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:
- Asset quality: Ideally, a royalty trust should control a portfolio of oil and gas properties with abundant reserves and a low decline rate. Specifically, you'll want to take a look at the reserve life index, or RLI, which is calculated by dividing reserves by annual production volume. Mr. Tait said there are many royalty trusts with an RLI in the nine to 11 range, which is quite reasonable.
- A balance between oil and gas properties: Oil and gas prices tend to move in different patterns. By finding a trust that mixes the two, you'll have diversification that will offer a measure of protection if one or the other tanks. "If you were going to buy one trust, you'd want to make it one that was pretty balanced," Mr. Tait said. "But if you're buying a portfolio of trusts, you can buy a really gassy trust and mix it with a really oily one and get your gas-oil balance that way."
- Management: The test here is how effectively management has added reserves at a reasonable price. Check to see if the trust has been able to increase reserves and production without issuing a lot of dilutive equity.
- Payout structure: Roughly 80 to 85 per cent of cash flow will likely go to pay distributions, with the remainder being tabbed for capital expenditures so additional equity does not have to be issued. A higher payout ratio is not a good sign.
Not like the other trusts
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.