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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.
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 |
