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Energy Income Trusts: A Comeback in the Making

Editor’s Note:  Today’s story is contributed by Dennis and Eric Hoesgen of Hoesgen Investment Partners and Canaccord Wealth Management. In this Oil and Gas Investments Bulletin-exclusive report, the Hoesgen brothers reveal what could be a comeback in income trusts (investment vehicles that aim to provide steady quarterly or monthly payouts.)  Enjoy…

-Keith

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The income trust game is back – just in a different form.

Canadian Finance Minister Jim Flaherty killed these high-yield, tax sheltered public companies on October 31, 2006 – not so affectionately called the “Hallowe’en Massacre” by the millions of investors who were enjoying 10%+ payouts annually.

Canadian companies had until January 1 2011 to convert back to a regular corporation or face new taxation that essentially reverted them back anyway.

But the market has found a loophole that may allow for many new trusts – especially in the energy sector:  don’t use Canadian assets. Two new income trusts have listed on the Toronto Stock Exchange (TSX) recently.

Last year, Eagle Energy Trust (EGL.UN) went public on the TSX, which was the first Canadian-listed oil and gas trust to launch since Flaherty’s Halloween surprise in 2006.

The company holds only foreign oil-producing assets – 1269 bopd of light oil production in Texas – a loophole that excludes it from the new Canadian tax regime.  The founders of Eagle Energy believe this new structure will serve as a template for other oil and gas companies.

They raised $150 million in their initial public offering at $10/share last November with an additional $20 million as well via a concurrent sale of securities to their vendor.

The company quickly followed up with their first distribution declaration a month later of $0.1064 per trust unit or 10.64% if you were lucky enough to have participated in the IPO.  The company is currently trading at $11.50/share as we write this, with an all time high of $12.10/share.

Parallel Energy Trust (PLT.UN) is the second new energy trust out, debuting in April 2011 on the TSX as well, after having completed a $342 million initial public offering at $10.00/share and also closing on a $51.3 million over-allotment option earlier this month.  The company plans to offer an initial yield between 8.5%-9.5%.

Parellel is producing 2900 boe/d of natural gas – again from Texas – though in their prospectus they say it is 67% Natural Gas Liquids, which get a higher price than straight dry gas.

The need for income has not gone away and we feel investors looking for a reliable source of investment income will begin to favour new oil and gas trusts.  It took about a decade before the trust market really took off last time.

This time around, with a new structure in place, and new rules to comply with, it could take much longer but the performance of Eagle and Parallel is certainly an indication the investor demand for this type of vehicle is there.

On the negative for investors, Canadian companies operating in foreign jurisdictions also offer a potential higher level of risk than that of a company whose assets are in Canada.  On the positive for the companies, Canadian companies have an advantage when they operate in the United States for example, since smaller energy companies can get access to capital more cheaply in Canada than south of the border.

BACKGROUND ON INCOME TRUSTS -

Since their debut in the 1980s, income trusts were madly popular with investors who loved their juicy quarterly or monthly payouts.  These vehicles were special in that they paid no corporate taxes but rather passed their profits on to unit holders who were then taxed.

Seniors, in particular, loved them for their ability to provide steady income at yields that were consistently better than that of traditional dividend-paying investments.

By the turn of the millenium, they had become the talk of Bay Street and any well-informed investor was not without at least a portion of their hard – earned portfolios allocated to Income Trusts.  In fact, by 2006, they became so attractive that telecom giants Telus Corp. and BCE Inc. were considering converting themselves from the traditional corporate structure into income trusts in order to reduce their tax burden.

The government stood by and watched for years while tax dollars fell by the wayside.  It was not until Gord Nixon, CEO of the Royal Bank of Canada, commented publicly about the possibility of converting the biggest bank in the country into an income trust that Ottawa finally took action.

On Oct. 31, 2006, Jim Flaherty, Canada’s Finance Minister at the time, announced his own “trick” but no “treat”, on a Halloween Tuesday unit holders will never forget.  He announced income trusts, with the exception of real estate investment trusts that adhere to strict rules, would be subject to tax on trust distributions — effectively, making them treated the same as corporations.  This announcement forced the stock-market value of these vehicles down by at least 15 per in reaction to the news. Some were way worse.

The number of energy income trusts has fallen dramatically since then. At that time, the Toronto Stock Exchange boasted 32 energy trusts with a combined market capitalization of $83.9-billion. In the last four years, that shrank to 13 with a total value of $57.2 billion.  The gap is even wider for all Canadian income trusts, which have tumbled from $209-billion in value to $140-billion.

Under the new rules, all new trusts from that date forward would be subject to the new tax regime, but Flaherty gave existing trusts (of which there were 255 on the TSX at the time, collectively worth more than $200 billion) until the then-far-off date of Jan. 1, 2011 to meet the new requirements.That deadline has come and gone and while the sector is not what it was years ago, the good news for investors seeking income is that the income trust could be making a comeback, as Eagle Energy and Parellel Energy Trust are showing.

Next story:  Oil & Gas Income Trusts, Part 2 — The ‘New Class’
Part 3:  The New Canadian Energy Income Trusts

Dennis Hoesgen and Eric Hoesgen are Senior Investment Advisors at Hoesgen Investment Partners in Vancouver, with Canaccord Wealth Management, a division of Canaccord Genuity Corp., Member – Canadian Investor Protection Fund. They can be reached at 604-643-0229 or hip@canaccord.com. The views in this column are solely those of the author. This report is provided as a general source of information and should not be considered personal investment advice or a solicitation to buy or sell securities.



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