Soaring Oil Trust Yields

Late in September the investment arm of Abu Dhabi National Energy announced an unusual takeover: It put up $5 billion to buy PrimeWest Energy Trust for $26.75 a share. PrimeWest is a Canadian oil and natural gas royalty trust that sells 50,000 barrels of energy (oil and its gas equivalent) per day and each quarter collects 200 million Canadian dollars, which is now the equivalent of $200 million in U.S. currency.

In response to the takeover announcement, the stock (symbol PWI) leaped 30%, to $26.25. It closed at $25.03 (U.S. dollars) on October 3, down 5% for the day.

Based on the trust's last twelve monthly distributions, which total $3 Canadian, PrimeWest sports a yield of 11.7%. It had been yielding 15% before the units (the term for shares of a trust or partnership) soared on news of the buyout, which is likely to close in November.

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Some Canadian politicians harrumphed about the national-security implication of selling an important asset to an Arab nation, but the government is unlikely to nix the deal or scare off the buyer. Even if Canada enacted a law to let the government review foreign purchases of energy reserves, it almost certainly wouldn't undo previously done deals.

The trusts have recovered nicely from a big drop last year after Canada enacted legislation that would have the effect of forcing many income trusts to reorganize as corporations, effective in 2011. Currently, Canadian trusts operate similarly to U.S. royalty trusts and real estate investment trusts. As long as the trust passes through most of the income it generates to shareholders, it avoids or defers income taxes.

The change would cut into the cash available for dividends and, in theory, cause either the shares to fall to maintain the yield or for the yield to shrink. But investors realized 2011 is a ways off and that, like Hong Kong after the handover to China, there's still money to be made from oil and gas in the ground in Alberta.

Still, the response of trust prices to the PrimeWest buyout has been surprisingly muted. Few of the other trusts soared after the announcement, despite the implication that many, if not most, of them are undervalued and are ripe for plucking by energy-hungry buyers.

Meanwhile, current yields on many of these trusts read like those of a roster of junk bonds issued by companies in bankruptcy: Harvest Energy (HTE), 17%; Canetic Resources Trust (CNE), 15%; Penn West Energy Trust (PWE) 13%, and Enerplus Resources (ERF), 11%. High yields generally suggest big risks, but how high can the risk be for trusts that own proven energy reserves?

Here's yet another puzzle. Because of the appreciation of the Canadian dollar (or the depreciation of the buck, if you prefer), the dividends from north-of-the-border trusts are no longer worth less than dividends in dollars.

So, in addition to higher dividends stemming from rising energy prices, you get the benefit of a stronger Loonie. Instead of translating a 14% Canadian yield into a 10% yield in dollars, you get the whole caribou. (There is a 15% Canadian withholding tax, but you can get it back from the Internal Revenue Service as a credit on foreign tax paid if you hold the shares in a taxable account. You don't get the break for tax-advantaged accounts, such as IRAs and 401(k)s.)

You'd think U.S. investors would be buying these trusts hand over fist. If they were, the units would be 50% higher, bringing their yields into line with other income investments.

Several trusts exhibited at a recent hard-money and natural resources investor show in Washington. When asked why the yields were so high, representatives of two of them said they didn't know and surmised that the market has just decided this is what they are worth.

There is optimism galore. And, frankly, there should be. Until the price of oil and gas starts to fall sharply, something that's unlikely unless there is a global recession, or Canada restricts investment in the energy sector, these investments offer about the best ratio of reward to risk that one can imagine.

One risk, of course, is the possibility of dividend cuts. But there's little talk of that. Consider Enerplus, which has paid 42 cents a month for two years. Although oil is priced in U.S., which means the real price in Canadian currency is falling, it has gone high enough to compensate for the move in the exchange rate. Enerplus has ten years of known reserves and several drilling and exploration programs, plus a piece of the famous Alberta tar sands from which energy companies are producing synthetic crude oil. So, Enerplus offers growth potential as well as substantial income.

That still doesn't explain the high yield. One drag on the share prices is that the province of Alberta, the source of most Canadian energy, is considering a big hike in the tax it collects off the top, from 25% to 30%, on energy production, says David West, a Toronto investment adviser and contributor to Canadian investor blogs. The Calgary Herald recently reported that the overwhelming majority of Alberta residents support a higher tax, which the energy industry is fighting. In my view, a local tax increase of this size isn't enough to overturn the case for these terrific investments.

Another concern holding down unit prices is the possibility that some trusts will convert to corporations. Canadian Oil Sands Trust (COS.UN), which owns 37% of the largest synthetic crude project and whose shares have rocketed from $5 to $35 (Canadian) in five years, is already weighing a conversion.

Since 2005, the trust has boosted its distributions by 300%, and it now yields 4.5%. The low yield reflects the higher capital investment needed to turn tar into sweet crude. Over time, profits should continue to grow handsomely and more of your return may come from growth rather than yield. Is that so terrible? No.

Over the years, supportive investment advisers have expressed amazement that the yields from various energy-related income-pass-through entities have generally trounced those of bonds and real estate investment trusts. The reason: Trusts are little known and little covered by professionals. Yet you can buy them with the same click of a mouse that you can buy ExxonMobil shares or a mutual fund.

Don't let their obscurity deter you. Trusts are a wonderful way to ride the energy boom and the strong Canadian economy.