Forming royalty trusts in oil and gas gets a damper in '84 tax law
Three years ago, oil and gas royalty trusts all but disappeared from view, their allure tarnished as oil prices sank under the weight of a worldwide glut. Now, just as these investment devices had begun to regain some of their lost ground, the Tax Reform Act of 1984 has squelched their attractiveness to investors. ''Issues that are selling at a premium because of the notion that they will increase royalty trusts are clearly subject to price erosion,'' observed Barry Good, an oil analyst at Morgan Stanley & Co.
Royalty trusts caught on with the investing public, beginning in 1979, when T. Boone Pickens Jr., chairman of the Mesa Petroleum Company of Amarillo, Texas, spun off the Mesa Royalty Trust. Less than a year later, market value of the combined assets tripled. In July, Mesa announced that it had bought back 88 percent of the interests in its trust, for $540 million, and was considering ways to repurchase the remaining units.
At present, there are 10 active trusts, including one of the most lucrative - Sabine Royalty Trust - with a total combined market capitalization of approximately $3 billion. Sabine Corporation, a medium-size oil and gas company based in Dallas, formed its trust in 1982. Hervey Priddy, the company's assistant treasurer, said that the present trust would not be affected by the legislation but that Sabine would probably not form another trust soon.
The Tax Reform Act of 1984 affects only prospective royalty trusts. Trusts now in existence, like Sabine, will be ''grandfathered'' (let stand) under the legislation.
The handsome results produced by Mr. Pickens for shareholders of Mesa Royalty Trust had led other companies to follow suit. One after another, companies like Louisiana Land & Exploration and Sabine started to spin off maturing properties in the form of trusts. The companies saw the advantage in that their lower reserve base magnified the effect of any addition to reserves, and Wall Street tended to award higher multiples to the exploration company.
Meanwhile, the Internal Revenue Service gave a boost to the royalty trust in 1982 when it confirmed its tax-advantaged status. The IRS ruled that monthly distributions to ''beneficial unit holders'' were subject to taxation only on an individual level. The question had been whether trusts would be taxed on both the corporate and individual level, like dividends.
The new tax act, however, eliminates the primary tax advantage associated with royalty trusts. Previously, the distribution of interest in the trust to shareholders wasn't taxable to the corporation. Under the new law, the corporation is taxed as though it had sold the property and then distributed the cash to shareholders.
The legislation had not put a complete damper on royalty trusts. Recently, two of the biggest attempts to form trusts have involved major oil companies.
The first came early this year when Pickens led an investors' group that sought to break up Gulf Oil before it was swallowed up by Standard Oil Company of California (now Chevron). Pickens had suggested that the combined price of a net-profits royalty trust representing 50 percent of Gulf's domestic producing assets and the residual value of the company might reach $70 to $80 a share - substantially above what Gulf was then valued.
Meanwhile, the Mobil Corporation has asked for an IRS ruling on a plan to form a royalty trust to hold oil- and gas-producing assets, with income to go directly to shareholders.
The action marks the first time one of the ''majors'' has embarked on the concept of royalty trusts. The ruling is still pending.