The scoop on royalty trusts
After two years in the dumps, royalty trusts are finally staging a comeback, particularly those based on the energy sector. In many cases, the yields are very attractive, but you must understand what you’re buying.
The cash-on-cash return is the figure generally quoted when looking at royalty trust yields. But all that tells you is the relationship between the current level of payments and the market price. The anticipated life of the trust doesn’t enter into the equation.
It should enter in to your calculations, however. These trusts are based on non-renewable resources. Sooner or later, the oil and gas properties that generate the cash flow will run out. That time frame is known as the Reserve Life Index (RLI). The shorter it is, the higher the yield must be to compensate for the fact that the resources will eventually run out if nothing is done.
Look at two specific examples. The Canadian Oil Sands Trust (CO.UN) owns a piece of the Syncrude project, which produces crude from the Athabasca Oil Sands. In this case, reserve life is not a major consideration since the Oil Sands are estimated to have a life of about 30 years and perhaps more. As a rult, the cash-on-cash yield from CO.UN is relatively low, at around 8% (trailing earnings).
Now consider Pengrowth Energy Trust (PGF.UN). This Trust is throwing off record distributions, and is currently yielding more than 16%. But Petro Panarites, who analyzes RTs for RBC Dominion Securities, sets the Reserve Life Index of this Trust at 15.1 years, about half that of Canadian Oil Sands. The Trust’s properties would be exhausted and the fund would generate zero income after that time, if nothing were done. That’s why investors demand the premium.
One of the main points to consider when looking at trusts with a relatively short RLI is whether anything being done to extend the reserve life. In this case, the answer is a strong “yes”. Pengrowth’s management has steadily added new reserves over the years to ensure that the Trust continues to remain viable. In fact, the RLI is longer today than it was a couple of years ago, proof of management’s success in making needed acquisitions.
That’s why Pengrowth has always been one of my favourites when it comes to energy trusts. I’ve seen enough evidence of management commitment and acquisition expertise to be satisfied that it is not going to wind down any time soon.
So when you’re looking at energy trusts, don’t be mesmerized by high yields to the exclusion of all else. Look closely at the Reserve Life Index. Then try to find out what the RLI was two, three or five years ago, if the Trust has been around that long.
If the RLI is steadily declining, there’s cause for concern. If it is holding steady or, better still, lengthening, it shows management is committed to creating long-term value for investors.