How long can the energy trust phenomenon last in Canada?
For now the trusts are in full flight, soaring above their equity peers with the help of a strong Canadian dollar and breathtaking commodity prices.
With the price of crude soaring more than 60 percent this year, no trust has benefited more than Canadian Oil Sands Trust, the only one of 33 trusts that is a pure play oil sands investment.
COST owns more than a one-third stake in the giant Syncrude Canada consortium, netting about 85,000 barrels per day, and has posted a more than one-third gain (excluding cash payouts) in unit value to climb above C$60 on the Toronto Stock Exchange.
On the other hand, the COST yield has slipped to an abnormally low 3.2 percent, but that could be destined for a rapid course correction.
Brian Ector, an analyst at Scotia Capital, predicts the cash flow per unit will rise 75 percent above his earlier forecast to C$8.19 a unit in 2005.
One astute investor, Seymour Schulich, predicts that average oil prices of US$37 a barrel could see the units climb in value to C$115 within three years.
Ector isn’t so bullish, suggesting that COST units currently reflect oil prices of US$43-$45.
“The challenge investors face when it comes to the oil and gas royalty trust sector today is that the market, in our opinion, is essentially discounting very close to current spot prices,” Ector said in a research report.
Suggesting there is very little room left to move, he said “the term ‘priced to perfection’ comes to mind.”
What could dramatically alter that outlook would be a sharp upward adjustment in crude oil forecasts closer to the current trading levels above US$50.
Guichon picks
Greg Guichon, managing director and portfolio manager at Toronto-based Rockwater Asset Management, said that if analysts started basing their projections on US$50 oil, money would start pouring into the sector, which TD Securities said has already raised C$3.4 billion in equity and convertible debt this year, helping fund 24 acquisitions costing C$5.1 billion.
Guichon recently put the spotlight on several Calgary-based trusts, such as:
Harvest Energy Trust — With its emphasis on heavy oil, the trust has recently extended its reserve life index to 7.5 years from 4 years through property acquisitions and has recently added medium gravity oil to its mix.
Paramount Energy Trust — Because management has a large stake in the trust, Guichon says its interests are in line with the public unit holders.
Acclaim Energy Trust — Guichon has been enthusiastic about the trust since mid-2003, noting solid gains in its trading value and an 8-year reserve life index.
More companies likely to enter trust ranks
Bruce McDonald, an analyst with Canaccord Capital, has contributed his own picks by raising the 12-month target prices for three oil-weighted trusts — COST, Harvest and Viking Energy Royalty Trust, noting that U.S. investors are moving back into the Canadian trust market because of a stronger Canadian dollar and falling yields on 10-year U.S. bonds.
Of those conventional E&P companies waiting in the wings, Calgary-based investment dealer Peters & Co. predicted in a recent research note that those likely to enter the trust ranks are: Penn West Petroleum, which is awaiting a federal tax ruling, Compton Petroleum, Fairborne Energy, Ketch Resources, Real Resources and Resolute Energy.
Most on the list have seen their shares take off over the last month.
In their stampede to take over the older more conventional sector of the industry, oil and gas trusts have pushed their market value above C$30 billion — still not much more than EnCana’s market-cap of C$27 billion — and pushed their share of total Canadian crude oil equivalent production to about 12 percent.
Trusts add little or no production
But the fact that they add little or no production or reserves through exploration generates a sense of nervousness among many observers.
Paying out 50 percent to 90 percent of their cash flow to unit holders while depleting their asset base has all the ingredients for what Andrew Martyn, vice president at Davis-Rea in Toronto, warns is a “day of reckoning.”
Trusts have already tasted one setback in 1997-98 when a slump in commodity prices slashed 40 percent of their unit prices, triggering a round of consolidation. Another blip in 2001 wiped 20 percent and more off unit values.
The threshold for a repeat is estimated by Peters & Co. at US$30 a barrel for oil and US$5 per thousand cubic feet for gas — levels it believes would see the bulk of trusts reduce their distributions.
But not all trusts are ignoring the possibility of disaster, steering an increasing share of their cash flow into exploration and setting the stage for what FirstEnergy Capital said could be a “new era of sustainability.”
As strategies are modified, trusts are evolving into “fully functioning oil and gas companies,” according to PrimeWest Energy Trust President and Chief Executive Officer Don Garner, while Don Gray, president of Peyto Energy Trust, said no value can be created without drilling wells, questioning whether some of his peers can survive.
For now, much of the good fortune in the sector stems from the return of U.S. investors to the market.
If the U.S. dollar continues to weaken, American investors can only profit from Canadian-dollar denominated investments, said Canaccord’s Bruce McDonald.
