Last month may have been the season for giving, but for some Canadian royalty trusts, it seemed the right time to drop a proverbial lump of coal into the Christmas stockings of their unit holders by drastically slashing their monthly distributions. The Boards of Advantage Income Trust (NYSE:AAV) and Baytex Energy Trust (NYSE:BTE), both announced that they would be cutting their payouts by 33% and 28% respectively. Analysts are now projecting that most if not all of the remaining royalty trusts will also follow suit, and cut their distributions over the coming year.
Weaker Energy Prices Have Reduced Cash Flow
The decision to reduce payouts is largely motivated by the immediate reality that existing distribution levels are unsustainable given the current level of oil and gas prices. A less immediate, but no less important, reason for cutting payouts has to be the fact that the deadline for the imposition of a 31.5% corporate taxes on trust entities is approaching rapidly. It is now less than two years away and is expected to divert an additional chunk of cash flow away from unit holder's pockets into the coffers of the Canadian government. (To learn more about this particular type of investment vehicle, be sure to read An Introduction To Canadian Income Trusts.)
Investors Buying Trusts
This drastically diminishes the appeal of these high yielding investments to income investors. But recently, the sector has begun to show signs of life following losses over the last year in the 70-80% range. While the recent uptick in oil prices is the obvious factor behind recent rallies in Advantage and Baytex. U.S. exchange lists Pennwest (NYSE:PWE) and Provident (NYSE:PVX) have also tacked on some sizable gains. Some investors may be seeing a silver lining in the pending payout cuts.
Trusts Put Cash Flow Back Into Exploration
With the fast approaching deadline for the unwinding of the income trust model; the only meaningful option open to the royalty trusts is to transform themselves into traditional oil and gas exploration companies. Cutting distributions increases the amount of cash available to put into exploration drilling and property acquisitions, activities that are considerably less costly to execute, given the drop in energy prices, than they were even six months ago.
It's a riskier proposition for unit holders than just collecting a hefty monthly distribution, but it is ultimately more sustainable, and potentially far more rewarding given the improvements in drilling technology. The recent move by the Alberta government to put some contentious royalty hikes on the backburner has also provided an incremental incentive for the energy trusts to divert more cash flow into drilling now.
The Final Word
Now that they've started the process of morphing into exploration focused companies, the Canadian energy trusts can no longer be viewed as income plays. That promises to make them attractive to a whole new class of less risk-averse investors.
Before jumping into this hot sector, learn how these companies make their money in our Oil And Gas Industry Primer.