Two views on energy trusts

Recently I took part in a panel discussion that included some distinguished American newsletter editors. During the course of the session, the topic of Canadian energy trusts came up.

As the resident Canadian, I was the first to be asked for my views on their prospects. I said we were advising caution and that at present we had no energy trust buy recommendations in any of our newsletters except for Canadian Oil Sands Trusts (TSX: COS.UN), for capital gains, and Vermilion Energy Trust (TSX: VET.UN). Both are covered by my Income Investor newsletter.

Once I was finished, two of the American editors responded and they were in total disagreement with my comments. In fact, they are strongly recommending Canadian energy trusts to their readers right now, especially those that are interlisted in New York. Two that were mentioned specifically were Enerplus Resources Fund (TSX: ERF.UN, NYSE: ERF) and Provident Energy Trust (TSX: PVE.UN, NYSE: PVX). Their rationale was that despite recent distribution cuts, the funds still offer a good yields as well as capital gains potential if oil prices recover in the months ahead.

They may well be right, but I am reluctant to advise readers to rush to buy these trusts. I have a number of concerns. First, there is a real possibility of more distribution cuts to come. Penn West Energy Trust (TSX: PWT.UN, NYSE: PWE) recent dropped its monthly distribution from 34c a unit to 23c but warned at the time it could cut again depending on “changes in commodity prices, production levels, and capital expenditures”. Past experience suggests that any distribution cut will result in a drop in the share price. It’s easy to say the market had already priced in future cuts but that rarely proves to be the case.

My second concern is the uncertainty surrounding the introduction of the income trust tax, which is now less than two years away. There has been a lot of speculation about how the tax will affect payouts and some energy trusts have already announced they will convert to corporations before that happens. Most of the energy trusts have large tax pools but at this point we don’t know how they will be deployed. The closer we get to tax day, the more nervous investors will become, I believe.

But my greatest worry is the price of natural gas. Oil may move back to the US$50-$60 range later this year but natural gas prices are likely to remain depressed and could even fall from their current low levels. “There’s an oversupply of natural gas,” says investment manager Paul Bloom, who runs several income trust funds for Citadel Group and monitors the energy sector closely. “And to make matters worse, we’re about to see an inflow of liquefied natural gas (LNG) landing in North America from places like Abu Dhabi where they are willing to sell it at almost any price.”

As a result, Bloom is avoiding energy trusts that rely on natural gas for a high percentage of their production and sales. Most conventional energy trusts fall into that group. Instead, he is focusing on the “oily” trusts like Vermilion and Crescent Point (TSX: CPG.UN).

As for the oil sands plays like Canadian Oil Sands Trust, while he expects some recovery in share prices if crude moves higher, he feels that growing environmental concerns in the U.S. may hold them back. The latest issue of National Geographic, which depicts the oil sands in a highly unflattering light, is a public relations nightmare for Alberta.

With all this in mind, I continue to advise caution when it comes to the energy trusts. For more aggressive investors, my top choice is Vermilion which may be able to maintain its 19c per month distribution ($2.28 a year) because of its exceptionally low payout ratio (30% of fund flows from operations in the third quarter, the lowest in the sector) and the fact it is already paying tax on revenue derived from its foreign holdings.

Talk to a financial advisor before deciding if Vermilion, or any other energy trust, is right for you.

Photo © Kanstantsin Shcharbinski