CANADIAN OILPATCH / ROYALTY TRUSTS
Be careful when buying royalty trusts
Returns appear high but there are potential risks
Where do we turn with interest rates so low and stock markets so high?
Something called royalty trust units are being promoted aggressively these days. Newspaper stock tables include some that appear to be spinning off double-digit returns.
Yet, as hot as the recent performance may have been, some versions of this hybrid investments have downside risks that novice buyers may not appreciate.
``Some of these trusts will never pay back the capital invested, much less provide a return on the money,'' predicts Bill Hammett of Majendie Charlton Securities Ltd. in Calgary.
Hammett's concerns apply specifically to certain royalty trusts that were formed to tap conventional oil and gas reserves.
Other trusts have been formed to operate assets with a longer life expectancy, such as mines, oil-sands plants, commercial buildings and gas-processing plants. These have their own advantages and disadvantages.
While Hammett acknowledges that the risk of loss in a conventional oil royalty trust is significantly less than with junior oil explorers, there is still some risk.
Under no circumstances should a cautious investor view this kind of trust as a secure alternative to earning income from a government bond or a blue-chip corporate share.
Greg Guichon, vice-president of ScotiaMcLeod, said investors need sound advice before they venture into these increasingly popular investment vehicles.
Almost $3 billion has flowed into royalty trusts in the past two years.
``Past performance is not a reliable indicator of future performance and risk factors will vary from trust to trust,'' said Guichon. ``Choosing between trust units is like choosing between stocks.''
Energy trusts buy mature oil or gas reserves from other energy companies, carry on production and then distribute available cash flow to the unit holders.
A variety of tax writeoffs may flow throw to the unit holders of some trusts. ``Each has its own particular tax aspects and has to be looked at very closely,'' said Guichon.
But purchasers should also be aware of the following:
Don't be fooled into thinking that the quarterly dividend, expressed as a percentage of the share price, will be one's true yield, even though the stock tables in some newspapers make that misleading calculation.
Part of the dividend of an oil and gas royalty trust is a return of capital. ``You won't know your true yield until you get your last cheque,'' said Hammett.
The value of one's investment could tumble if energy prices do not remain steady or rise. A sharp rise in oil prices - the one big upside potential for the trusts - is not widely expected for a decade or more. Prices could drop if Saudi Arabia were to turn up the tap.
Tired old reserves cannot be exploited at the same consistent pace year after year. Gradually, less and less can be extracted and production costs may start to exceed revenues. There are also costs of abandoning a well, said Guichon. ``Some trusts set aside money for abandonment and some don't.''
Because royalty trusts are not involved in exploration, there is not the same potential as with oil companies that do exploration.
Royalty trusts can borrow or take in more unit holders to fund the purchase of additional reserves, which helps to maintain the income of the early-bird investors.
Market conditions could change, making it difficult for the trust to acquire new reserves for production or to attract new unit holders. The growing acceptance of royalty trusts has resulted in higher prices for old reserves and higher profits for the promoters.
As with conventional oil stocks, price gains in the past two years have been fueled by rising oil prices and falling interest rates. A report prepared by Guichon's firm notes that the greatest risk facing energy trusts would be a combination of rising interest rates and falling commodity prices.
Both are a real possibility. A rising Canadian dollar could make matters even worse for oil and gas producers.
Guichon suggested Pengrowth Energy Trust and ARC Energy are two of the better royalty trusts that specialize in conventional oil and gas production. |
