Canadian Royalty Trusts – Will Dividends Rise or Fall?

Some may scoff at the question. "Of course they must decline," they say. After all, we know that it is "likely" that in 2011 Canadian energy royalty trusts will lose their special status as non-taxpaying entities which flow income directly to unit holders (with no revenue flowing to the provinces or nation in which they are located except that paid by the very few employees of the trust who reside in that province or nation.)

Whether you like the Canadian provinces’ and Canada’s national decision or not, you must admit the current structure does seem a bit unfair – the Canadian provinces and national government provide roads for these companies’ royalty-paying firms to drive on, schools for their kids, etc., but the only income the provinces or federals receive in return is the scant amount they receive from the personal income taxes of the few employees that work to flow the royalty income to the unit holders.

So let’s take a fresh look at Canadian energy royalty trusts as if they were already being levied taxes on their earnings since that will probably happen, like it or not, in 2011. (There is always a slim chance that IF the Liberal Party wins the next election and IF they can get the votes and IF they decide to pursue it, the current tax-advantaged structure could continue. I don’t consider it likely but if it did happen, it would give an “extra” rocket boost to the Canadian energy royalty trusts…)

These royalty trusts (often called “CanRoys”) usually own 100% of oil and/or natural gas wells and/or mineral rights on a portion of producing wells, and/or mineral rights on other types of properties containing “wasting” assets like oil and gas, such as coal or metals. To be entitled to the current tax pass-through treatment, an outside company must do the actual work of extracting / producing the resource while the CanRoy has just a few employees to process their royalty income from the operators of the field or mine and distribute it pro rata to the unit holders.

Since most CanRoys own interests in a number of individual wells, oil fields, or mines, they offer an easy way to diversify investments across a number of different properties, sort of like ETFs do for a particular investment sector.

Whether or not the CanRoys enjoyed a special tax advantage – and they will most likely not do so going forward – their success also rests upon two other factors that are equally important and which have gotten lost in the shuffle as everyone focuses upon their need to reserve funds to pay taxes:
1 -- What is the price of the underlying commodity, and
2 -- Is the CanRoy replacing assets faster than it is depleting them or depleting them faster than it is replacing them?

This last issue is quite important since, by the time the exploration and production companies spin off the assets by creating a new CanRoy or by selling them to an existing one, those wells or mines are typically beyond their peak producing years, so their revenue will gradually decline – by definition, their distributions, taxed or untaxed, will decline as well unless they are particularly adept at replacing assets either by being solid negotiators or by having cash to buy when the underlying assets are cheap.

Then there is the price (and just as importantly, the expectations of where that price will go) of the underlying commodity itself. If other investors believe natural gas, for instance, is going to $1 per million BTUs (MMBtu) – as most did recently, when it was selling at $2 per MMBtu – but you choose to buy at the bottom, you could score quite the coup. It's the same with these CanRoys.

That's because one key difference between CanRoys and US royalty trusts is that, in the US, once a trust is formed with x number of properties, they are not allowed to acquire additional properties. Because they are restricted to owning only their original properties, by definition their distributions will decline over time until, ultimately, the trust will be dissolved. But CanRoys can be actively managed so they can issue new shares or debt in order to buy more properties. For this reason alone, I would prefer the CanRoys to US-based royalty trusts.

So how do we best assess the three primary factors that will determine the distribution payouts – and capital gains prospects – of CanRoys going forward? And which ones might stack up the best?

1. Tax changes. Penn West Energy (PWE) in 2007, the year after the national government announced that CanRoys would be converted to tax-paying corporations in 2011, said the following in their Annual Report: “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.” Okay, let’s say that for this variable, distributions will decline by 25%. So a 10% yield will become “just” 7.5%. A 12% yield would decline to “only” 9%. Etc.

2. The price of the underlying commodity. It seems to me this is where the pendulum swings back in the CanRoy investor’s favor. Is there any question that India, China and the other emerging nations will use more gas, oil, coal, uranium, timber, etc. in the future than they do today? If I walk today, I covet a bicycle. If I have a bike, I wish I had a scooter. If I have a scooter, I imagine what it would be like to have a car. There will be cyclical downturns of course, but the secular trend goes only one way: demand up, supply struggling to keep up. If oil, gas, coal, etc. rise in value by 25% even as the distributions decline 25%, that means no change. So far, advantage CanRoys.

3. Asset replacement. Is the CanRoy replacing assets faster than it is depleting them or depleting them faster than it is replacing them? Here the advantage goes to the larger, better-capitalized CanRoys. Currently, the limits on how many new units Canadian trusts can issue is based on their market capitalization. This places smaller trusts at a competitive disadvantage, but any nimble firm that replaces assets faster than it produces them will do well. Advantage: All CanRoys, especially the bigger ones and especially the ones that have a lower payout ratio (meaning they keep a good chunk of cash to acquire new assets at good prices) and a long reserve life (meaning they can pick and choose when to buy assets.)

Based upon the above 3 criteria, I can suggest for your consideration and research the following CanRoys: Enerplus Resources Fund (ERF), Pengrowth Energy Trust (PGH), Petrofund Energy Trust (PTF), PrimeWest Energy Trust (PWI), Provident Energy Trust (PVX), Penn West Energy Trust (PWE), and Harvest Energy (HTE). Of these – again, based upon my 3 primary criteria – I am buying ERF, PWE and PGH.

Beyond the usual market risk caveats and the caveat not to place all your eggs, or even all your yield eggs, in the same basket, I should note that since Canadian trusts are not organized as corporations, in theory unit holders currently have unlimited liability for the actions of the trust. In practice, however, it unlikely in the extreme that unit holders will ever be liable for the trusts’ actions. And – in the Every Cloud Has a Silver Lining Department – as they convert to corporate status, even this disadvantage goes away.

Advantage: CanRoys, old or new.

Full Disclosure: Long ERF, PWE, PGH.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

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Comments

[Old Trader:]

Joseph,

I've heard that some CanRoys have been squirreling away some cash, and will be able to maintain distributions beyond the 2011 deadline ( not indefinitely, of course, but for as long as a year, or more beyond the cut off date).

In regards to asset depletion for oil producing trusts, some bought known producing properties with the intent of applying secondary and/or tertiary production techniques to maintain/increase production levels. Of course, this swaps higher cost of production for exploration risk.

Fwiw, I like and own PVX because of their midstream assets.

Oct 20 08:48 AM

[a. palmer jr.:]

I bought HTE before the recent crash and they have reduced the dividends so much that in my case they're hardly paying any dividends at all. Couple that with the 15% tax and it's not paying as much as a regular stock. If the price goes up very much I'm looking to get rid of my HTE before anything else happens to it.

Oct 20 09:20 AM

[Joseph L. S...:]

RohanRider, small town investor and Old Trader --

All valid and important points. RohanRider, CanRoys' distributions will often fluctuate year to year, sometimes wildly, based upon the actual cash flow they receive as royalties, whether they choose to distribute 90% or 100%, new acquisitions, debt offerings, etc. When I buy them, I am looking at a moving average of distributions and mentally use a moving average mindset for future distributions. I believe that I will sometimes receive 7 cents a month, sometimes 10, and sometimes 12 -- but over time if they are good business people and if oil and gas continues to rise with or slightly ahead of inflation (the former at least partially in my control to analyze, the latter the assumption I proceed under) then the distributions will rise.

small town investor, it is an important point that the final tax effects on US citizens are not yet fully known. The bad news is out -- if CanRoys are to be taxed as corporations, they'll have less money available for distributions. But as you point out, there may be a benefit to US taxpayers that will partly mitigate that effect -- or they may be taxed at some hybrid rate lower than the top corporate rate. Politics is the art of compromise!

And, Old Trader, you are so right. Not only have some been squirreling away cash, they've been revising their business models and amassing tax credits (called "tax pools") that allow them to continue for as much as three years in a completely or partially tax-sheltered environment where they won't be paying (or paying in full) their corporate taxes.

This issue is far more complex than any single article could cover (it is, after all, a political AND economic decision!) but I hope this introduction adds to investors' thinking the other two important variables here -- the price of the underlying resource and the skill of management. Thank you all for your additions to the discussion!

Oct 20 09:33 AM

[ronkr:]

A coherent, timely, and interesting article. One point however, in trying to do dd on the canroys featured, I ran into deadends on PWI and PTF. Can you shed further light on these two?

Oct 20 10:01 AM

[casey00001:]

Joseph, Thanks for a well written article. What do you think about the concept that if the Canroys are forced to incorporate they will do so in the United States? (Thereby sticking it to the Canadian Gov't who promised prior to being elected they would leave the Trusts alone.) Seems politicians break promising outside of the US also.

Oct 20 10:48 AM

[tc1:]

Joseph, another great article you've served up for us.

What is your assessment of the CanRoy Baytex (BTE), which has outperformed most of the others this year and seems to have a more sustainable, if lower, dividend?

Oct 20 11:08 AM

[Brad Castro:]

Just wanted to thank you putting this together - as I mentioned in my comments to your previous article, I was very interested in your take on the CanRoys. You make a good case.

Oct 20 12:01 PM

[Jimbo:]

The author seems to be saying that no entity in Canada received taxes on Canroy dividends. As an owner of several Canroys, I have bee paying 15% to SOMEBODY for years.

Oct 20 12:08 PM

[casey00001:]

Jimbo, are you a Canadian Citizen? I thought only US holders of these stocks were taxed on the dividends? Meaning taxed by Canada before the distribution got sent to the US. If you are indeed a Canadian citizen and paying tax on your dividends, what does the Canadian Gov't hope to accomplish by ruining that revenue stream?


On Oct 20 12:08 PM Jimbo wrote:

> The author seems to be saying that no entity in Canada received taxes
> on Canroy dividends. As an owner of several Canroys, I have bee paying
> 15% to SOMEBODY for years.

Oct 20 01:24 PM

[CashOut:]

The has one major inaccuracy: Revenue Canada collects taxes at 15% of dividends paid to US shareholders (even if they are in a Roth, IRA, etc).

Oct 20 03:22 PM

[erewhonman:]

One other major problem. You claim as follows:

"To be entitled to the current tax pass-through treatment, an outside company must do the actual work of extracting / producing the resource while the CanRoy has just a few employees to process their royalty income from the operators of the field or mine and distribute it pro rata to the unit holders."

Not so. Most CanRoys have large capital budgets not just to replace production but to increase it. Some are actual leaders in emerging plays such as Crescent Point (just converted back to a corporation) in the Bakken, NAL in the Pembina, etc. etc. So there is a strong hands on growth model for may CanRoys. On many reserves, production, RLI are all increasing whether by drill bit or takeover.

Oct 20 03:41 PM

[zipgorp:]

First - primewest got bought by Taqa and is no more.
Second - trusts may continue after 2011 by using up tax credits, for example I believe Pennwest has 275 million in tax credits so it they chose to they could stay a trust for longer than 2011, but they will probably revert to an exploration and production company from the trust structure in 2010 or 2011 as well.

what is missed is the tax on the distribution was paid by who ever the distribution was paid to, so the tax was not missed by the government just collected from individuals intead of the corporation. Apparently the government didnt see it that way and destroyed the trust sector (except for REITs, real estate apartment trusts)

Oct 20 06:46 PM

[Steven Ward:]

You buy the Canroy's simply based on the cheapnessof their assets and the RLI. The dividend status is completely unknown as well as the payout yield.

If Canroys like PWE stop the dividend entirely they will have tremendous cash flow to apply towards debt reduction and the purchase of new assets. The market will reward these companies over the next few years with price appreciation grreater than any current yield or future yield.

For a contrarian view see my SA article titled, "Canadian Royalty Trusts Will Never Return to Their Former Glory." I think it is still timely. I'm not impressed with yield, particularly when PWE can nearly pay off all her debt by eliminating the dividend for about 18 months.

For the record I'm long Crescent Point which recently converted to a corporation.

Oct 21 12:44 AM

[Uncle Pie:]

As pointed out above, Crescent Point converted to a corporation without reducing their distributions.
Also look at Vermilion Energy trust: since most of their oil and gas production is outside of Canada (in Europe), their tax situation is expected by most analysts to be largely unaffected by the termination of tax benefits of the income trust structure.
This writer owns shares of both of the above securities.

Oct 21 09:52 AM

[longoil:]

KNOC has made a bid for all outstanding HTE trust units:

"CALGARY, ALBERTA--(Marketwire - 10/21/09) - Harvest Energy Trust ("Harvest") (TSX:HTE.UN - News) (NYSE:HTE - News) today announces that it has entered into an agreement (the "Arrangement Agreement") with Korea National Oil Corporation ("KNOC") for the purchase of all the issued and outstanding trust units (the "Units") at a price of C$10.00 per Unit for a total cash consideration of approximately C$1.8 billion plus the assumption of C$2.3 billion of debt."

This is great new for anyone who purchased HTE over the last year at $7.00 or lower a share that stand to make a 50% profit.

However, I will be very surprised to see this deal go through. Many HTE share owners were Viking and Calpine trust unit holders who bought in at anywhere from $10 to $40 per unit and were then taken over by Harvest Trust. I doubt they would be willing to take a huge capital loss to give KNOC access to cheap Canadian oil.

The Koreans are following in th footsteps of their big brothers (The Chinese) and are scouring the world for dwindling oil resources. Given the currrent market conditions, they are taking advantage of the poor share price of HTE brought on the inept management of CEO John Zahary et al.

Oct 22 08:22 AM

[Tom C.:]

Do these trusts afford U.S. unit holders the benefit of exchange rate gains of the Canadian dollar against the U.S. dollar? I assume they do since the royalties are earned at the wellhead in Canada and then paid in U.S. dollars to U.S unit holders. Assuming the U.S. dollar continues its decline, this would be an additional advantage of owing a Canadian royalty trust. Thank you.

Oct 22 11:58 AM

[longoil:]

Dividends paid to US trust holders from Canadian income trusts automatically rise when the US dollar falls in value. The pay out in Canadian dollars remains the same, but when dividends are converted to USD, US holders benefit from the increased value in the Canadian dollar.

Oct 22 03:06 PM

[beabaggage:]

PWI was bought out by Arabs years ago! get with the program!
we all should have sold then, they are way down from then due to Harper's madness in CN and the low price of NG.
HTE bot by Korea for a song, $10 unit CN. they take over a refinery in a strategic place north atlantic in tip top shape, a foot hold in oil sands (pwe only independent w oil sands assets left) and a bunch of debt from the refinery acquisiton. harper is selling cn to the highest bidder. 1/1/2010 the foreign tax on divs goes to 25% on most of these trusts from 15%, you can only claim so much on your US Taxes like $300 or so. EWC best way to play CN or a closed end fund like OGF-UN. TO or VIP-UN.TO, Brompton funds managed by Manulife, very conservatively since they started managing. nice divs. PVX has paid debt way down, sold their US assets at the top of the market 7/08 and fringe assets recently.

long OGFun, VIPun, PWE, PVX, sold my HTE at the annoucement for $9.36 US. ERF on my radar but is overpriced now.
check out Consumerswaterheatersi... trust, a good one recently reduced div debt all restructured way down, pays .054 mo CN not subject to 25% only 15% in US net eff yield is about 10% on current US price. cash flow cow. hidden asset in smart meter business in CN. long that too. CN has helped me get back to "even" but it has been a struggle. short brazil that is the next bubble to burst.

Oct 23 09:49 PM

[Drew Thomas:]

Can anyone explain how the 15% tax on CanRoy dividends affects me if I am a U.S. taxpayer but hold the CanRoys in a tax-deferred account (e.g. IRA)? And how it likely would affect me after the CanRoys convert to corporations?

Nov 22 11:14 AM

[untrusting ...:]

Think you are wrong. Would be very surprised to NOT see the HTE deal go through. The HTE shares continue to trade 1/2-1 million shares/day since the announcement and would suspect that KNOC or their agents are buying every share they can at current market prices which are basically trading at $10 Canadian divided by the C$ exchange rate daily. They are extracting about a $0.10/share premium, ie paying 10 cents less than market value as above to buy shares every day.

Thus would be very very surprised if the deal does not go through. Would suspect that between HTE management, KNOC and agents, and low price buyers ($3-6 ranges), that between them they own more than sufficient shares to approve the deal.

BTW, we purchased quite a few shares of HTE back in the $3-5 ranges and have now sold all of our HTE holdings gradually after the KNOC announcement and ramp up above $9, with the last part being sold yesterday. After the last HTE dividend payment, it just made little sense to continue to hold with the shares essentially selling at deal price adjusted for exchange rate, and it made more sense to lock in pretty good gains plus dividends by exiting the HTE stock.

Unfortunate for the "old" $10-$40 HTE shareholders, but just cannot see anyway that they can ever recover on the investment. Maybe some competing higher bid will magically appear, but we personally think that is unlikely.... but you never know, it is an outside possibilty. Just not one we personally are willing to gamble on.


On Oct 22 08:22 AM longoil wrote:

> KNOC has made a bid for all outstanding HTE trust units:
>
> "CALGARY, ALBERTA--(Marketwire - 10/21/09) - Harvest Energy Trust
> ("Harvest") (TSX:HTE.UN - News) (NYSE:HTE - News) today announces
> that it has entered into an agreement (the "Arrangement Agreement")
> with Korea National Oil Corporation ("KNOC") for the purchase of
> all the issued and outstanding trust units (the "Units") at a price
> of C$10.00 per Unit for a total cash consideration of approximately
> C$1.8 billion plus the assumption of C$2.3 billion of debt."
>
> This is great new for anyone who purchased HTE over the last year
> at $7.00 or lower a share that stand to make a 50% profit.
>
> However, I will be very surprised to see this deal go through. Many
> HTE share owners were Viking and Calpine trust unit holders who bought
> in at anywhere from $10 to $40 per unit and were then taken over
> by Harvest Trust. I doubt they would be willing to take a huge capital
> loss to give KNOC access to cheap Canadian oil.
>
> The Koreans are following in th footsteps of their big brothers (The
> Chinese) and are scouring the world for dwindling oil resources.
> Given the currrent market conditions, they are taking advantage of
> the poor share price of HTE brought on the inept management of CEO
> John Zahary et al.

Nov 26 12:59 PM