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TORONTO (GlobeinvestorGOLD)—Oil-and-gas royalty trusts are the black sheep of the income trust family.
An ideal trust is based on a steady, utterly reliable business producing a stream of cash flow that can be passed on to unitholders in the form of monthly or quarterly distributions.
Oil-and-gas royalty trusts don't fit the profile. Leveraged to oil and natural-gas prices, they can be unpredictable both in terms of paying steady distributions and the day-to-day performance of their unit prices. So why buy them? In a word, yield. Royalty trusts pay the fattest cash yields in the income-trust universe—as much as 13 to 18 per cent.
High return, high risk. As analyst Gordon Tait of BMO Nesbitt Burns Inc. in Calgary puts it, "There's a lot that can go wrong with royalty trusts." To help you avoid these pitfalls, let's look at some of the things you need check when choosing one:
Royalty trusts aren't just riskier than other income trusts, they also behave differently. Take their reaction to interest rates, for example. Back in 1999, a move up in rates put a damper on the trust sector as a whole, but rising oil prices helped royalty trusts do comparatively better. "Royalty trusts are an oil-and-gas play," Mr. Tait said. "Interest rates would have a minor influence."
The vagaries of oil prices make it a challenge for royalty trusts to maintain steady distributions to unitholders. To help offset this, royalty trusts commonly use hedging. Expect roughly 25 to 50 per cent of oil or gas production to be hedged using such instruments as fixed-price contracts. As well, it's well worth checking to see how a trust has managed its distribution flow over the years. You should be able to get this information on a royalty trust's Web site.
There has been a fair amount of talk in recent months about whether the three-year run-up in the income-trust sector has created a bubble. Generally speaking, it hasn't. In fact, the royalty-trust niche was actually a lukewarm performer in 2002. Through Dec. 9, the royalty-trust portion of the Scotia Capital Income Fund Index rose 1.9 per cent in unit-price terms and 15 per cent in total return (distributions plus unit price increase).
Are royalty trusts a buy? If you're looking for a high-yielding security and don't mind the volatility and risk, then they might well be.
Rob Carrick has been writing about personal finance, business and economics for more than 12 years.