Of Note:There has been some talk that the Conservative Party in Canada may submit a proposal for a new trustlike
structure in its next budget.
There has also been talk that the Liberal Party may support rolling back the maximum 2011 tax to 10%.
However, both these scenarios are only speculative.____________________________________________________________________________________________
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Canadian royalty trusts (CANROYs) are oil and natural gas producers that have gained the interest of investors because of the
high-income distributions they pay—anywhere between 6% and 13%. These trusts are able to pay these distributions because they don’t have to pay Canadian corporate income taxes (31%) as long as they distribute their income to shareholders. Income distributions are similar to dividends. However, technically, trusts pay out income distributions, while corporations pay out dividends.
Another appealing point for investors: U.S. trusts pay out cash flow generated by existing properties but are not allowed to acquire new properties. As such, cash flow declines over time as assets are depleted.
Canadian trusts, on the other hand, can acquire new properties. So, theoretically, they can pay out indefinitely.
However, beginning in
January 2011, CANROYs will be required to pay corporate taxes. One concern has been that, as they are required to pay these new taxes, they may significantly cut their income distributions, thus losing their desirability to investors who were attracted to them specifically because of their high yields.
There has been some talk that the Conservative Party in Canada may submit a proposal for a new trustlike structure in its next budget. There has also been talk that the Liberal Party may support rolling back the maximum 2011 tax to 10%. However, both these scenarios are only speculative.
According to most observers, though, the real determinant of what will happen to payouts by these companies will be what the prices of oil and gas do in the future.Analyst PerspectiveSo what will happen in 2011? “
My sense is that most of them will convert to regular corporations,” says Gordon Tait, a research analyst with Calgary-based BMO Capital Markets. “However, they will maintain the same managements, same asset bases, and same operating strategies.
Instead of paying an income distribution through a trust, they will pay a dividend through the corporation.”
As Tait sees it, the corporate dividend rates will depend a lot on what commodity prices are doing. “For example, a lot of these trusts reduced their distributions quite significantly when oil prices fell below $40 a barrel,” he points out. If oil and gas prices increase, this may increase CANROY distributions now, as well as their dividends when they convert to corporations.
However, there is no universal plan that all CANROYs will follow. For example, according to Tait,
one trust that has already converted, Advantage Oil & Gas Ltd. (NYSE: AAV; TSX: AAV), has cut its distribution off. Two others, Crescent Point Energy Trust (TSX: CPG) and Enterra Energy Trust (TSX: ENT.UN), also converted early but continue to pay out the same in dividends that they did in income distributions before their conversions. “
The market was very receptive to this, which sent a signal to the other trusts,” Tait says.
Another determinant of future dividend rates may relate to evolving corporate strategies. “For example, some of these companies may attempt to focus on growth and no longer feature dividends,” he adds.
Menal Patel, a senior vice president with National Bank Financial Inc., essentially sees similar things on the horizon. “
Most of these companies will be converting to dividend-paying corporations, either prior to January 2011 or on that date,” he says.
He adds that
if the yields are cut materially, these companies will lose the interest of some investors, especially those in the United States. Nonetheless, Patel anticipates only a modest trimming of dividends specifically related to the new corporate structures and resulting tax rate. Like Tait, Patel believes that a lot of what happens with individual companies will be a result of their strategies. “With the ones that change their corporate strategy a bit to focus more on growth, then yes, dividends could be cut even more,” he says.
The real determinant, according to Patel, is what the prices of oil and gas do. “
If oil goes back up to $100 and gas goes up to $6 to $7, then I don’t anticipate much decline in dividends,” he says
While BMO Capital doesn’t make specific recommendations public, Tait says that they “do favor trusts that have production weighted more toward oil than natural gas, as well as trusts with strong balance sheets.”
Meanwhile, Patel says that from a growth perspective,
there are certain trusts that have asset bases from which they can grow. Four of the most notable are ARC Energy Trust (TSX: AET.UN), Crescent Point, Daylight Resources Trust (TSX: DAY.UN), and Vermilion Energy Trust (TSX: VET.UN). He also sees potential, to a smaller degree, for NAL Oil & Gas Trust (TSX: NAE.UN) and Baytex Energy Trust (TSX: BTE.UN).
From a yield perspective, it is even more challenging to pick winners, Patel says. “I am hesitant to predict anything because strategies can be all over the place.”
PerspectiveIn sum, the good news is that the most complicated determinants as to whether to invest in CANROYs and their soon-to-be corporate structures may not be the most important determinants.
The most important determinants may well be something simpler: what the prices of oil and gas will be in the future. Now, if you just had a crystal ball to figure that out.
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William Atkinson
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