It may be time to start investing in the Canadian royalty space to get energy exposure despite the fact that sector has been hit with a perfect storm in recent months, forcing aggressive across-the-board cuts to distributions and sharp declines in share prices. With all of this baked into prices and some tailwinds starting to form, the sector may be one of the bigger values out there.
The most damaging dynamic in the space was the sharp decline in the prices of energy. After skyrocketing to all-time highs near $150, crude oil prices plummeted to 6-year lows. Because 90% of industry revenues came from upstream oil and natural gas production, the sharp decline in prices led to severe cash flow problems.
Meanwhile, operating costs increased along with the price of energy. Higher demand for labor in Canada combined with production cost inflation presented a significant challenge as the sharp correction in energy prices was not matched by an equally sharp decline in operating costs; prices initially fell much more quickly than costs. Cash flows immediately reflected the erosion of margins.
A less obvious weight on the trusts was the freezing of global credit markets. While the energy trusts were immune from the credit crisis for a while, it finally caught up with them as banks were forced to reel in credit facilities both long and short. Companies with existing lines of credit and bank borrowings were forced to repay debts more quickly than anticipated. This further dampened cash flows available for distributions.
All of these market forces impacted the CRT industry's ability to pay distributions, either through decreased cash flow or increased obligations. Share prices have reflected this, with enterprise values being priced for bankruptcy earlier in the year.
The good news is that all of these competing factors have forced the Royalty Trusts to tighten up their belts and pursue more conservative financial and operational strategist. For example, the industry's average payout ratio is just 57%, meaning today's post-cut distribution levels are extremely well-covered. This is also indicative of the financial state of the CRT'S.
Companies now generally have the cash flow necessary to sustain current distributions at prices as low as $30 BOE. Further, due to the past constraints imposed by lenders, balance sheets are now perhaps the strongest they have ever been in the industry.
Meanwhile, operating costs are finally declining as the termination of exploration and production projects by numerous companies in Canada has put downward pressure on prices. Global equipment inventories are at all-time highs, which also put beneficial downward pressure on costs. Meanwhile, companies have cut capex aggressively to further insulate cash flows.
One of the main concerns for investors in this space is the looming 2011 conversion deadline for Canadian Royalty Trusts. While it is true that trusts will be faced with a 31% tax rate on earnings after converting to dividend paying corporations, the average size of tax pools in the industry is enough to sustain dividend distributions at current taxable levels until 3 years after a conversion to a corporation. For trusts that convert in 2011, that means there will be no tax effect on distributions until 2013 at the earliest. For the trusts that convert prior to 2011, tax pools will protect distributions from the higher corporate tax rate until 2-3 years after conversion to a corporation.
Moving forward, the larger trusts are unlikely to convert to dividend-paying corporations prior to the January 1 st , 2011 deadline. Although the outlook for acquisitions at these depressed price levels is very bright, the larger corporations have enough margin inside the Safe Harbour restrictions to make any equity issuance necessary to acquire properties. It is possible that more of the smaller trusts may convert prior to the deadline if an acquisition target that looks attractive will come at a price that requires substantial equity financing.
So while it has been a seemingly unending parade of bad news for the Canadian Royalty Trust industry, it may finally be time to start looking at them again as values. The larger trusts such as ARC Energy (AET-U in Canada) and Enerplus (NYSE: ERF ) are also the most the stable. Smaller trusts like Zargon could be attractive takeover targets at these price levels. Either way, it has been a long time since these trusts have been this well off.