In the last few years we have seen markets roiled by banking meltdowns, housing meltdowns, job meltdowns, sovereign debt meltdowns and leadership meltdowns. It does not seem like there has been any good news since Lehman Brothers went up in smoke. Yield seeking has become a favored strategy among investors in the past several years.
In 2001/2002 we saw similar headline risk with terrorism, war, the tech bubble and recession on our front pages everyday. It was during this time that I first discovered oil royalty trusts as an investment. It was like a light coming on for me. I could get a monthly payout based on oil prices ... what a fabulous idea. I bought in and was amply rewarded. Late summer of 2002 my career brought me to Alberta and I quickly learned, if there is one things Canadian like to invest in, it is natural resources stocks. I soon found Canadian oil royalty trusts to invest in, and I was amply rewarded. However, there are subtle and important differences.
The Tale of the Tape
U.S. based oil royalty trusts are simply pass through vehicles. There is no management or employees. There is no strategic vision or mission statement. There is simply a piece of land sitting on oil producing property with lawyers collecting and distributing the royalty. Brilliant!
The trade offs? Well, you get the volatility of the oil price, and believe it or not there are months when oil prices do go down. You own a depreciating asset, and when the reservoir is finally drained your trust will be worthless. As such, part of the income you are collecting is actually a Return of Capital which is lowering your purchasing price. You will be lowering your dividend income today but will eventually get hit with the capital gains on the back side. You are also beholden to the drilling levels on the land. Any number of things can impact you, such as weather, lack of drilling equipment, shut ins, etc. In the end, you get a monthly payment but you never know how much until you open your mailbox or bank statement.
In Canada the trust structure has changed since I arrived in 2002. The trust was a vehicle for companies to pay generous distributions to the unit holders with no corporate taxes. Since it was such a tax efficient set-up, too many companies jumped on the band wagon and the federal government had to change the rules. By in large, Canadian oil trusts have converted to corporations and now pay dividends. However, they have that meddlesome corporate tax burden. What differentiates a Canadian (former trust) oil producer is the fact it is a company. There is management, there is land acquisition, mergers, forecasts, strategic plans, etc. Most importantly, there is management of the dividend. It should be steady and reliable.
So the question; Is there value in blending a volatile U.S. oil trust that is leveraged to oil prices with a Canadian oil producer that pays a predictable stream? To answer this I will use the rear view mirror and assume $10,000 initial investment on January 1, 2008, and look at three scenarios. Scenario 1, 100% allocation to San Juan Basin Royalty Trust (SJT). Scenario 2, 100% allocation to Crescent Point Energy Corporation (CSCTF.PK). Finally, Scenario 3, 50% allocation to each.
Scenario 1: On January 2, 2008 we buy $10,000 of SJT
We now own 287 units at $34.80 and just a few weeks later our monthly checks start rolling in. In our first few months we look like geniuses. Our unit prices are moving smartly and every distribution check is getting bigger. Our first distribution check is $64 and in months our distribution has doubled to $129.15.
But, hold on. Just seven months after we fired out of the gate we our down 60% in unit price and our monthly payout is $1.72. For the three month period of April-May-June 2009 our total distribution is a paltry $10.91. If we had implemented this buy and simply held on through thick and thin our initial investment of $10,000 would today be worth $6,800. Well that’s no fun. Did our income at least offset that? Nope. The total distribution income would have been $1,963.
If our purpose is income, the typical purpose for investing in a royalty trust, what other data can be gleaned from reviewing the numbers? The median distribution would be $37.45. The mean distribution would be $40.90 with a standard deviation of a whopping $26.06. That means approximately two-thirds of the time your monthly distribution will be $40.90 +/- $26.06. I don’t know about you but I would not plan any essential activities around an income that could be 65% less than average on a regular basis.
Scenario 2: On January 2, 2008 we buy $10,000 of CPG
We now own 403 units at $24.82 and just a few weeks later our monthly checks start rolling in. For the first few months CPG pays a $0.20/unit distribution and then raises that to $0.23/unit in June 2008. The distribution has not changed.
In June 2009 the trust converts to a corporation. Because of the solid, predictable dividend and the fact it is a company the stock is able to trade based on the fundamentals of the oil and gas markets and the ability of management to meet results. As such, while our dividend does not change from month to month, our $10,000 investment has grown to $18,000. Yay! However, should there be a short term spike in the commodity we would, at best, see only a short term spike in stock price. Unless we decided to realize that gain, there would be no lasting benefit to the shareholder. The total dividend/distribution in this term is $4,388.
Scenario 3: On January 2, 2008 we buy $5,000 of SJT and $5,000 of CPG
Why would we do this? We have seen that buying CPG in January 2008 was clearly a better investment in terms of monthly income and capital appreciation. Yes, that is the benefit of the rear view mirror. In January 2008 we certainly could not have anticipated the outcome of the investments and let’s not forget, after just nine months SJT was rocking.
The point here is diversification is still important and there are many ways to think about diversification, not just across asset classes. We can diversify across borders, across currencies, across structures, across dividend methodologies or any other number of ways you can think of. Also, as we hear with every disclaimer, past performance is no guarantee of future returns.
So for the purposes of showing diversification is a good thing let’s complete the exercise, especially for anyone that was inclined to think SJT from the start. An equal weighting of the two holdings would have given us 144 units of SJT and 201 units of CPG. Our equity value today would be $12,461, not too shabby. Our total distributions would be $3,173. When we look statistically at the income, we have a monthly median of $66.12, a monthly mean of $65.02, and the standard deviation came all the way down to $12.81.
Disclosure: I am long Crescent Point Energy.