Background
Energy Royalty trusts are neither stocks nor bonds, although they share some of their characteristics. Investment trusts are created to hold interests in operating assets, which produce income and cash flows that are passed through to investors. A "trust" is a legal instrument, which exists to hold assets for others. A "trust" investment that uses a trust (the legal entity) to hold ownership of an asset and pass through income to investors is called a "securitization" or an "asset-backed security".
The trust can purchase common shares, preferred shares or debt securities of an operating company. Royalty trusts purchase the right to royalties on the production and sales of a natural resource company. Royalty Trusts are attractive to investors because they promise high yields compared to traditional stocks and bonds. They are attractive to companies wishing to sell cash flow producing assets because they usually provide a much higher sale price, or proceeds, than would be possible with conventional financing. The investment characteristics of both types of trusts flow from their structure. To understand the risks and returns inherent in these investments one must go beyond their promised yield and examine their purpose and structure.
Oil, gas and coal Royalty Trusts pay monthly or quarterly dividends (royalties) based on the prices paid for their already discovered natural resources. Dividends currently range from 6% to 12% from the various Royalty Trusts available on either the New York or American Stock Exchanges. Separate operating companies are contracted to produce, market and sell the resources, so there is no exploration risk. The prospectus for these Royalty Trusts talks about "forecasted" revenues and earnings. Oil companies also realize that "proven reserves" have an element of guesswork, and that there might be less oil in the ground, or it may be more difficult to recover than expected. This means that the 10% "yield" is not fixed in stone. As with all investments, one must take the time and do a complete analysis.
U.S or CanadianThere are a few key differences between Canadian energy trusts and U.S. royalty trusts. U.S.-based royalty trusts (which are legally precluded from making acquisitions financed by new debt and/or equity and, therefore, cannot as readily replace depleted reserves) are essentially blow-down investment vehicles. Canadian energy trusts are very different. In fact, Canadian energy trusts have managed, during certain extended periods, to actually increase per trust unit production, discounted cash flow value and distributions, in addition to maintaining reasonable monthly or quarterly distributions on the trust units. The ability to acquire assets and finance them with new equity, combined with a tax-efficient structure, leads to a financial vehicle that is radically different from its U.S. counterpart.
Apart from the ability to grow and replace reserves, there are other noteworthy structural differences between Canadian energy trusts and their U.S. counterparts. The most significant difference relates to the substantial component of U.S. royalty trust assets that are actually overriding royalty interests, as opposed to the vast majority of Canadian energy trust assets, which are operated and non-operated working interests. In this sense, Canadian energy trusts are more similar to conventional oil and gas production companies (with no higher-risk exploration activities) than U.S. royalty trusts, which in many instances can be more accurately characterized as financially structured derivative instruments to oil and gas assets.
Canadian energy trusts appear to offer a somewhat higher yield than their U.S. counterparts, which may, at least in part, reflect the overriding royalty nature of the U.S. royalty trusts, cash flows (and, therefore, lower operating leverage and capital requirements). The U.S. royalty trusts typically have no debt, reflecting the blow-down character of their assets and operations and the absence of acquisition activity. Meanwhile, Canadian energy trusts do carry some debt, reflecting previous acquisition activity and development capital, which are typically funded, in whole or in part, with debt.
Some U.S. Oil, Natural Gas and Coal Royalty Trusts include;Most Canadian royalty trusts are listed only on the Toronto stock exchange. However, the following trusts are traded on either the New York or American Stock Exchanges.
For U.S. investors, the tax treatment of a Canadian royalty trust's dividends depends on whether the trust is registered in the U.S. as a foreign partnership or as a corporation. The differences are far too complicated to detail here. The Canadian government applies a 15% non-resident withholding tax on distributions to U.S. investors. However, U.S. citizens can apply for a refund for at least a portion of the amount withheld.
Some Royalty Trusts may also pay Section 29 Tax Credits if they are producing Fuel from Non-conventional Sources (FNS) such as coal seam gas (coal bed methane or CBM) and other fuels such as biomass methane from waste landfills or livestock manure. Tax credits may be used to reduce income tax from other sources of income (i.e. active, passive, earned, unearned, dividends, interest, rents, IRA and pension withdrawals. You should obtain specific income tax advice from a qualified tax professional before considering any investment.
Unit holder LiabilityCanadian trusts are not corporations, and in theory at least, unit holders have unlimited liability for the actions of the trust. In practice, however, most experts consider it unlikely that individual unit holders will ever be held liable for the trusts actions. However we are not experts on the subject, and recommend you contact a trust directly regarding unit holder liability before investing.
Other IssuesMuch of the attractiveness of investing in Canadian royalty trusts hinges on the trust's tax-free status. This status hinges on each trust's ability to qualify for Canadian mutual fund status. The status requirements are somewhat vague, but Canadian mutual funds are intended as investment vehicles for Canadian citizens. Some individuals within the Canadian royalty trust community have expressed concern that increasing participation by U.S. investors may cause the Canadian government to either restrict foreign (U.S.) ownership or otherwise change the rules. To avoid bringing that problem to the forefront, most trusts are attempting to limit foreign ownership to 49%, but there is no guarantee that staying below that limit will insure a trust's mutual fund status.
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