Canada has a long history as a haven — for prescription-drug bargain hunters, for instance, and for draft-dodgers. Soon, we might well add American investors to that list of shelter seekers.
A number of Canadian investment vehicles — most notably energy trusts — are asserting themselves as options for investors who want to hedge their exposure to American taxes and to the ups and downs of U.S. stock markets.
According to Leslie Lundquist, portfolio manger of Bissett Income Fund in Calgary, “Canadian energy trusts have provided U.S. investors a shield since the collapse of the NASDAQ bubble in 2000.”
How strong a shield? Over the past three years, the total return of Vancouver's Canaccord Capital's royalty trust index averaged 30 percent per annum.
True, Lundquist largely attributes this success to a positive correlation with West Texas Intermediate crude prices, which are improving. But the energy trusts in many cases are not correlated to U.S. markets, and, at any rate, they often present significant tax advantages.
Like master limited partnerships, trusts are tax efficient in that a significant portion of the cash distributed (typically over 50 percent) is considered a return of capital, providing investors a 50 percent tax shield. On an average trust yield of 12 percent, that means 6 percent is completely off-limits to Uncle Sam.
And it gets better. The 2003 Bush tax cuts place a 15 percent ceiling on dividends. That means for every dollar of cash distributed 50 cents is completely tax-free, while the other 50 cents is taxed at 15 percent. In effect, trust investors get 92.5 cents of every distributed dollar tax-free. By contrast, U.S. dividend investors get 85 cents of each dividend dollar tax-free, and trust distributions average over 13 percent per unit.
Canadian energy trusts are actively managed collections of oil and gas properties that are considered depletable assets. Since trust managers must keep a watchful eye on reserves to gauge depletion, the reserve life index, also called RLI, is a helpful trust metric.
Gordon Tait, trust analyst at BMO Nesbitt Burns, says trust reserve estimates tend to be conservative compared to exploration-company estimates because “trusts are geared only toward production and represent the lower risk side of the oil business.” That said, the Security Commission in Alberta province, where a good number of trusts are located, is adopting stricter rules regarding accounting for trust reserves. The risk inherent in reserve estimates was underlined during January when conservatively managed Pengrowth Trust revised downward its reserve estimates for Sable Offshore, dropping Pengrowth by 5 percent in a day.
That high return implies high risk is a proposition no less true in Canada than in the United States. Tait wants it known that trusts are not fixed income investments: “With trusts,” says Tait, “nothing is fixed. Oil and gas prices go up and down, so does output, so do cash distributions.”
Trust cash flows key to energy prices. With North American oil inventories currently near historic lows, that hardly seems a problem. But in 1998, oil prices fell to $10 a barrel, and some trusts cut their distributions to zero. Notes Tait, “It was pretty ugly.”
Trust payouts are made in Canadian dollars, or Loonies, which rose by double-digits against greenbacks in 2003, rewarding U.S. investors handsomely. That said, the effect of a strong Canadian/weak U.S. dollar is complex. A muscular Loonie weakens the trust top line; since oil is priced in (declining) U.S. dollars, trusts make less per barrel. Bruce McDonald, analyst at Canaccord Capital, expects “currency stabilization” going forward, claiming, “we could easily see U.S. dollars move 10 percent higher against Canadian,” (a prediction underscored by indications of a future easing from the Bank of Canada). A stronger U.S. dollar and weaker Loonie would lower returns to U.S. income-seekers, though a pre-translation 13 percent return would no doubt take away some of the sting.
Who to Trust
Among U.S.-listed Canadian trusts, “two solid performers with incredible track records,” in McDonald's words, are Enerplus (NYSE: ERF) and Pengrowth (NYSE: PGH). Enerplus is more “gassy,” with a production profile that is 57 percent natural gas; Pengrowth “oilier,” at 46 percent oil. Comparing Enerplus to Pengrowth is a contest of the virtuous: the debt/enterprise value ratios are 11 percent and 14 percent, respectively, against a trust average of 16 percent. Reserves at both trusts, despite Pengrowth's recent haircut, are above-average.
None of this has been lost on U.S. investors, who own 53 percent of Enerplus and 41 percent of Pengrowth. As McDonald notes, price appreciation accounted for over half of trust total return in 2003, as compared to an average of 21 percent the past three years. What made 2003 so different was the huge amount of new cash, much of it coming from U.S. buyers seeking to hedge against the declining dollar. The implicit logic: If the U.S. dollar soars in 2004, look for American income-seekers to shop elsewhere. Plus, both trusts now trade above net asset value. Says McDonald, both Enerplus and Pengrowth are “historically, a bit expensive.”
McDonald expects a “rocky first quarter” and advises investors to wait for a better entry point, particularly in advance of stricter reserve rules. The analyst also cautions investors to select trusts able to offset declines in commodity prices by raising production levels and to choose Canadian-listed names, rather than names more familiar to U.S. investors, which are overbought.
One trust that clears the bar on all counts is Canadian Oil Sands trust (COS:UN: TSX), which generates income from its 35 percent working interest in Syncrude, a consortium of oil companies developing the huge Alberta Oil Sands resource. (This resource is conservatively estimated to have an asset life of 35 years.) Though COS trust yields just 4 percent, the trust forecasts a 50 percent increase in Syncrude production over the next 18 months. In McDonald's view, that production increase will hedge oil price volatility, since the trust will be able to grow its top line even in the face of an oil price decline.
Canadian Oil Sands, “will have room to raise its distribution levels,” says McDonald, “though most other trusts have only room to lower them.”
Noting that Canadian Oil Sands is the only trust trading below NAV, McDonald says, “Here's one trust that may be worth talking to your U.S. broker about.”