 2018 to $1.83 per unit in 2022, compounding at 21.2% a year. In the YTD, the Trust has paid $2.05 per unit in distributions, compared to $0.63 per unit for the same period in the year prior. Distributions paid have risen from $6.43 million in 2018 to $16.8 million, compounding at 21.2% a year. In the YTD, distributions paid amount to $18.84 million, compared to $5.79 million for the same period in the year prior.

As can be seen from what we have said, the Trust’s business model is incredibly simple to understand, and this is a good thing for an investor. Although it can be said that the simplicity of the model means that there is no chance of any informational advantage, the analytical simplicity does make it easier to invest for the long haul.

Limited Risk, Lots of Upside

The savvy investor will have noted that, as a royalty earner, assuming operating expenses remain largely flat - there are no meaningful reasons for them to grow markedly - it is virtually impossible for the Trust to make a loss. That theoretical perspective is borne out by the facts, with the Trust earning a profit even during the pandemic lockdowns that devastated the oil & gas sector.

The Agreements are tilted in favor of the Trust, with no costs incurred by the operating companies deducted before calculation of royalties. This is important given that the Mobil Agreement accounts for the larger share of royalties.

The oil & gas sector is defined by a boom and bust cycle that makes it a perilous sector to invest in. In every business, managers typically overestimate future free cash flows (FCF) during boom times. This tendency is heightened in commodity markets, where producers lack pricing power. This forces them to chase the direction of price movements, raising too much capital during booms, and investing too heaving in capital expenditure, until the is a glut of supply, prices collapse, driving returns on invested capital (ROIC) toward the cost of capital, and capital flees the industry until profitability returns. This ebb and flow of capital has been called the “capital cycle” by Marathon Asset Management, or, the “asset growth effect” by researchers.

The trust’s business model means that it stands outside this process, because it is not itself a producer, it “merely” takes royalties. This means that, in boom periods, it acts as a sort of option on industry upside, but when a bust occurs, so long as some production is occurring, the Trust is very likely to still earn a profit.

Valuation

The Trust has a price/earnings (P/E) multiple of 4.31 compared to 25.06 for the S&P 500 and 6.86 for the MSCI World Energy Index. Thus, the firm appears attractive against both its peers and the wider U.S. market. With $24.82 million in FCF in the trailing twelve months, and an enterprise value of $108.13 million in enterprise value, the Trust has an FCF yield of 22.95%, compared to the market’s FCF yield of 2.3%, according to New Constructs’ calculation. This tells us that the Trust is producing FCF at a cheaper rate than the wider market.

Conclusion

The Trust has a very simple business model that takes out much of the risk from investing in the gas sector. Rather than the boom and bust cycle that defines the sector, investors can look forward to enjoying a Trust that de-risks their investment while providing an attractive option on any upside. Concretely, this benefit can be seen in the Trust’s history of profitability. In a world of uncertainty, the Trust offers a great deal of certainty in my view.