Canadian Royalty Trusts Offer Relative Safety And High Income

By Eugene Bukoveczky | August 13, 2010 AAA

They're not exactly high flyers, but the Canadian oil and gas royalty trusts listed on U.S. exchanges should continue to attract investors' attention because of their high yields - up to 8-9 percent in some cases.

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Although their primary listing is on the Toronto Stock Exchange (TSX), interest from U.S. investors prompted many of these so-called "Canroys" to seek a New York Stock Exchange listing. Although most were eventually dropped, several larger operators like Baytex (NYSE: BTE), Enerplus (NYSE: ERF), Pengrowth (NYSE: PGH), Provident (NYSE: PGX) and Penn West (NYSE: PWE) continue to trade actively on the Big Board.

Major Tax Loophole To End In 2011

Originally set up as trust structures to take advantage of Canadian tax rules in force at the time that waived the payment of corporate taxes, these Canadian royalty trusts now face a year-end deadline to revert back to corporate entities following the closure of that glaring tax loophole by Canadian tax authorities.

However, despite facing the prospect of having to pay out a higher portion of their free cash flow into government coffers, most are determined to continue paying out the lion's share to shareholders as dividends. Some, like Baytex, have even declared they will try to maintain their current payout level after the year-end tax deadline passes.

Canada U.S. Tax Treaty Should Still Benefit American Investors

For U.S. investors interested in this sector, it's important to understand that the net amount of the dividend received will depend on the U.S./Canadian exchange, as they are paid in Canadian funds, and the amount of withholding tax charged by the Canadian government on distributions to non-Canadian residents. At present, a tax treaty between Canada and the U.S. limits that withholding tax bite to 15 percent, a portion of which can be recovered from the Internal Revenue Service (IRS) as a foreign tax credit.

New Technology Prompts Canadian Conventional Oil Recovery

Keeping these fairly generous cash flows going is ultimately a function of how much oil and gas these companies can produce, and at what price they can sell it. Those deriving a greater portion of their cash flows from natural gas sales were hit hard when the price of natural gas fell sharply a few years back.

Generally, the oil and gas fields they exploit are relatively mature and well understood geologically, limiting exploration risk. Recent technical advances in the industry, such as 3D seismic and advanced horizontal drilling and multi-stage fracturing, or "fraccing", have facilitated extraction of oil from fields previously dismissed as uneconomical. This technology prompted a renaissance of conventional oil exploration production in Western Canada, in which many of the trusts are heavily involved with continued steady production gains as a result.

The Bottom Line

For those investors looking for the relative safety of high yielding shares, the Canadian royalty trusts should fit the bill. (For related reading, see An Introduction To Canadian Income Trusts.)

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