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Why oil and gas royalty trusts are bursting with energy

Oil and gas royalty trusts aren’t just doing well, they’re running ahead of equities, says this advisory — and they should be able to keep it up

It’s over. Tax returns have been filled out, sworn over, signed and sent on their way (except, apparently, for some Net filers). Now we can all start thinking about how to save on next year’s tax bill.

Of course there is one very prominent tax saving vehicle that is open to you for two and a half more years — income trusts. And there happens to be one group of income trusts that is gushing over with good news.

Oil and gas royalty trusts have been doing land rush business. No surprise, perhaps, when you look at runaway crude oil prices and the long-awaited recovery in natural gas prices.

But as in all races, not everyone is at the head of the pack. Some royalty trusts are well out in front. The Money Reporter, one of Canada’s foremost authorities on income investing, tells us which trusts are doing best, why they’re flying so high, and how long this party can be expected to go on.

Income trusts outperform equities

Although oil and gas trusts are the big winners, the fact is that income trusts as a whole are outperforming Canadian equities by a wide margin. No doubt this is a perpetual puzzlement to those who swore that trusts would be ploughed under shortly after the “Halloween tax” announcement of 2006.

But why look a gift distribution in the mouth? This income advisory points to five royalty trusts that put up “pretty performance numbers” in the month before it went to press.

Canadian Oil Sands Trust (TSX-COS.UN) led the way with a 15.1 per cent advance. Also in double digits were Enerplus Resources Fund (TSX-ERF.UN), with a 13.8 jump over the same period, and ARC Energy Trust (TSX-AET.UN), with a 10.5 per cent rise.

Freehold Royalty Trust (TSX-FRU.UN) is close behind with a 9.5 per cent increase, while AltaGas Income Trust (TSX-ALA.UN) is up 6.8 per cent. And none of these figures include their distributions, which average 9.2 per cent per year.

Some spectacular figures

Look at the year to date and some of the figures are even more spectacular. ARC Energy Trust is up 37 per cent, Freehold has gained 27 per cent and Enerplus has picked up 16.9 per cent. In this case, Canadian Oil Sands Trust trails a bit at 16.5 per cent. But if we go back a year, this oil sands giant has gained 56.4 per cent!

We could pile more numbers into the equation, but you get the picture. The one oddity in the picture is that all of these royalty trusts were outpaced in the past month by a lone outsider — CI Financial Income Fund (TSX-CIX.UN), which posted an 18 per cent gain. In the main, however, royalty trusts rule the roost.

The rise in prices is the main reason, of course, but there’s more to it than that.

An animal unlike any other

If you want to know why income trusts behave the way they do, says the Money Reporter, take a close look at what they are. Even when the income trust market was in its nascent stage, states the advisory, “we adamantly maintained our position that income trusts are an animal unlike any other.”

They are not a substitute for bonds. And they’re not a substitute for pure equities, either, even though the similarities are greater and they ride side by side on the S&P/TSX Composite Index. Income trusts are “a separate and distinct class of assets, with their own unique set of risk and return characteristics and correlations.”

With oil and gas equities it’s all about the rise and fall of the share price. But with the trusts, there’s something else at work — what does it take to sustain the cash distribution?

The best royalty trusts aren’t just rising with oil and gas prices, they have every chance to keep on doing well even if prices retreat somewhat (as they have by about six dollars since Monday due to several “we-haven’t-got-enough-oh-wait-maybe-we-do” news releases about supply). The advisory explains why.

Keeping profit levels up

“Prices can go up,” says this advisory, “even go up a lot, and still not be high enough to generate a profit.” But beyond a certain level, profits flow. Natural gas is generally profitable for the firms that produce it as long as the price remains above US$7.00/MMBtu (Million British Thermal Units). It’s at $10.93 now and hasn’t been below $7.00 since mid-October.

The situation is similar with oil. For instance, Canadian Oil Sands Trust pays a distribution of $3.00 per unit per year. It’s estimated that as long as oil prices average $90 a barrel, unitholders collect a net profit of $3.00 per unit. If we take that as the break-even point, then the higher the average goes above $90, the higher the net profit.

At Wednesday’s close, the price still stood well above that level at $113.46. It fell briefly under $90 on February 2 this year, but has not been consistently below that level since last October. “Remember, it’s the average price that counts,” says the advisory, “and the average has been well above $90 for some time.”

Summing up all the various upheavals and events that push the price of oil back and forth (including the onset of the summer driving season), the advisory opts for the higher side.

“Taken together, they show that oil could remain above the $90 average for quite some time yet, and natural gas above $7.00,” concludes the Money Reporter. “That’s why, even though the prices of our oil and gas royalty selections are up, they are buys.”

The market says that when commodity prices go up they must come down. But this advisory says that oil and gas prices are going to defy the laws of gravity for a while yet, and keep some rich distributions flowing.