Expert: Steven Taylor - 12/6/2006

Question
Steve

Last year I started dipping into the high yield Canadian oil trusts. Recently, the Canadian Government has announced that these trusts are going to be taxed starting in 2011. All of them seemed to have dropped around 25% since. However, the American Big oils, COP in particular, have announced big refinery changes to process this type of crude in the future. The theme of buying Canadian instead of Middle East is most likely still very strong. Isn't there going to be a rally in these stocks like PDS and PWE some day? Since the price of crude seems to be going back up, I would think they are still a bargain and subject to move up, but, what do I know?

Answer
Bill, this is a complex question, especially because we have to separate the taxation and law issues from the underlying commodity prices, as well as the fundamentals of each individual company.

Regarding the change in trust laws, I think it was inevitable that a change would be made. The Canadian Federal government was just losing far too much tax revenue to these trusts. Additionally, there was never any firm guidance about the taxation issue to begin with, so it was seen as a loophole that these conversions were going through to avoid the tax. If it kept up unchecked, just about every non-development company in Canada could have converted. The rules still might be modified, but I think the new rules will largely remain in place.

What that means for most of these trust companies is that they no longer will trade as income vehicles but instead more on their merits as growth investments. It will probably also mean there will be more mergers within the industries. In terms of oil, the high prices are not going away, and Canada is politically secure, so these stocks might trade at a premium. But, there is also the Kyoto agreement on the horizon - if Canada remains in and pushed the timetable up, it will have an effect on how these companies do business and likely increase costs. If you review the regulatory filings of these Canadian oil and gas stocks, you will find a risk factor about Kyoto which should be reviewed.

Because of the popularity of trust stocks in Canada and the premium valuations that they fetched for the last few years, a lot of companies converted to trusts that had absolutely no business doing so. Because of the trust structure, almost all of their income was passed through to trust holders and that left little capital for investments. Too many of these trusts, particularly in the oil and gas field, will need to replace their current reserves with new ones fairly soon, but have limited capital available to do so. This has been a problem with trusts from the beginning, but is worse now as their ability to go back to the market and sell additional trust units to pay for capital spending has been restricted by the changes. Even at a 25% drop, some of these trusts are overvalued while some may recover nicely (and/or be acquired by others). When reviewing the investment merits of individual trust companies, analyze how each would do as a non-trust company, paying particular focus to the quality and life of their assets. Some are very high quality and long-lived, while others may really surprise you.