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Energy trusts — taking the short and the long-term view

A leading authority on income trusts assesses the future of energy trusts in light of rising and falling prices, and has one last word on BCE.

Let’s pick through the wreckage and see what comes up. Despite yesterday’s upswing on the Toronto exchange, there have been a good many collateral victims of the past week’s market rout.

Crude oil is one of them. After ringing the bell at $100 a barrel at the beginning of the month, it has tumbled down to $89.95. But wait a minute — that’s still pretty high. A year ago, $80 a barrel seemed a lofty number.

In fact, the same fear of a looming U.S. recession that has afflicted the markets has also cut into the price of crude. If that recession spreads, the demand for raw materials will start to slacken around the globe. That’s the theory, at any rate.

Does that mean that energy will cease to be a worthy investment? Somehow we doubt it. But let’s not generalize. We’ll examine the question through the prism of energy income trusts. This means gas as well as oil royalty trusts, so the price of crude is not the only benchmark that counts in this discussion.

Up until a few days ago, energy trusts had been doing very well, according to one of Canada’s leading authorities on the subject, the Income Trust Guide published by the Money Reporter.

In the past month, each of the energy trusts recommended by this advisory posted gains: the least gain was 2.7 per cent by Freehold Royalty Trust (TSX-FRU.UN), the highest was 9.72 per cent by ARC Energy Trust (TSX-AET.UN).

Before we examine energy trusts in detail, we’ll get an assessment on the progress of income trusts in general. Afterward, we’ll get an update on the ongoing saga of the big deal at BCE.

Not like the good old days

Just three years ago, “it was absolutely a normal thing for income trusts not just to outperform common shares, but to do so by a wide margin,” comments the Income Trust Guide.

Since the income trust tax was announced on October 31, 2006, all that has changed of course. “These days, income trusts regularly underperform common stocks in terms of price, leaving us to determine whether the distribution on a particular trust is high enough to more than make up the difference.”

In other words, the difference in price between trusts and common shares is not the sole determining factor in the value of the trusts. They are different investments, which is why they achieved their popularity in the first place. Those cash distributions count for a lot.

Nonetheless, the price differential does offer a fair guide to just how well income trusts are doing on the marketplace. In general, the answer has been OK, but not quite like the good old pre-tax days.

So when there’s good news, “let’s have at it,” says the advisory.

A very good year?

The index numbers told an interesting story over the past month. While the S&P/TSX Composite Index, covering both common shares and trusts, fell 0.7 per cent, the Income Trust Index fell 0.9 per cent.

But it was a different story with the Energy Trust Index: it rose 2.5 per cent on the month, not counting distributions. That was 3.2 per cent better than common shares.

How unusual was this? Well, over the past three years, energy trusts had fallen short of the TSX by 14.73 per cent compounded. Over the past 12 months, it trailed the TSX by 7.1 per cent.

The advisory believes it could be “the start of a very good year for energy prices, if the consensus forecasts for oil and natural gas prices are correct even just in direction if not magnitude.”

This suggests that the recent drop in the price of crude is temporary, not a trend (and there is a veritable Tower of Babel of conflicting opinions on the subject, including one well-regarded observer who forecasts that oil is on its way up to $150 a barrel!)

The other side of this argument is whether the price is your only determinant in buying, holding or selling an energy trust or stock. Or, how far would the price have to fall to really cut a hole in the profits of the best energy firms?

There are no snap answers to that question, but we can examine the Income Trust Guide’s favourite energy trusts a little more closely.

A good opinion of natural gas

Among the rising tide of energy trusts mentioned above, the two names cited, Freehold Royalty and ARC Energy, are both holds at the moment, says the advisory. But three more royalty trusts are buys, and two are among the Best Buys This Month.

In these two cases, natural gas has prompted the good opinion of the advisory.

AltaGas Income Trust (TSX-ALA.UN) is sort of an all-purpose natural gas company, with a batch of services at its command. Says the advisory: “Natural gas prices have recovered from their doldrums of last summer, and some forecasters have them going higher through 2008. More importantly, they are now solidly above the US$7.00 MMBtu level that is widely considered the break-even level. That means gas producers will be needing the infrastructure that AltaGas provides.”

Enerplus Resources Fund (TSX-ERF.UN) divides its resources between oil and natural gas, but gets the advisory’s attention due to its added capacity in natural gas. “Just as natural gas prices started to rise along with oil prices, Enerplus gobbled up Focus Energy Trust for no cash, just units, which adds more natural gas diversity and a longer reserve life (RLI) to an oil company that already had the longest RLI in the conventional oil industry.”

The third Best Buy of the Month, by the way, is not an oil and gas energy trust, but it does resell gas as well as electricity — it is Energy Savings Income Fund (TSX-SIF.UN).

Testing the progress of energy prices

Meanwhile, the third energy trust that the advisory recommends as a buy is one of the biggest of them all, Canadian Oil Sands Trust (TSX-COS.UN). This is one of those investments that stands as something of a test of the progress of energy prices and investors’ patience with them.

With its enormous reserves (some 35 years’ worth) and its undivided emphasis on the oil sands, this trust looks across a long-term horizon that will pass through many ups and downs in the price of oil. Its production keeps on growing, but how will the trust hold up after the advent of the trust tax in 2011, or of sharper royalties from the Alberta government in 2015? We know the demand for energy will contract and expand from time to time, but it is hardly likely to diminish in the coming decades.

On top of all the other questions raised in this discussion, we have one more: would investors be wise to leave energy investments out of their portfolios altogether? We won’t presume to give a definitive answer to that one. It’s up to you.

We can answer the following question: Is that BCE deal going to get done? Barring a completely unforeseen chain of events, the answer is yes.

One more kick at the BCE cat

One of the most famous deals in Canadian history appeared to run into a little heavy weather. It has taken longer than expected for approval from the CRTC, so the deal has been pushed back into the second quarter of 2008.

In short, says the Money Reporter, you can fully expect the Ontario Teachers Pension Plan Board and its partners to take over BCE Inc. (TSX-BCE) as planned.

The odd factor out in this whole deal has been the share price. There doesn’t appear to be any doubt that the deal will be done at the announced price of $42.75. Yet for months the price has hovered around $39, and the market rout has kicked it down even further — to $34.95 at today’s opening.

If the market’s price doesn’t reflect the agreed-on price for the closing, does that mean the market thinks the deal will fall through? Not really, says the Money Reporter. This discrepancy “could be attributed to arbitrageurs having one more kick at the BCE cat.

“Hold BCE in anticipation of getting $42.75 when this deal closes, plus at least one more quarterly dividend.”

So there’s one thing you can count on. The one other thing we’d all like to count on is that the market won’t go down again tomorrow. Here’s hoping.