How To Pick Oil And Gas Trusts
One great reward about being a blogger is the new insights you gain from researching and presenting articles. It’s one thing to skim over the Internet for the lowdown of income trusts, but quite another to articulate them to an audience. So much to learn still despite spending a couple of evenings on O&G trusts. Well, this post wraps up my part on the income trusts series initiated by Thicken My Wallet. I hope you’re enjoying it so far.
Saving the worst for last, oil and gas trusts are probably the most provocative group of all.
O&G trusts are holding structures that own the right to royalties on the production of natural reserves. These trusts do not engage in explorations. Instead, they negotiate and buy royalties from exploration companies. These exploration companies will generally stay behind to manage the production, but the trusts and their unitholders own the right to the stream of profits from the reserves. The one key difference between investing in O&G trusts and most other investments is that at the end of the day, your equity vanishes! Poof! Your objective is to squeeze every drop of your money back from the reserves, and hopefully a little more to compensate you for the risk-taking.
On the surface, O&G trusts have few bright spots:
- No exploration risks
- Reserves are well known
- Productions are well known
- Operation costs are well known
Alas, these trusts also come with a number of caveats; one being the limited lifespan of these reserves, many of which will not survive more than 10 years. In order to nourish the cash distributions to unitholders, the trusts must continuously replenish depleting reserves through new acquisitions. Huh? New acquisitions? Where are the down payments coming from? Through share issuances and debt financing of course. This part bugs me the most. This arrangement is reminiscent of the Ponzi scheme, where money from new investors is scrounged to maintain distributions to existing unitholders. The tale doesn’t end here, because the new reserves, as their predecessors, also have a limited lifespan. Saving investors from the agony of waning income, the trusts must dig themselves into deeper holes by tallying up even more investors and even more money to fund even more new reserves.
This illustrates the fundamental flaws of this trust model. No rational investor will want to share her profits when she’s the one risking her money on the line. If she’s the rightful owner of the new oil wells, she deserves all the cash flow produced from it.
Our anxieties shouldn’t end here. In addition to the dwindling reserves, investors must be conscious of future oil and gas prices. For instance, the price of crude oil today is $75 which is near its historical high. If the production cost per barrel of oil is $45, one may project a margin of $30 per barrel until all the reserves are depleted, but this is not a sure thing. A mere $10 drop per barrel would evaporate 33% of the profits. Even a cursory understanding of the intricacies behind oil and gas trusts explains why cash flows from O&G trusts can be erratic over time when compared to bonds. Oil trusts achieve high levels of operating leverage as their production costs are largely fixed no matter what the crude oil price is. Profits are a function of the prevailing crude oil price. As oil price diverges from costs, profits expand. Conversely, as oil price gravitates toward costs, profits erode. The lowest cost producers have the best competitive advantage against price volatility.
Finally, O&G trusts are very interest rate sensitive, as with all income trusts. This is a given.
With these caveats in mind, I’ve compiled the following criteria to help jump start your search if you’re extremely bullish on energy prices.
- Long-life reserves - Keep the distributions coming longer.
- Low(est) cost producer - Profits from the lowest cost producers are the least sensitive to energy prices. Likewise, a small dip in oil prices can wipe out all of profits from the least efficient producers.
- Clean balance sheet - The less debt on the balance sheet (low Debt/Equity ratio), the less sensitive it is to interest rate fluctuations.
- Low payout ratio - This is especially true for O&G trusts that engage in Pac-Man acquisition sprees.
Example: Canadian Oil Sand
If I were to invest in an oil trust, it’d probably be Canadian Oil Sand. It owns a 37% interest in the Syncrude project, a pure play in an oil sand that has stunning reserve life of 40+ years. I believe the slow depletion rate is confirmed by the miniscule 3% in of Return of Capital. The trust also sports a healthy 0.36 Debt/Equity ratio and 55% payout ratio, notwithstanding a weak 4.9% yield. 
Based on some preliminary readings on their web site and StockChase.com, they have just completed the third and final stage of their Syncrude 21 expansion. With capital spending behind them, analysts expect distributions to rise this and next year subject to oil price remaining at a high level.
According to Syncrude, their operating cost per barrel is $26.46 in 2006. That’s pretty cheap! Perhaps I’m missing something, but there is an enormous margin between the operating cost and the market price of $75 per barrel. The dual of low debt obligation and efficient production should yield some breathing room from external crisis such as deteriorating oil price and soaring interest rates.
Other Oil and Gas Trusts
Additional Resources
- In case you’re interested, a video of the oil sand production process is available here: “How We Make Oil at Syncrude”
- Hot idea fuelled energy trusts - A nice history on energy trusts.
- To keep abreast on the current energy prices, visit Bloomberg.
I wish I had money when Harvest dropped to $24… now it’s back to 34$… too bad!
I would like to have your opinion on something; What is going do happen once trusts will have to pay taxes? Most of them are distributing almost all their profits as they are not paying taxes on them…