Trust These Canadian Trusts

11/12/2004 12:00 am EST

Focus:

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

"I recommend that all fixed-income investors consider Canadian oil and gas royalty trusts as a fixed component in their portfolios," says Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor. Here, he explains the basics of these trusts and some top picks.

"Canadian oil and gas royalty trusts are not like oil exploration companies that expend monies searching for new oil reserves. No, these people buy existing proven reserves from companies who do. Companies who are the risk takers in the oil business, selling proven reserves that produce income over a long period of time for cash today to fund new exploration. It’s a win-win arrangement that works extremely well when prices are stable or rising.

"Given the double digit rates of return paid out by Canadian oil and gas trusts at even lower oil prices, it is small wonder that this sector is attracting increased investor attention. Such attention is warranted for a variety of reasons. For investors seeking steady monthly income, such funds offer high income not tied to the traditional risks, i.e. credit defaults or interest rate fluctuations. Here you are tied to the price of oil and gas, an awfully attractive tie right now. How long can it last? I don’t know, but those who play in this market see contracts for oil deliveries four years out being made at $40 a barrel. At $40 a barrel, most of these trusts could distribute higher payouts than they have over the last year.

"The Canadian trusts differ from those set up in the USA in two significant ways. First, they are allowed to replace reserves with new purchases. Hence, the trust can go on forever while the USA variety will eventually deplete all its reserves. The second difference is that the Canadian trusts’ dividends are eligible for the 15% tax treatment in the US versus full taxation for all the US dividends. Granted both countries recognize depletion allowance and a Canadian tax of 15% is withheld on the payouts which can be taken as a US tax credit, but these are mainly paperwork differences.

"An allocation of 5% to 10% would be a conservative allocation, which would not only enhance your overall portfolio return, but also diversify your interest rate exposure. Because of the high rate of return, I believe they are appropriate for either taxable or tax sheltered accounts. The 15% Canadian withholding can be removed for tax sheltered accounts by notice to the paying agent or, alternatively, by a refund request to the Canadian government. You should know that the Canadian government is enacting legislation that will require these trusts to be over 50% Canadian owned in order to continue to keep their tax free status. This will result in trusts issuing resident and non-resident shares in the near future, if they have not already done so. For US investors, this should prove a windfall since the demand for foreign shares will be much greater than for Canadian. This has already caused a price disparity to open up on those trusts who have split the shares, and I suspect this disparity will only grow unless some bright light figures out a way to circumvent these rules.

"Given all these trusts have going for them today, I see them as undervalued and not dependent on $50 oil to support current dividend levels. I first recommended Canadian Oil and Gas Trusts in August and if you bought them, you’ve done well. The trusts I recommended are Provident Energy Trust (PVX ASE) and Petrofund Energy (PTF ASE). If you bought them, you’ve done well. While these Canadian energy trusts have been hot as a pistol over the last two months, their run may be far from over. In addition, this month I am adding a new choice to my previous recommendations. Enerplus Resources Fund (ERF NYSE) is a trust, which is only 40% oil and 60% gas producing. Since these two energy sources are moving on separate tracks, there is less of a dependence on just oil prices. At a price of $32 the dividend yield is 10.3% (eligible for the 15% tax rate). The dividend is likely to rise substantially given the recent surge in oil prices. Note that the trust hedges about a third of its sales by forward contract. The reserves picture is also quite bright, currently at some 12.5 years production. Hence, they will not need to expand reserves in the current high price environment."

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