TAKING STOCK

Royalty trusts no longer fit for a king

by Malcolm Berko

Dear Mr. Berko:
My broker sent me a copy of a Money Magazine article that he found in his dentist's office that recommended three Canadian royalty trusts with delicious-sounding dividends. Provident Energy at $10.50 yielding 13 percent, Harvest Energy at $24.25 paying 13.5 percent and Enerplus Resources at $42 paying 10.2 percent. Because they are all in the oil and gas discovery business they are good investments. And according to the article, because they are Royalty Trusts that pay all their income to their shareholders, they do not have to pay Canadian taxes and can pay that money to their shareholders. My broker wants me to invest $6,000 in each of these. What do you think?
W.S.
Vancouver, Wash.

Dear W.S.:
Some dentists are notorious for keeping old magazines in their waiting rooms. In fact, the dentist I use has a Time magazine with President Roosevelt's picture on the cover ... Teddy!

I glimpse Money Magazine when it comes out and I've not seen any recent discussion about Canadian royalty trusts (CRTs). So you might ask your financial adviser to revisit his dentist and check the date on that magazine.

Yes, many CRTs pay generous dividends (10 percent to 15 percent) and have a multiyear record of extraordinary dividend payments - which may stop abruptly as a rabbit's tail in January of 2011. Because Money failed to address this, along with its CRT recommendations, I'm certain as a sunrise that the article's date is pre-2006

CRTs can pay those generous dividends because they're not liable for Canadian corporate taxes, providing they distribute their income to shareholders. This seemed like a superb idea so a number of big non-energy Canadian companies began to convert their corporate structure to trust status and avoid paying taxes. But the Canadian government saw the scribbling on the ramparts and changed the rules.

Beginning in 2011, all existing trusts will pay taxes at the same rate as regular corporations. Darn, darn and darn, they killed the goose! This change may hurt most CRTs long before 2011 rolls around. Every time a barrel of oil or a cubic foot of gas is taken from the ground, the trust's reserves are drained by that amount.

Previously, a trust would compensate for the loss by using its high-yielding shares as currency to purchase additional assets. And that was an attractive inducement for someone who owned oil properties to sell. But now that those shares have lost their glitter, good acquisitions will be harder to find and without continuing acquisitions many CRTs will not be able to maintain their generous payouts.

So without incentive to pay its earnings to investors, many CRTs will use their cash (after taxes) to fund expansion, which is expected to reduce their distribution yields as low as 3 percent to 5 percent. So between now and 2011, some CRTs will convert to regular corporations, many will have to reduce their distributions as their reserves dwindle and some with significant reserves may continue their high pay outs until "boomsday."

Frankly, I think right now may be a wise time to unload CRTs rather than buy them because those Canadian geese are no longer laying golden eggs. And it saddens me to recommend the sale of Enerplus Resources Fund (ERF-$46.33) yielding 10.6 percent, Advantage Energy Income Fund (AAV-$12.84) yielding 11 percent, Pengrowth Energy Trust (PGH-$20.55) paying 12.8 percent, Penn West Energy Trust (PWE-$31.07) yielding 12.5 percent, Baytex Energy Trust (BTE-$26.75) yielding 8.5 percent, Harvest Energy Trust (HTE-$23.42) paying 15 percent and Provident Energy Trust (PVX-$11.15) paying 12.7 percent. These issues and I have been good friends during the last five or so years; they've paid marvelous dividends to our clients and maintained their values. And while I believe that these seven CRTs may not reduce their dividends this year, certainly some of them will do so by mid-2009.

However, we both know that months before that happens the insiders will dump their shares and their market values will begin to melt like butter on a hot skillet. So I'm reminded of some very special advice a wise man gave me years ago: "it's always better to sell too soon than too late."
I don't think that you should buy those CRTs and I suggest that you might consider telling your broker to change dentists.