Be wary of energy trusts

The headline on the front page of The Globe’s Report on Business made it seem like big news: Energy trusts deemed risky, it read. The story, published in January, quoted a report released by Standard & Poor’s on the popular oil and gas income trust sector. The article pointed out that distributions from these trusts will fluctuate with the rise and fall of crude oil and natural gas prices and noted that the reserves of these trusts could decline to the point they are no longer viable.

Is anyone surprised at this? The volatility of the energy trust sector has been obvious for years and I have warned about it on several occasions here and elsewhere. That’s the reason why the cash-on-cash yields of most oil and gas trusts are so high. Viking Energy Royalty Trust (TSX:VKR.UN), for example, was recently yielding about 17.4 per cent based on a projected monthly distribution of 8c per unit.

The high risk factor is why we do not have a lot of energy trust recommendations in The Income Investor newsletter, which I publish. The only exception at present is Peyto Energy Trust (TSX:PEY.UN), which closed on March 8 at $29.40 (it was recommended in Sepmber at $19.90), for a projected yield of about 6.1 per cent. Unlike most other energy trusts, Peyto does its own exploration and development and holds rights to some of the most productive and cost-efficient natural gas reserves in Alberta.

Canadian Oil Sands Trust (TSX:COS.UN) is the only one that has a long-term reserve life because it is involved in oil production from the vast Athabasca Tar Sands. However, it is an example of the high risk involved in this sector. In early March, the trust announced that it is facing huge cost overruns relating to phase 3 of the Syncrude project and that the completion of the work has been delayed several months. The share price immediately plummeted by more than $8. This is the sort of thing that can happen in this volatile sector.

When not to be scared away
The issue of reserve life can be overstated and investors should not be scared away from a quality energy trust because of it. The reality is that a well-managed trust is able to continue to add new reserves over time, either through their own exploration and development (e.g. Peyto) or, more commonly, by acquisition (e.g. Pengrowth).

Pengrowth (TSX:PGF.UN, NYSE:PGH), for example, has successfully replenished its reserves for years, primarily through acquisitions. At the end of 2002, total reserves were actually 29 per cent higher than they were in 1997 (final 2003 figures are not yet available). So although the trust has a reserve life index of 11.1 years, it does not mean that the wells will run dry after that. What it does mean is that the trust will have to spend more money to maintain its reserve base and, with energy prices so high, that could mean a drain on distributable income. So far, however, Pengrowth’s management has been able to acquire good producing properties without that happening.

The bottom line is that you need to be selective if you want to add an energy trust to your portfolio. Those with the highest yields are usually not the best choice. The ideal energy trust will have a long history (part of which may be as a corporation before the trust conversion), strong management, and a record of adding to reserves. Steady distributions would also be an advantage but few energy trusts can offer that because of their sensitivity to oil and gas prices.