Cash In On Canadian Oil Sands

By Matthew McCall | July 16, 2007 AAA

Traditionally, there haven't been many options for U.S. investors wanting to take advantage of the Canadian oil sands. This changed when Claymore Securities introduced the Claymore SWM Canadian Energy Income ETF (AMEX: ENY) this July 2007.

What's in a Name?
Do not be fooled by the "energy income" part of the exchange-traded fund's (ETF) name, thought it does serve some merit.
Claymore included this phrase in the name because the ETF has the option of buying Canadian royalty trusts along with stocks related to the oil sands. The royalty trusts are best known for their large distribution payouts, often in the double-digits.

Due to Canadian tax regulations, the royalty trusts are able to pass along income to investors on a monthly basis, thus resulting in a large dividend yield. Late last year the Canadian government announced plans to repeal the special tax status for the royalty trusts and the sector immediately took a hit. Most have yet to recover.

Bull or Bear
The ETF methodology attempts to combine the most profitable and liquid Canadian royalty trusts with the most highly focused and fast growing oil-sands producers. The stocks eligible for inclusion in the ETF are traded in Canada and primarily the Toronto exchange.

Depending on the current trend of the price of crude oil (bullish or bearish), the ETF will use one of two allocation strategies. At the end of each calendar quarter the price of oil is determined, and if the closing price is above the four-quarter moving average price, crude oil is considered in a bullish trend according to the ETF. If the price is below the moving average, the trend is bearish. (For more on stock market wildlife see, Stock Basics: The Bulls, The Bears And The Farm.)

Once the trend is determined it allows the ETF's management to allocate the stocks on the first day of the calendar quarter. During a bullish trend 70% of the assets will be investing in the oil sands and 30% in the royalty trusts. The exact opposite will occur during a bearish phase.

At the end of the second quarter, the four-quarter moving average was approximately $65 and the price of oil was above $70. Therefore, Claymore would implement the bullish phase strategy and have 70% of the allocation invested in the oil sands. The same could have been said about last quarter; however, at the end of the fourth quarter of 2006, the price of crude would have been below the moving average.

O China
Canada has China to thank for the large amount of investment it poured into developing the oil sands over the years. The growing population and infrastructure in China is demanding more fossil fuels. With the price of oil near record levels and supplies not growing, it has made the heaviest users of energy think outside the box for supplies.

There is currently a pipeline under construction that will link the Alberta oil sands to the Pacific Coast for easy transport to China. And who do you think was an investor in the project? You guessed it, China.

Second Place Isn't Always Bad
Canada is the second largest country in the world in terms of land area; it is also is the second largest country in the world in terms of global proven oil reserves, behind Saudi Arabia. In 2006, the Alberta oil sands produced 1.2 million barrels per day and that number is expected to double over the next decade according to the Trends Magazine article "Oil Sands: The Near-Term Strategic Energy Solution". Not only will China continue to take advantage of the abundance of oil in Canada, but hopefully the United States decides to take advantage of its neighbor to the north.

I feel the demand for fossil fuels, oil in particular, will continue to rise over the next decade and that supply will be stagnant at best. Simple economics indicates rising demand plus unchanged supply will result in higher prices. Throw in the geopolitical wild card with Iraq and Iran and the price of oil could see $100 in the next few years.

Top Oil Sands Plays
Two of the three largest holdings of ENY are also traded in the United States as ADRs. Suncor Energy (NYSE:SU) and Imperial Oil (NYSE:IMO) are two stocks that have benefited greatly from their exposure to the oil sands as investors all over the world have been buying up shares. In the first six months of 2007, SU gained 14% and IMO was up an amazing 26%. Both stocks are currently sitting either at or near new all-time highs, and I believe there is room for more upside in the future.

Oil Sands vs. Royalty Trusts
Because my long-term view on the price of oil is bullish and I believe the Canadian oil sands will become more prevalent players in the market, it makes sense to favor buying ENY. However, the one concern is the tax implications the royalty trusts may run into in the next few years. There have been rumors that the Canadian government may be second guessing the tax changes planned for the royalty trusts in the next few years. In reality, the special tax treatment is scheduled to be removed and we must assume it will happen.

If oil were to stay in a bullish phase, then I would be comfortable holding the ETF. On the other hand if oil took a turn for the worse, 70% royalty trusts would not be an investment choice I would make. Therefore, I will give the new Canadian oil sands/royalty trust ETF a half thumbs up for now.

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