You have probably heard stories about someone finding oil on their land and living off the resulting passive income.
An energy company shows up, drills a well, and the landowner starts receiving royalty cheques every month. They do not operate the well. They do not hire workers. They simply own the rights to the land and collect a slice of the production.
You can do something similar without owning acreage or negotiating with oil companies. All you have to do is buy shares of Freehold Royalties (TSX: FRU).
Source: Getty Images
What is Freehold Royalties?
Freehold Royalties is not a traditional oil producer company. It also does not run pipelines, nor does it manage refineries. Instead, it owns royalty interests on millions of acres of land across Canada and the United States.
Freehold owns the rights to oil and gas production on that land. When an operator drills and produces oil or natural gas, Freehold receives a percentage of the revenue. This all comes from their gross overriding royalties, which are contractual rights to a portion of production from wells drilled by other companies.
Because Freehold does not operate wells, it avoids many of the costs traditional energy companies face. There are no drilling expenses, no field-level operating costs, and no abandonment liabilities. That makes the business far more capital-light.
The financial results reflect this model. Operating margins are often dramatically higher than those of oil producers. The company also carries relatively modest debt compared to many exploration and production firms.
The Freehold dividend
For income-focused investors, the main attraction is the dividend. Freehold pays a $0.09 per share dividend monthly. If you annualize the most recent monthly payout and divide it by the current share price, the yield comes out to 6.2% as of February 20.
That yield will fluctuate with the price of oil and gas, since royalty revenue depends on commodity prices and production volumes. If the share price goes down, the yield will also be higher, assuming no dividend cuts.
Importantly, management targets a payout ratio of around 60% of free cash flow. That means they aim to keep a buffer rather than distributing every dollar earned. During weaker commodity environments, this policy helps protect the dividend.
Freehold has also stated that its dividend is sustainable at oil prices well below recent highs. Compared to smaller, highly leveraged small-cap oil explorers, that makes it relatively resilient.
