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February 24, 2009

In Energy We Trust

There are two facts of which I am certain with regard to energy resources on this planet. First, the problem of experiencing a dearth of resources has not gone away. The issue is simply in remission while the globe works its way through a depression. Second, with crude oil prices sitting below production costs in most regions, exploration and drilling is at a standstill. In areas imposing higher extraction costs, in fact, the pumping has stopped. It does not take a quant to add these numbers up: when global demand returns, which it will, oil production simply will not expand fast enough to keep up. If you thought energy prices hurt at $140 per barrel, wait until they are twice that level.

One method of capitalizing on the next round of the energy bull market is through the purchase of Canadian Royalty Trusts. Like REITs in the United States, Canroys distribute the bulk of their earnings as dividends in order to maintain a tax free (pass through) status. The benefit of this structure is that as earnings expand, both the stock price and the dividends rise. Based on historical distributions, the payout rates at $200+ oil could easily eclipse 100% of current prices. For example, at its peak distribution rate (2007-08), Penn West Energy was paying unit holders $4.08 per annum. Should oil soar into the $200s, margin expansion could place profits high enough to pay distributions of $9 or more per annum. PWE currently trades at $9.30.

The caveat... and as I incessantly remind readers, there always is one... is that Canada intends to begin taxing the trusts as corporations in 2011. The new tax status removes the requirement that the bulk of earnings be distributed. There is no doubt that the structural change will reduce payout rates. However, the change in tax treatment has been fully priced into shares for quite some time since the Canadian goverment announced the change in 2006. There are numerous efforts in motion to reverse the decision, and any positive development along these lines would provide an instant boost to share price on the order of at least 50%, judging by the downward reaction to the news in 2006.

In selecting which trusts to buy, I was looking primarily for two characteristics... or rather lack thereof. I excluded any trust which has relied on private placements to meet cash flow requirements. Private placements are highly dilutive and usually contain terms quite unfavorable to existing shareholders. I also excluded any trust which had a large amount of foreign holdings. Cash flow is much more secure when the resources are contained in North America.

Timing the purchase of investments is the counterpart to determining which ones to make. By no means do I see an economic expansion on the horizon, so oil demand is not likely to expand in the next few months or even quarters. However, big money doesn't always wait around for the obvious signs, so rather than wait for news, we can take our cue from the charts. One of the trusts on my short list, the aforementioned Penn West Energy, looks to have been the recipient of quit a bit of accumulation recently:

stock chart

stock chart

Two other trusts I have on my radar are PGH and CNQ. For the record, I've opened an exploratory position (pun intended) in Penn West. I'm not one for the absurd notion of dollar-cost averaging. I prefer performance-cost averaging, meaning if the shares behave as expected, I will add more. The intention is to eventually build a 10-15% position.


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