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Canadian Royalty Trusts – Will Dividends Rise or Fall?

|Includes:Enerplus Corporation (ERF), HTE, PBA, PGH, PTF, PWE, PWI

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 unitholders (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 unitholders.

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 unitholders.

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 propertie, 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 (NYSE: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 (NYSE:ERF), Pengrowth Energy Trust (NYSE:PGH), Petrofund Energy Trust (NASDAQ:PTF), PrimeWest Energy Trust (NASDAQ: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 unitholders 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.

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