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Canadian Royalty Trusts

CANROYS

Which way are crude oil prices headed? Some pundits tell us they’ve peaked, while others advise that thanks to mushrooming demand from emerging countries, we’ll soon see crude at $200 per barrel. 

Given the uncertain outlook, it makes sense to go with stocks that would profit if oil and natural gas prices continue moving up, but would still provide a good return if they don’t.

Canadian royalty trusts  (a.k.a. CANROYs) fit that bill. The trusts produce oil and natural gas from reserves that they own or control, mostly in western Canada. 

Currently, the trusts don’t pay Canadian federal income taxes if they pay out most of their profits to shareholders. Consequently, they all pay hefty dividends.

Rising Energy Prices Saved The Day
I first described royalty trusts in an August 2006 column. As luck would have it, barely two months later, the Canadian government proposed taxing royalty trusts the same as regular corporations, starting in January 2011. That proposal eventually became law.

Word that the government was taking away the punch bowl sunk royalty trust share prices. But since then, crude oil prices have doubled, and natural gas prices have soared 70%.

Rising prices help royalty trusts in two ways. First, when energy prices rise, the value of a trust’s oil and natural gas reserves (the stuff still in the ground) rise proportionally. Thus, since my October 2006 column, the value of a typical trust’s reserves have grown somewhere between 70% and 100%, making the trust worth that much more to a potential acquirer 

Further, while costs remain relatively fixed, the cash generated from oil and natural gas production moves up with energy prices, allowing the trusts to increase their payouts to shareholders.

Not that they aren’t high already. Most trusts are paying dividends equating to seven to 13% yields (yield is the payments you receive over the next 12-months divided by your purchase price).

High Payouts Temporary
But, what happens when January 2011 rolls around and the trusts have to start paying federal income taxes? By that time, many trusts will have been acquired or converted to regular corporations, and others will be contemplating such moves.

No matter which strategy they choose, dividends will probably shrink substantially, or disappear entirely. However, some trusts have already converted to regular corporations or have been acquired. In those cases, share prices moved up on the news. So if that trend continues, you could collect the high dividends until 2011, and then sell without taking a big loss when and if, the high payouts stop (beware: we are in uncharted territory, nobody knows for sure what will happen).

If energy prices rise between now and 2011, your share prices would probably also move up. Your biggest risk is a prolonged steep drop in oil and natural gas prices. If that happens, both your dividends and share prices would probably drop.

Where to Find CANROYS
You can see a list of Canadian trusts, including dividend yields, on Investcom (www.investcom.com). Click Income Trusts under Canadian Markets on its homepage, then select Resource Trusts, and finally, select Energy from the Industry Sectors menu.

Click on the trust name to see a description of the trust’s business. From there you can see its dividend history, analyst ratings, price charts, and the like.

By the way, the terminology for trusts is different than for regular stocks. You buy “units” instead of shares and dividends are called “distributions.”

Trust Ratings
Investcom lists around 40 trusts, although not all pay significant dividends. If you need help sorting through the list, Money Sense Magazine grades the trusts from A to D, where A is best, based on a variety of fundamental and price action factors. You can see the list on Canadian Business Online (www.canadianbusiness.com) by selecting Stocks from the Markets menu, then clicking Income Trusts, and finally, Canada’s Best & Worst Income Trusts. Money Sense lists a variety of types of trusts besides oil and gas producers. So click on the Industry header to sort the list by industry, and then focus on Oil & Gas producers.

More Trust Info
You can use Reuters (www.reuters.com) to see analysts’ forecasts, financial statements and a variety of other fundamental information for each trust. The ticker symbol format for Canadian stocks varies on different U.S.-based financial sites. So, it’s best to search based on the trust name rather than ticker symbol.

Want the Best CANROYs?

Dividend Stock Specialists

Dividend Detective

www.dividenddetective.com

Google Finance (finance.google.com) is a good resource for trust news, including quarterly earnings press releases. It’s worth spending some time looking at those earnings reports. Because trusts take all sorts of non-cash write-offs, cash flow is more significant than reported earnings. Fortunately, most trusts list some form of cash flow on a per-share basis near the top of the report. It may be labeled “funds from operations,” “operating cash flow,” or something similar.

Your best prospects are trusts that are distributing no more than 70% of cash flow to shareholders, and lower is better. The bigger the cushion, the lower the chance of a dividend cut if energy prices drop.

Tax Issues
Finally, you need to know that the Canadian government applies a 15% non-resident withholding tax on distributions to U.S. investors. However, U.S. citizens can apply for a refund when they file their U.S. tax returns. Many trusts provide income tax filing instructions for U.S. unitholders on their websites. Nevertheless, you should consult with your tax advisor before investing.

Keep in mind that no matter how good a particular sector or industry sounds, something unexpected can always happen. Never allocate more than 20% of your investment portfolio to any single industry.

published 6/8/08

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