Wednesday, February 2, 2011
The deadline has passed.
As of January 1, 2011, Canadian royalty trusts no longer exist.
For many years, Canadian royalty trusts were great friends to the income-seeking investor. These companies were similar to MLPs or REITs here in the U.S. As long as the business passed 90% of its income on to shareholders, it could avoid corporate taxes. It was a great setup... Shareholders received big dividend checks. And the stocks rose as more investors wanted in on the yield bonanza.
Many oil companies went that route. It was easier than being a "real" oil company. Instead of taking exploration risk, they could buy older oil fields cheap and pass the income directly on to shareholders. The company would then command a market cap reflecting its dividend yield.
The only problem was, the Canadian government started "losing" lots of tax revenue as many conventional companies went the royalty route. In 2006 alone, nearly $50 billion worth of corporations became royalty trusts. So on October 31, 2006, Canada announced a plan to completely eliminate the trusts' tax benefits by January 1, 2011.
Trusts' shares collapsed in response. The three big Canadian royalty trusts – Enerplus Resources Fund, Penn West Energy Trust, and Pengrowth Energy Trust – all lost nearly a third of their value in just a few days. It turned out to be an incredible time to buy.
Soon, the market came back to its senses. It realized the deadline for the trust conversion was four years away. By midsummer 2007, all three trusts rose back up to nearly pre-announcement levels. It was an easy 40% gain in just six months.
We've got another incredible buy opportunity today. Let me explain...
Canadian royalty trusts that were forced to convert back to regular old corporations had two choices: continue to pay out a big chunk of earnings (after taxes)... or invest the after-tax earnings back into the business.
Royalty trust shareholders were in it for the yield. So former trusts that continued their payouts have soared right along with oil prices. Most of the trusts simply reduced dividends by 20% to cover taxes and kept right on pumping out cash.
But any former trust that cut off the income stream got left for dead. Take a look...
This chart compares Advantage Oil and Gas (the red line), a $1.2 billion former Canadian royalty trust, to Enerplus (the black line) and Penn West (the blue line).
Enerplus and Penn West exploit older, fully developed fields. At least 90% of their reserves are developed and producing right now. So the companies must continue to acquire production to grow. Because they're paying out their cash earnings, they'll have to take on debt or sell more shares to grow.
Unlike its larger cousins, Advantage chose to convert to a more traditional exploration company. It will use profits for capital growth rather than investor income. That will allow it to lower its debt and grow organically. While this is probably a more stable, sustainable growth model, the market hated it.
That looks like an opportunity to me. Choosing not to pay a 5% dividend doesn't make these companies worth 60% less than their former peers. Value investors haven't found the stocks yet... but they will. And these stocks will play catch-up.
Of course, not all those former trusts that quit paying dividends will make great investments. But they're a great place to look for bargains in the oil and gas sector today.
See what the world's best resource investor Rick Rule is pushing as the safest, smartest alternative to tanking in oil from the Middle East and South America here: A High-Income Bet on Rising Energy Prices.
"When things get just a little bit better," Matt says, "a beaten-down stock with great fundamentals is like a coiled spring being released." Learn how to spot these stocks here: How to Reliably Find Safe Stocks Poised to Skyrocket.