Apr

13

I have been partially invested in Canadian Royalty Trusts for 2 years that have returns above the risk free rate.

Does anyone have any opinions or insight into this type of investment?

From what I've read their high return rate seems secure as long as oil is above $50/ bbl.

Alan Millhone gives a quick assessment:

Oil above $50 ?  I suspect you are safe for decades! 

Stefan Lewellen replies:

I know nothing about Canadian Royalty Trusts, but I can recall many instances in the past where a seemingly "risk-free" investment offering high returns has actually led to heavy losses.

One must remember that as the price of oil drifts higher, the economic story behind developing alternative energy sources becomes more and more compelling. These projects may not make any economic sense at $50/bbl, but at $150/bbl they may be quite profitable. At some point, such substitutes (or some other new development) will reduce the demand for oil – and oil prices will decline appropriately. Whether this happens in six months or twenty years is anyone's guess, but the fact that there is some non-zero probability that prices will fall below $50 makes this a strictly risky investment (in my opinion). If the probability of low oil prices is extremely small relative to the return premium over the risk-free rate, this could still be an excellent investment – but I'm not sure I would classify it as an investment of the risk-free variety.


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2 Comments so far

  1. George Parkanyi on April 13, 2008 6:15 pm

    Hi Sam,

    I live in Canada, and currently I have one income trust in my portfolio - Precision Drilling (PDS on New York). Precision drilling is Canada’s largest oil services company, and made it onto my value stock screen a while back, which is why I bought. It is the 2nd best performer in my portfolio currently, up about 36% over its average cost base, and is still delivering an 8.8% or so yield.

    I agree with you that there is some good risk-reward in this area at the moment, but you do need to be selective. You want to have a good look at the balance sheets and cash flows in particular. And not all are in oil and gas. There are many businesses that have converted to income trusts - restaurant chains, the Yellow Pages, trucking companies, alternative energy companies such as Northland Power, and even a major telco (Telus).

    In fact, it was Bell Canada’s intent to convert to an income trust that precipitated the federal government changing the rules and making them taxable (like they were before as corporations; the point of them was to avoid double taxation of dividends - that’s why mainstream corporations starting converting). They all took a hit about 16 months ago, burning a lot of seniors - including many in the U.S. - who had invested in them for income (so much for risk-free). Everyone knows they will be taxed again in a few years, but the yields for many currently have a sound basis, and there’s always the chance the government may relent (especially if there’s a change of parties in the next federal election).

    Cheers,
    George

  2. Craig Bowles on April 17, 2008 10:58 am

    Stefan’s $150 seems about right. Oil priced in gold has been in an upward channel since the late 1990s. We tested the bottom of the trend in late 2006 and 2007. The scary thing is moving back to the top of the channel with gold remaining at $950 would see oil at around $170/brl. That’d be your 3rd leg up for Elliott Wave people. Maybe we avoid recession and get $7 gasoline. Composite economic indexes continue to act similar to the 1978-80 growth slowdown. The central banks are just as crazy as they were then.

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