When government securities offer little nominal income and the official policy to devalue the U.S. dollar degrades principal, Canadian income stocks look like an attractive alternative to investors who want a current cash distribution. Indicated distribution yields are 5-10% a year and the assets producing that income tend to retain their real value when currency loses purchasing power. Our buy recommendation, Canadian Oil Sands Trust (COSWF.PK), is a pure play on long-life oil production through its 37% ownership in Syncrude, a massive oil production facility managed under agreement by partner ExxonMobil (XOM).
COSWF has a McDep Ratio of 0.68 while it currently pays 7.8%, a level widely expected to be adjusted somewhat in 2011 when most income trusts become tax-paying corporations. We also support yield-oriented investor interest in natural gas producer, Peyto Energy Trust (PEYUF.PK), valued at a McDep Ratio of 0.81. Peyto currently pays 10.0%, a level likely to be reduced closer to the peer median. The three traditional oil-oriented producers, Penn West Energy Trust (PWE), Enerplus Resources Fund (ERF) and Pengrowth Energy Trust (PGH), valued at McDep Ratios of 0.82-0.97, may need no further adjustment in distributions that yield 5.6-8.9%.
New Income Model Working
As Canada ends the tax practice of encouraging income trusts to make distributions without being taxed at the trust level, all of the trusts will convert to corporate form imminently to minimize taxation of funds to be distributed as dividends. Most Canadian oil and gas corporations seem to pay little current corporate tax because of deductions for reinvestment that the government apparently wants to stimulate. As a result, a high income/moderate growth model may deliver an attractive total return.
The transition to the new model seems to be working so far judging from recent volume trends. PWE, ERF, and PGH each arrested volume decline in the second quarter of 2010. PWE has just declared its first monthly distribution at the low end of its telegraphed range as management believes it has unusual opportunity to drill horizontal wells with multiple fracturing stages on its conventional, light oil properties. In January 2009, ERF was among the first to adjust its distribution to a level it expects to maintain while it has raised reinvestment. PGH made its adjustment in October 2009.
Peyto May Adjust High Payout
Peyto Energy Trust has delivered surprisingly strong volume growth while maintaining the highest distribution yield of the five trusts. Advantageous hedging has helped to sustain payout at the highest ratio of distribution to equity Ebitda. Our measure of sustainability takes Ebitda estimated without the benefit of hedging and reduces it by the ratio of debt to present value.
The trust’s concentration on natural gas in the Deep Basin where reserve life is long offsets possible trimming of the distribution. Natural gas concentration is unique at 78%. Reserve life index by our measure is 21.5 years. Though we know that natural gas usually has lower operating cost than oil and that higher operating costs for oil can be justified by higher price, we are still impressed by Peyto’s record of keeping cost nearly flat for the past decade.
Canadian Oil Sands Trust Puts Distribution Variables in Focus
After the market close on September 23, management disclosed a lower Syncrude volume estimate for 2010 of 105 million barrels compared to 110 previously. New guidance was promised to accompany the release of third quarter results on October 27. In their race to deliver capacity operations promised by 2011, the ExxonMobil engineers may be adding modifications that extend the Coker 8-1 turnaround maintenance currently underway.
Management also estimates that when the trust converts to a corporation on January 1, 2011, cash from operating activities will be reduced by about 25% to allow for corporate income tax. Accumulated “tax pools” are expected to be available to “fully shelter taxable income for about a year”. In any case, management intends to make capital expenditures from cash flow before paying distributions in 2011. Chief Financial Officer Ryan Kubik’s warning “a distribution reduction from current levels is likely” has been disseminated broadly. The distribution is likely to be unchanged for the last quarter of 2010 and the “likely” change would begin with the first quarter of 2011 when final results for 2010 are in and plans for operations and capital expenditures for 2011 are firmer.
Meanwhile, our distribution projection of C$0.50 a quarter remains the “indicated” rate. Ebitda minus Interest per Unit of about C$0.90 a quarter next year exceeds distribution by an ample margin. Management’s 2010 guidance from July also supports continuing the current distribution if we adjust for capacity operations, substitute current oil futures price and allow for capital expenditures near the same level as budgeted for 2010.
Longer-term, the outlook appears bright with plans to expand capacity to 540,000 barrels daily in 2020, up 54% from 350,000 currently. As a result, there is a growth component to add to an attractive return from current income.
Finally, we note the animals apparently like Syncrude’s environmental efforts. Rare bison twins were born during the 2010 calving season on land reclaimed from oil sands mining operations.
Originally published on September 24, 2010.