Investors in the new wave of energy income trusts won’t notice any difference from the old ones – except a slightly lower yield, says Richard Clark, CEO of Eagle Energy Trust (EGL.UN-TSX), the first NEW energy income trust to go public since the Canadian government changed the tax rules on trusts in 2006.
All Canadian trusts had to convert to regular, tax-paying corporations by December 31, 2010. New trusts are allowed with one huge caveat – they cannot use any Canadian assets.
“The payout ratios probably were too high” on the old trusts – some were 100% of cash flow, he says. “Perhaps this resulted in more risk for the asset class than was ideal. And in returning more capital to their unitholders more quickly, the old trusts perhaps overly benefited those early investors. The taxable component of the distributions was around 20% in the late 1990’s, but by 2006 it was over 80%.”
He said the original trusts – somewhat unintentionally – did some things that he wouldn’t necessarily do again, with a view to keeping trusts more sustainable.
Dennis Feuchuk, President and CEO of Parallel Energy Trust (PLT.UN-TSX) agrees: “I think the new trusts will have more disciplined practise with capital and cash distributions” than the old trusts.
Prior to the Canadian government’s announcement on October 31 2006 that income trusts with Canadian assets would no longer be allowed (the Halloween Massacre), the oil & gas trust sector had an average yield of ~12% (compared to 5% from oil & gas corporations today), says Kelly Nichol, CEO of North American Oil Trust, a private company.
Whereas Clark says “The ideal yield for this new asset class may be more like 7-10%.”
I agree with Clark but would add two points – one in favour of a lower yield, and one not. One factor favouring lower yields – which can also mean higher stock prices – is what is called “yield compression.” This happens when there is so much appetite for high-yielding investments that the market is willing to bid up the share price of a stock to accept a lower yield.
Eagle Energy itself jumped 20% in the first three months after its $10 IPO in November 2010, with no change in its payout, as investors were willing to take a lower yield.
Just to illustrate, Eagle Energy is paying out $1.05 a year in its first year to shareholders. At $10 per share, that’s a 10.5% payout. At $12 per share it’s an 8.75% payout.
But the second point is–investors cannot underestimate the greed of the market. The trusts were VERY popular investments vehicles – oil trusts made up $60 billion in market cap in 2006, vs. $600 million today (that’s a 100:1 ratio, BTW) – and the oilpatch executives and the investment bankers were able to raise equity easily to make up for any shortfall in cash a high payout ratio might cause.
I believe Clark’s pioneering efforts in creating these new trusts will become a huge new industry again, very quickly. And human nature says that high-payout-raise-equity game could happen again.
One other difference between the old and new trusts is that the previous trusts had to limit the amount of non-Canadian shareholders to 50%. But this new class of trusts has no such restrictions. This means Americans, who have basically zero interest rate in their home country, can own 100% of these new trusts – creating a much larger demand pool for the stock. (However, the income component of the distributions will be subject to a 15% withholding tax for Americans, that the transfer agent will collect automatically. This will be credited to their US taxes.)
Clark was previously part of the senior management team at Shiningbank Energy Income Fund, a heavily natural gas weighted income trust that was bought by PrimeWest Energy Trust. So he has been intimately involved in the sector before and after the Canadian government ended the trust game. Clark says Eagle Energy Trust will be different in a few key ways.
“Our payout ratio is targeted at 50%, lower than most of the old trusts. This will go part of the way to reducing the projected yields to under 10%. Our return of capital component is also targeted to be much lower than was the case in most of the old trusts. Eagle is also targeting assets with more conventional upside, and so ultimately, hopes to hit a balanced growth and distribution strategy that is sustainable.”
“We want to make the return OF capital as low as we can make it, like 35-40%. And we want to get land where PDPs (Proved, Developed and Producing drill locations) make up less than 40% of the package. That makes for a more balanced income and growth approach – which I believe is sustainable.”
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If it was that simple, why did it take four years for the first new trust – Clark’s Eagle Energy Trust – to get listed?
“A lot of people understood the essence of the rules, but they were accountants, not entrepreneurs,” says Clark, adding that new Canadian rules surrounding foreign asset trusts came out in “dribs and drabs” right up until 2010, making it difficult to move before then.
- It was not until 2010 that the market finally focused on all the companies that were LEAVING the trust sector, making it difficult to get traction with investors on new companies ENTERING the trust space.
- In the oil patch, there are the “trust guys” and there are the high growth “exploration guys,” and these two groups have somewhat different technical and business skill sets. Very few of the “trust guys” had oil and gas operating experience outside of Canada. And the U.S. has some key differences in how the oil and gas industry is structured, and in taxation, that require a strong knowledge of the U.S. energy patch.
- Many people believed that the MLPs in the US – Master Limited Partnerships – already have this market covered.
Next issue: Will these trusts change the way junior E&P companies operate – as they did in the last trust cycle?
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