Canadian Royalty Trusts Will Never Return to Their Former Glory

by: Steven Ward

Someone (allegedly John D. Rockefeller, but no one is sure) said, "More people have been robbed of their money chasing yield than those that have been robbed at knife and gun point."

The Canroys

About 90 percent of Canadian Royalty Trusts, or Canroys, are based on a "Sustainable Business Management" model that pays out large chunks of cash flow from operations. Canroys avoided the "Blow Down" model, popular in the US due to a lack of sustainability. The Blow Down avoids debt, pumps assets dry and payout to shareholders can be up to 95 percent of cash flow. The Blow Down model attracted capital and seemed to justify the lower returns generated by lands that were on their last legs. The model also avoided risky exploration negating any large write downs that could upset cash flow along with upsetting investors at the breakfast table when they read the morning financial pages.

However, a problem occurs when management wants sustainability to keep right on going. So the Canroys implemented the "Sustainable, Accretive" model that incorporates active day to day management.

But Canroy management also wanted to avoid exploration risk, hence the practice of debt accumulation and share dilution for asset purchases.

For the last several years, the Canroys piled on debt and share dilution for acquisitions to keep the hamster on the treadmill.

Rarely did the Canroys conduct exploratory drilling. They didn't have to. Junior E & P's were more than willing to explore and develop properties, usually gas, achieve 5,000 per BOED production and then sell out to the Canroys at handsome profits. This quite literally became a racket with the same management teams selling out and then re-cycling themselves into another company and repeating the business model over and over again.

Rarely did the Canroys complain and rarer still did the Canroys comply with standard and accepted accounting definitions of "cash flow". Why bother with GAPP? It just gets in the way of the "Sustainable Model".

It was a "happy" time of seemingly unending lush dividends for unit holders, and rarely was there a discouraging word from management, investors and the brokerage houses and investment banks that produced mounds of investment data and brought to market E & P's who turned themselves into Canroys. Investors wanted yield and the Canroys could deliver.

Trick or Treat and the Destruction of Capital

It is truly an international world. A butterfly sneezes in China, causing a wind to blow down a forest in Oregon. A country one tenth the population size of the US has handed every US Canroy investor a financial setback totaling hundreds of millions of dollars.

The so called Halloween Massacre of 2006 occurred and everything changed. No longer could the Canroys buy production from E & P Juniors on borrowed funds or share dilution or by any means. The Canadian government put Safe Harbor Rules into effect that limited the amount of capital each Canroy could raise for further acquisitions. This restriction is devastating to Canroys ending production growth, as we will see later.

Also, as part of the Halloween Massacre, Canroys will be taxed at higher rates starting in 2011.

Then, 2 years later, as in now, the banks and insurance companies lost a bundle on sub-prime CDOs and credit swaps, and are continuing to lose money. The result is that lending dried up and Canroys have recently turned to private placement and share dilution to raise funds.

What will the Canroys do? There are several options.

  1. Do a Blow Down, pump assets dry before the tax change in 2011.
  2. Convert to an E & P corporate and financial structure.
  3. Convert to a Master Limited Partnership, (MLP) in the US.
  4. Sell to anybody for the best price.
  5. Something else.

Numbers one through four are self explanatory, with the caveat that option number 3 could run into newly proposed Canadian Law designed to thwart a US MLP move backed by Canadian assets.

Let's look at option number 5.

Option 5 is mentioned in every Canroy annual and quarterly report, usually worded that management is keenly aware of the tax change in 2011 and leaves all options open including corporate structure change. Then in Management Discussion or elsewhere, management points out that the Trust has built significant tax pools. Tax pools large enough not to incur Federal taxes for up to another 2 to 3 years after 2011, thus implying the Trust will maintain and keep paying its dividend, which after all is the rhyme and reason we all invested in Canroys.

The average investor, particularly the US investor, concludes that Canroys will continue on as a Trust in structure if not in name, and at the least it will carry on as a Trust in lush payouts.

Under the new Canadian Tax Law for 2011, with the appropriate acronym of SIFT, as in sift all the money out of investors' pockets, US investors, along with their pension funds, will not fare as well as Canadian Investors who have their Canroy shares in an approved pension/retirement fund.

A quote from Penn West's ((NYSE:PWE)) 07 Annual Report goes as follows:

If structural or other similar changes are not made … For U.S. investors, the distribution yield net of the SIFT and withholding taxes would fall by an estimated 25.1 percent in 2011 and 23.8 percent in 2012 and beyond.

Penn West has Tax Pools that PWE's management claim will make the company "Tax Free" at least until the end of 2013 and maybe longer. All Canroys make such "Tax Pool and Tax Free" claims.

While the Canroys, with their tax pools, maybe able to fend off a Federal Canadian tax hike for awhile, the US investor gets the Bums Rush, regardless of tax pool accumulation.

Currently, there is only a 15 percent Canadian withholding for US investors. Do not expect a structural change. It appears that even with tax pools shielding Canroys from Canadian Federal Tax, US investors still get a whopping 50 percent withholding increase after 2011.

Ah, but the US investor gets a tax credit from his or her government right? Yes, but maybe not for long. Another ominous cloud on the horizon lies in Congressman Markey's (D. Mass.) proposal to cancel the withholding credit currently enjoyed by US investors under current tax code. Congressman Markey is a dedicated Marxist – Leninist who is determined to destroy capital accumulation for all individual US investors. If the Democrats' campaign rhetoric is an indication, Markey will soon have plenty of company in the Congress looking for additional revenue. And the US investor is one of those sources.

Asset Whack

The new Albertan Provincial Royalty Tax will hit the Trusts on their conventional production in 2009 with at least a 10 percent increase, to as high as a 20 percent increase in additional Royalties from current Albertan Royalty levels.

Conventional oil and gas production bears the brunt of the higher Albertan Royalty, and most Canroys are in the conventional business. It should be noted that in most annual reports, the Canroys poo poo the hike as not being worthy of the investors' concern. The prime example here is Penn West, which has maintained that the higher royalty will only affect the company "minimally".

However, no less than Kurt Wulff himself dropped Penn West's asset value by 12 percent, not on the lower prices of oil and gas, but solely on the higher Alberta Royalty. One wonders what happened to all the other assets of Canroys doing business in Alberta that Mr. Wulff doesn't follow. Are their assets written down, did they report it to the shareholder, or is Penn West the only recipient of this distinction? I doubt it.

But I can only quote the late Illinois US Senator, Everret Dirksen, who once said, "A million here and a million there and pretty soon you are talking real money." The higher Alberta Royalty is "Real Money".

The Alberta Hike

One Canroy CEO is taking the Royalty hike seriously. Penngrowth's (NYSE:PGH) CEO is talking about going overseas to find new growth. His reasoning: the Alberta Hike in his view, presents a material obstacle for his company's future growth in Alberta. He states that the returns aren't there. Not "minimally" indeed.

But, why bother to go overseas? Just become an E&P or an MLP or something. Why all the trouble? Why venture internationally where only 2 Canroys have roamed. Why not stay and buy up all these great Western Canadian Sedimentary Basin assets (WCSB) like Penngrowth did recently with a purchase of 1billion dollars of Chevron Canadian assets.

The WCSB's best days of conventional oil and gas production are over. Conventional drilling has headed for British Columbia, Saskatchewan, the Yukon and the Northwest Territories. But in these lands the words "infill" and "step out" drilling are still rare due to the newness of the finds and the expense of development. Step out and infill drilling, along with acquisitions, were the Canroys' bread and butter. Here, in the other provinces, there is only high risk exploration, hitherto shunned by the conservative Canroys.

The prizes that remain in Alberta are unconventional assets that require a lot more capital and yield a lower ROI no matter the price of oil and gas as compared to conventional production.

Only large volume production for oil sands works and only a large and long life reserve with a multi billion dollar commitment works for shale gas as stated by Birchcliff Energy (OTCPK:BIREF) on its estimate to develop its Montney Shale holdings. To be precise-1.5 billion dollars so says the Birchcliff CEO.

A New Era for Canroys?

That is a whole new ballgame, and the Canroys' reaction to it can be easily measured by Penn West and Enerplus (ERP) who have large if not substantial unconventional resources, and who so far for all these years just twiddled their thumbs on their tar sands. Their focus was on the more conventional side with the usual secondary recovery operations where warranted.

In fact, Penn West and Enerplus, instead of developing the large un-conventional asset base, have chosen to purchase conventional assets instead.

Enerplus this year sold its Deer Creek Oil Sands holdings and maintains a slow production approach to its Kirby heavy oil resource. Not exactly risk taking that builds empires.

The Hamster Standing Still

Let us look at the 5 biggest Canroys traded on the NYSE. They are:

Penn West, Enerplus, Penngrowth, Advantage Income Trust, (NYSE:AAV), and Baytex, (NYSE:BTE).

These 5 Canroys hold the largest US shareholder base. Remember sustainability and how important it is to the Canroys. Here are some interesting numbers for the above 5.

Proven Producing FD&A Costs for 2007

Simply stated, this is when a company takes its proved but undeveloped assets and places them into production. It shows the carrying costs of the asset base. It is oil and gas combined BOE.

Important Note: The average price for a barrel of crude for 2007 was $72.10 per barrel.

  • PWE: $27.00 per BOE
  • ERP: $42.00 per BOE
  • PGH: $18.00 per BOE
  • AAV: $27.50 per BOE
  • BTE: $23.00 per BOE

Operating Costs

Now let us use the Q2, 2008, (the most recent numbers available) Operating Cost numbers on a per BOE basis.

  • PWE: $13.00
  • ERP: $10.00
  • PGH: $16.00
  • AAV: $14.00
  • BTE: $16.00

The Canroys are limited in their capital formation and their acquisitions and do not explore. Thus the 2007 FDA proved cost numbers gives us a recent historical cost basis, which is a legacy cost when dealing with an acquisition and combining them with the most recent operating cost numbers gives us a good handle on what to expect with the collapse of oil and gas prices as we go forward.

Total FDA and Operating Costs Per BOE for Proved Un-Developed Assets

  • PWE: $40.00
  • ERP: $52.00
  • PGH: $34.00
  • AAV: $41.50
  • BTE: $39.00

The coming year, with prices below $60.00 per BOE, is not going to be good for these Canroys, nor for their investors. The current collapse of these Canroys' unit prices reflects the low prices of oil and gas and probable payout cuts that reflect the true risk reward ratio of the units.

But the largest "Fear Factor" on these Canroys is the Effective DD&A Re-Cycle Ratio. This ratio indicates how many BOEs you can add with the remaining cash flow, after distribution payout, for each BOE you produced. A 1 to 1 ratio means you are treading water and can produce 1 new BOE for every BOE you produced.

More than a 1 is good. Less than 1 means you are not replacing production at all after payout.

How did these Canroys fare for 2007 when oil averaged $72.10 per barrel?

Not a single one achieved a 1 for 1 ratio. All were less than 1.

In other words, they are dying. They are dying with costs taken from past quarters where oil and gas prices were much higher than they are now. That should be staggering to any investor.

Put another way: These 5 Canroys are in a Blow Down model whether they realize it or not, or admit it or not to the shareholder.

But unlike US Blow Down Trusts, these Canroys have debt, in most cases greater than a 1 to 1 ratio and they have active and high management costs. And for what? Management's job is to achieve sustainability but there is none. So who needs management?

The Party Is Over

The Canadian Government took away the punch bowl, kicked everybody out of the dance hall, and turned off the lights.

Canroys needed debt, they needed acquisitions, they needed the cheap funds they borrowed garnering larger returns on oil and gas with pricing seemingly run amuck. Only in that way could they afford to pay higher and higher prices for marginal assets and ignore GAPP Accounting Rules and call the purchase "Accretive".

When the Canroys couldn't acquire more assets due to Safe Harbor Rules, when the Canroys couldn't attract more US investors with expected high yields devoid of deathly Canadian withholding, when the Canroys had their assets whacked by a higher Alberta Royalty, when they all suffered due to an un-precedented collapse in oil and gas pricing - where they all are suffering now from higher priced asset purchases, and why did people still hold the Canroys?

Yield baby, yield.

As long as oil and gas prices stayed high and higher, the day the Black Swan would take His Due seemed so far away. So hold baby, hold.

The Future

Clearly, the Canroy structure no longer works with all the rule changes and credit markets drying up. Those Canroys who seek true sustainability will convert to corporations particularly if they are included in the proposed Canadian corporate tax reduction.

They will eliminate their payouts and return to a true E&P structure. Only by eliminating payouts can the Canroys pay down debt and add to reserves in an "honest fashion."

By now investors should understand that Canroys are not E&P companies at all.

Some may start to conduct themselves as a Blow Down Model with reductions in staff, vast reductions in costs and pump the asset dry over the next 8 to 10 years.

There can be further difficulties for Canroy investors with management taking chunks of land out from the Trust and placing un-developed assets with a wholly owned or partially owned explorco while the Canroy holds all the debt that purchased the assets.

All shareholders should reject this model. Keep your lawyers at the ready.

But what is clear to me is that the Canroys will never be what they were no matter what the price of oil. Why? The rules changed and no one wanted to believe the worst could happen with the high price of oil.

Can oil and gas return to former pricing? I doubt it until after 2011 or 2012, placing the new restrictions in effect. Even so, these 5 Canroys have not demonstrated an ability to increase reserves after payouts no matter the cost or price of oil and gas.

A Silver Lining

One of the reasons Canroys avoided exploration was that it made their cost of capital cheaper. That no longer applies. Turning back into an exploration company can be positive for the shareholder who is now under water with his or her unit purchase price.

Penn West is a good example for this approach. Eliminating the current payout entirely produces 1.5 billion annually for purchases, expedited debt reduction and increased funds for drilling. The investor makes it up on the increasing share price. That 1.5 billion is what Birchcliff needs to fully exploit its Montney Shale holdings.

The Canadian Junior Explorcos are in deep trouble. A good number have excellent prospects and no cash for exploration. The Canroys can step in and pick up bargain after bargain if only they would convert to a corporation and slash the payout.

Buying up small explorcos on the cheap or spending money on high impact drilling will do far more for the beaten shareholder than stubbornly clinging to the current model.

The one silver lining for all Canroys is that they have cash flow. But when and how will they use it to improve the lot of their shareholders is anyone's guess.

It is clear that the market responds positively to large reductions in debt, large retained earnings and improved drilling prospects.

The Canroys are in the perfect position to "Buy Straw Hats in the Winter".

Their strength and the salvation for their shareholders lie in being counter-cyclical. They have the money to do it. But will they?

A Ho Hum Approach

A possible scenario is that the Canroys will continue the high payouts until 2011 and then do a "Due Diligence Review" where the Board will implement the conversion to a corporate model. That seems to avoid most litigation efforts by shareholders large and small alike.

It also may wipe out any chance of truly accretive asset purchases and long term sustainability for the company and its shareholders. Waiting could lose the moment.


I have no basic recommendations for this class of investment except to say if you have ridden it down this far, you might as well stay put and see what happens.

But on second thought, I do have some recommendations for US shareholders. Demand, don't ask but demand, that your Canroy start the process of slashing payout, paying down debt and buying cheap assets.

Demand the conversion to a corporate model, demand that your Canroy lobby the Canadian government for oil and gas companies to be included in the Corporate Tax Reduction Act.

Or simply demand a Blow Down Model with no gimmicks and with vast cost reductions. Either way you will be better off than you are now.


Chasing yield is not good. Rockefeller was right.

Stock position: None.

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