Sabine Royalty Trust: Investors Have Another Chance To Take Profits

About three months ago, I recommended taking profits on Sabine Royalty Trust (NYSE:SBR) due to its high cyclicality and its inherent risk around its all-time highs from a long-term perspective. Since my article, the price of oil has declined 13%. The stock of Sabine Royalty Trust initially dipped 18% but it then retrieved all its losses. The stock has sometimes deviated from the price of oil temporarily but it has always caught up with this price in the end. Given also the long-term risk of the trust, which results from the high cyclicality of the prices of oil and gas, investors should probably take advantage of the recent recovery of the stock and take their profits.

Business overview

Sabine Royalty Trust is an oil and gas trust that was founded in 1983. It has royalty and mineral interests in oil and gas properties in Florida, Louisiana, Mississippi, Oklahoma, New Mexico, and Texas. The trust has a pure upstream business and hence it is much more sensitive to the prices of oil and gas than the well-known integrated oil majors, such as Exxon Mobil (XOM) and Chevron (CVX). Due to the high cyclicality of Sabine Royalty Trust, investors should make sure that they understand the current phase of the cycle of the energy market before purchasing the trust.

The vulnerability of Sabine Royalty Trust to the downturns of the energy market is clearly reflected in its performance record. In 2014-2016, when the price of oil plunged 70%, the trust reduced its annual distribution by 53%, from $4.03 in 2014 to $1.88 in 2016. The trust also reduced its distribution by 33% between 2018 and 2020, mostly due to the fierce downturn caused by the pandemic.

On the one hand, Sabine Royalty Trust has proved more resilient to downturns than most of the other oil trusts. To provide a perspective, Permian Basin Royalty Trust (PBT) cut its distribution by 67% in 2015 and by 64% in 2018-2020. On the other hand, investors should not underestimate the vulnerability of Sabine Royalty Trust to the cycles of the energy market.

Sabine Royalty Trust is thriving right now thanks to the exceptionally favorable conditions prevailing in the global energy market. Before its invasion of Ukraine, Russia was producing approximately 10% of global oil output. Due to the sanctions imposed by the U.S. and Europe on Russia, the output of the latter has significantly decreased. As a result, the global oil market has become exceptionally tight this year. This is the reason behind the rally of the price of oil to a 13-year high earlier this year.

A similar situation is evident in the global natural gas market as well. Before the sanctions, Europe was purchasing about one-third of its natural gas from Russia. Due to the sanctions, European gas prices skyrocketed to new all-time highs this year. As a result, the U.S. began to export a record number of LNG cargos to Europe, and thus, the U.S. natural gas market became exceptionally tight. This caused the price of U.S. natural gas to rally to a 13-year high in the summer.

The positive effect of high oil and gas prices was evident in the latest quarterly report of Sabine Royalty Trust. In the third quarter, the trust saw its average realized prices of oil and gas jump 65% and 142%, respectively, over the prior year’s quarter. As a result, it more than doubled its distributable cash flow per unit, from $2.39 to $6.13. In addition, the trust has offered an all-time high annual distribution per unit of $8.65 this year. This distribution is more than double the previous 10-year high distribution per unit of $4.03, which the trust offered in 2013 and 2014. It is thus easy to understand how much the trust benefits from the extremely favorable conditions of the energy market right now.

It is also worth noting that the annual distribution yield of Sabine Royalty Trust currently stands at 10.9%. This yield is higher than the 7.9% average distribution yield of the stock over the last decade.

However, it is critical to realize that oil and gas prices are not likely to remain excessive for years. The price of oil peaked just a few days after the invasion of Russia in Ukraine, in February, and has gradually declined to a 52-week low. The decline of the oil price has partly resulted from a global economic slowdown, which has been caused by the aggressive interest rate hikes implemented by central banks in an effort to curb inflation.

In addition, most countries are suffering from the energy crisis caused by multi-year high prices of oil and gas, and thus, they are doing their best to diversify away from fossil fuels. As a result, there is a record number of renewable energy projects that are being developed right now. When all these projects come online, they are likely to take their toll on the prices of oil and gas.

The recent decline of the price of oil below its level just before the invasion of Russia in Ukraine is a strong bearish signal. It essentially means that the global oil market has absorbed the impact of that invasion, and hence, the invasion is not relevant anymore. While the price of oil remains above historical average levels, investors should probably become prepared for the next downturn of the oil price. No one can time the next downturn of the oil market, but history has taught us that the oil market has always gone through dramatic boom-and-bust cycles every few years. There is no reason to believe that the cyclicality of this industry will suddenly disappear.

The 10.9% distribution yield of Sabine Royalty Trust is certainly attractive on the surface. However, the trust is likely to significantly reduce its distributions whenever the next downturn of the energy market shows up. Such a downturn may be caused by a global recession or the boom of renewable energy projects. As mentioned above, the trust drastically reduced its distributions between 2014 and 2016 as well as between 2018 and 2020.

It is also remarkable that the stock has remained essentially flat over the last three months, around its all-time highs, whereas the price of oil has incurred a 13% correction during this period. Such a divergence may occur in the short run, but the stock price of Sabine Royalty Trust will inevitably catch up with the price of oil at some point.

Nevertheless, this is not the primary risk factor of the trust. The main risk factor is the cyclicality of the trust. In 2018 and 2019, in which the average price of WTI was $65 and $57, respectively, Sabine Royalty Trust offered annual distributions per unit of $3.42 and $3.02, respectively. These distributions are more than 60% lower than the annual distribution per unit of $8.65 in 2022. This helps explain why the stock traded at much lower levels (35%-50% lower than the current stock price) in those two years, which were characterized by normal oil prices. It is thus easy to understand the downside risk of the stock whenever the next downturn of the energy market shows up.

Upside risk

As long as the price of oil remains above average, the stock price of Sabine Royalty Trust is likely to remain around its all-time highs. The stock will greatly benefit in the event of a strong recovery of the global economy from its latest slowdown or the emergence of an unforeseen geopolitical event, which may affect global oil supply. Such scenarios are likely to vindicate those who are unwilling to take profits on Sabine Royalty Trust. However, I believe it is not a prudent investment strategy to rely on such unlikely catalysts.

Final thoughts

As long as oil and gas prices remain above historical average levels, Sabine Royalty Trust is likely to keep thriving. Moreover, no one can predict when the next downturn of the energy sector will show up. However, given the high cyclicality of this sector and the all-time high stock price of Sabine Royalty Trust, risk-averse investors should probably take profits on the stock in order to save themselves from a negative surprise in the future.