O! Canadian Energy Calls Out

12/13/2012 10:00 am EST


Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

If you're looking to put some stocks into your tax-deferred accounts, now is a very good time to consider some solid Canadian energy stocks, notes Elliott Gue of Energy and Income Advisor.

On October 31, 2006, Canada's Finance Minister Jim Flaherty announced that his government would start taxing royalty trusts as corporations on January 1, 2011. A frantic sell-off ensued, wiping out about $35 billion worth of market value by the end of the next trading session.

The timing of Flaherty’s announcement and the severity of the subsequent plunge led market-watchers to dub the event the Halloween Massacre.

In the years leading up to the announcement, Canadian royalty trusts had become increasingly popular among income-seeking investors. Free from corporate-level taxation in Canada, these pass-through entities disbursed much of their cash flow to shareholders in quarterly or monthly distributions. Even better, the Internal Revenue Service classified these distributions as qualified dividends, ensuring that US investors paid a tax of only 15% on this income.

Memories of the infamous Halloween Massacre prompted many investors to swear off Canadian equities, a shortsighted move that overlooks the 48% total return posted by the S&P/TSX Income Trust Index from November 1, 2006, to December 31, 2010. In comparison, the S&P 500 generated a loss of 11.2% over this holding period.

Although most royalty trusts converted to corporations, Canada’s energy sector is still home to promising growth stocks and a large number of dividend-paying securities that offer elevated yields.

The country boasts some of the world’s largest oil reserves, from Alberta’s vast oil sands to emerging shale basins and a series of heavy-oil plays across western Canada. Our favorite upstream operators have the wherewithal to grow oil production significantly in coming years, while the surge in drilling activity and output has created opportunities in the midstream and oilfield-services segments.

And US investors shouldn’t overlook the benefits of exposure to the Canadian dollar. The nation’s financial system avoided the excesses that characterized the US credit bubble and emerged from the Great Recession in solid shape. Canada’s strong economy and fiscal strength should support the value of its currency relative to the US dollar and the euro—an appealing prospect for many of our readers.

Before we highlight one of our top Canadian energy stocks, here’s a quick review of the basic tax implications associated with equities that trade on the Toronto Stock Exchange: Investors in the US can claim the 15% withholding tax levied by Canada as a credit against their domestic tax liability. Even better, Canadian equities held in a tax-advantaged account such as an IRA or 401(k) aren’t subject to this 15% withholding tax.

With the US tax rate on dividends likely to rise in 2013, Canadian equities that offer a solid yield are a great option for retirement funds.

Suncor Energy (SU) became Canada’s largest integrated oil company after its 2009 merger with Petro-Canada, a blockbuster deal that included additional acreage in western Canada’s oil sands, as well as refineries and a portfolio of international upstream assets. The energy behemoth operates three primary business segments: refining and marketing (60% of 2011 revenue), oil sands (28%), and international and offshore (12%).

In the past, our investment thesis for Suncor Energy has focused primarily on the firm’s oil-weighed production mix and potential to grow output significantly from its assets in Canada’s oil sands, an operation that accounted for 46% of the company’s 2011 net income. Suncor Energy’s presence in the Alberta oil sands dates back to the 1960s, when the firm pioneered the first commercial-scale mining operation.

Oil-sands deposits contain bitumen, a heavier hydrocarbon that must be blended with a lighter product such as condensate or processed into a synthetic crude before entering the pipeline network for delivery to end-markets. Producers extract the bitumen in one of two ways:

  • Shallow deposits of the viscous hydrocarbon (about 20% of Canada’s reserves, according to the Oil Sands Developers Group) can be exploited via pick-and-shovel mining.

  • Oil sands located more than 80 meters (about 260 feet) below the surface require in situ production techniques that usually involve pumping steam into the formation, to increase reservoir pressure and heat the bitumen until the hydrocarbon can be pumped to the surface.

In both instances, the extracts undergo processing to remove water, sand, and other contaminants from the bitumen, after which the output is diluted with lighter products or upgraded into synthetic crude oil for transport to the marketplace. Much of these diluents come from gas-processing plants in western Canada and Enbridge’s (ENB) Southern Lights pipeline in the Midwest US, though additional import capacity has been proposed.

In the near term, Suncor Energy will continue to benefit from rising in situ output at the Firebag project, the first phase of which came onstream in 2004, and whose second stage flowed its first oil in 2006.

Suncor Energy’s oil-sands segment posted record quarterly production of more than 340,000 barrels of oil equivalent per day in the three months ended September 30, driven by infill drilling at Firebag 1 and Firebag 2, as well as a faster-than-expected increase in production from the third phase of the project.
These results are even more impressive when you consider that planned maintenance at the McKay River development and one of the firm’s upgraders—a facility that transforms bitumen into synthetic crude oil—constrained output.

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