Buy Canadian Oil Stocks?

Editor's Note: This story has been updated since its original publication in the May 2011 issue of Kiplinger's Personal Finance magazine.

Surging oil prices and the powerful Canadian dollar are two obvious reasons to own Canadian energy stocks. Just as important is evidence that a change in Canadian tax law that became effective this year hasn't been as disastrous as some advisers and analysts expected it to be.

Attractive yields remain a major allure of Canadian exploration-and-production firms that were once set up as trusts but now have been reorganized as traditional corporations. Although their yields have been cut in half in many instances, the stocks typically pay in the range of 4% to 7%. That’s not anything to scoff at in a world where ten-year Treasuries yield 3.4% and money-market funds pay essentially nothing. And there’s no reason to think that these companies won’t deliver annual total returns of 10% or more as oil prices stay high and the financial markets put a premium on companies with secure sources, as opposed to those with oil reserves in, say, Iran, Iraq or Libya.

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What’s more, the strength of the Canadian dollar gives U.S.–based investors a dividend bonus. Today the loonie fetches $1.05 U.S. (compared with 80 cents as recently as 2009). So if you invest in a stock that pays out $1 Canadian per year, for example, you will actually collect annual dividends worth $1.05 in U.S. currency.

To partake of all these advantages requires nothing more than a brokerage account and a bit of background about the former-trusts-turned-corporations. Getting that information isn’t hard. These companies have some of the best-organized and most-informative Web sites I have ever seen in any industry.

If you’re unfamiliar with this story, it dates to 2006, when Canada’s government got sick of seeing all kinds of corporations, not just in energy, restructuring as trusts to avoid corporate taxes. As trusts, the firms didn’t have to pay corporate income taxes as long as they distributed essentially all their earnings to shareholders (it’s similar to the way real estate investment trusts work in the U.S.).

Canadian legislators infuriated investors and advisers on both sides of the 49th parallel by forcing these entities to restructure as corporations, making them liable for corporate-level taxes before they dispense any dividends. Share prices plunged on the logical assumption that the trusts would have to slash dividends, cut way back on capital expenditures or do both if they had to start paying income taxes. As a result, dividend yields soared beyond 10% (beyond 15% in a few instances). Analysts figured that some trusts would give up, that they’d sell off their assets, make a final distribution to shareholders and then close up shop.

A few trusts did vanish. But as it happens, most decided to stick around. Baytex (BTE, $61.04), Enerplus (ERF, $31.19), Daylight Resources (DAYYF, $11.60), Penn West (PWE, $25.60) and about 15 others now exist as corporations (stocks in bold are those I recommend; prices and related data are through April 21). Their executives decided to stay in business in large part because this is a fabulous time to be in the energy business in Canada. The nation is a Mecca for high-technology oil and gas development, mostly in Alberta, British Columbia and Saskatchewan. Alberta’s tar sands and shale formations in all of these provinces will easily supply billions of barrels of oil over the next several decades. They will also produce vast amounts of natural gas.

Exaggerated Tax Fears

Beyond the exciting production prospects, the remarkable part of this story is how the fears about damage from the new tax law are proving to be exaggerated. None of the newly reorganized oil and gas corporations have cut their dividends this year or have indicated that they plan to (although Penn West and Daylight cut their payouts in 2010).

Moreover, in their final years as trusts, most of the firms managed to accumulate “tax pools,” northern lingo for tax-loss carry-forwards. So, for example, Daylight should pay no corporate income tax until 2018, according to the Canadian investment firm Canaccord/Genuity. The rest have enough shelter to avoid paying corporate income taxes for two to six years. Afterward, these companies should be able to limit their tax liability most of the time to about 10% of their earnings, not the 30% the government and angry shareholders first assumed.

That will leave ample cash to pay decent dividends and to invest in the ground. So far this year, share prices are strong. The stock of Baytex, for example, has gained 30%. Thanks to the current spike in oil prices, energy-related stocks are surging across the board, but Canada’s ex-trusts are generating comparable appreciation with way more income than shares of integrated oil giants, such as ExxonMobil (XOM).

If you invest in individual issues, you should focus on companies that focus on oil rather than natural gas, which is cheap and abundant. Baytex is 80% oil, while Crescent Point Energy (CSCTF, $46.30) has slightly more. Vermilion Energy (VEMTF, $53.48) is about 65% oil and has six years of tax shelter. Enerplus, by contrast, is about 60% gas, although it predicts that the amount of its business from gas will fall to 50% by next year.

If you prefer to invest through a fund, consider Guggenheim Canadian Energy Income ETF (ENY, $22.81). The exchange-traded fund yields just 2.3% because it includes companies that don’t pay high dividends. But it’s still a good choice, because prospects for Canadian energy producers are so bright.