Canadian royalty trusts were a boon for the Canadian energy sector, but the Halloween massacre in 2006 scared a lot of people away. However, there's still great income and growth up north, says Elliott Gue of Energy and Income Advisor.
Gregg Early : I am here with Elliott Gue, editor and publisher of Energy and Income Advisor. Elliott, I wanted to ask you about what is happening with our northern neighbor, Canada. There was some pipeline news a few months back and now the dollar seems to be in a place where maybe it might weaken, but Canada has been doing fine. How is the energy market doing up there?
Elliott Gue: The Canadian energy market has been doing very well also. I think that it's a market that has been a little bit out of focus for many investors.
Several years ago-back about a decade ago-we saw a lot of companies in Canada in the energy side began to list as royalty trusts. Basically, royalty trusts were a class of investment that was tax-advantaged; they did not pay any tax at the corporate level in Canada, and they simply passed through the earnings that they had, the cash flow that they had in the form of typically monthly dividends or distributions to unitholders.
They offered very high yield and plenty of tax advantages. If you happened to be an American investor, Canada has a 15% withholding tax rate. They do not hold taxes on dividends paid into American individual retirement accounts. So these were extremely popular yield-oriented investments.
But then of course, in 2006 the Canadian government-in a move that has since come to be known as the Halloween Massacre-actually changed the taxation of trust and said that trusts would no longer have this favorable tax treatment starting in 2011. So after that happened and after 2011 rolled around, a lot of people forgot about Canada and forgot about Canadian energy stocks.
But the reality is that even though many of them are currently listed as corporations now, several of them still pay dividends on a monthly basis and offer yields of 7% or even 8% in many cases. And many of them have also built up a number of tax credits over the years-that means that they don't really pay corporate taxes anyway.
Obviously there are still a large number of very fast growing oil and gas producing fields in Canada; it's the largest source of foreign oil in the United States. I think that there is still a lot of opportunity up there. These stocks are pretty cheap because a lot of people are ignoring them, because they think that there aren't opportunities there anymore after the change in the trust taxation.
Gregg Early: And the yields are two or three times higher than a lot of the companies down in the United States. Is there still a tax-deferred advantage?
Elliott Gue: The withholding tax for Canada is still 15%, so even after 2013, assuming that some of the tax hikes go into effect in the wake of the fiscal cliff; the Canadian government is still only going to withhold 15% of your dividends, which is among the lowest in the world.
In addition, they will continue to not withhold dividends on monies paid into an IRA account, an individual retirement, or a tax-deferred account. It's still a huge advantage for investors that want to hold these assets in a tax-deferred account.
For example, the equivalent structure in the United States would probably be a Master Limited Partnership, and those can be a little bit difficult to hold in an IRA account because they generate unrelated business taxable income. Kind of a quirk in the US tax law means that you might actually owe tax even if they are held inside an IRA or a 401(k) account
But several of these Canadian energy companies pay monthly distributions, have a low withholding tax, do not withhold taxes for IRAs, and offer yields equivalent to MLPs in that 7% or 8%-plus range.
|pagebreak|Gregg Early: I would say also that even with the energy boom that is going on in the United States, Canada still has a huge market of its own, including Asia, right? They are building pipelines to the west from Saskatchewan, and they don't really necessarily depend on selling their oil or gas to the United States, either, since China and Asia is a huge market.
Elliott Gue: Absolutely. I think that there has been a lot of talk in recent years of US energy independence, and it's certainly true that the US is a growing oil producer now for the first time in three decades.
But the fact is that we produce about 7 million barrels a day and consume about 20 million in the United States. So I would also say that the US is still a pretty huge market for Canadian oil. We will still need to import a lot of oil into the US market for years to come.
The other point I would note about that is that a lot of Canadian crude is heavy crude or oil sands-type production, and US refiners are among the only in the world set up to actually handle the refining of those types of oils. They are actually in very high demand right now, because refiners can purchase those oils at cheaper prices and make a higher profit from refining the oil.
Canadian oil still has a big market in the United States...but you are absolutely right. Longer term, looking out 20 years or so, you are going to see Canadian crude making its way all over the world. They are building additional pipeline capacity to take oil out of Canada's west coast.
They are also building additional capacity to take natural gas in the form of liquefied natural gas (LNG) out of Canada's west coast to markets that are very hungry for gas now, places like Asia and like China. And remember that though natural gas prices are very depressed here in the US and Canada, in North America, they are four or five times higher in China and Europe. So there is definitely a very lucrative market for exporting liquefied natural gas.
Gregg Early: Do you have any stocks you like in this sector, or which stocks do you like? I am assuming you do have stocks you like. Which stocks should people look at?
Elliott Gue: Absolutely. There are a large number of plays up there within Canada with significant yields. One that I just added to Energy and Income Advisor as a new pick is a company called Twin Butte Energy (Toronto: TBE). I would recommend you buy in Toronto if you can, because it's a lot more liquid there than it is over the counter.
This is a relatively small producer. They focus on heavy oil production. Basically in Western Alberta and Eastern Saskatchewan, really around a city called Lloydminster, which is partly in Saskatchewan and partly in Alberta.
Now what I mean by heavy oil, heavy oil is really a more viscous, dense form of crude. It is crude oil, but it does require additional steps in order to be refined, so it's a little bit more difficult and a little bit more expensive to refine than light sweet crude oil, such as might be produced say in the deepwater Gulf of Mexico.
It is still very valuable, and as I mentioned earlier, it tends to trade at a discount to light sweet crude oil. This is actually an advantage for US refiners, because they are able to buy it at a discount and then refine gasoline and diesel fuel, which they sell at full price, and they are in an even much higher profit margin.
Another thing about that oil is that a number of new pipelines are being built from that area that will carry that heavy crude oil into markets like Chicago and other parts of the Midwest and mid-continent of the US. So there is actually a fast growing market for Western Canada Select, which is the key benchmark for this heavy oil.
Twin Butte Energy this year is producing about 15,000 barrels of oil equivalent per day. It's about 90% crude oil; they don't produce very much natural gas at all. Again, a major advantage, with crude oil prices being very high right now and gas prices being very depressed.
By the end of 2013, they should be producing over 19,000 barrels of oil a day. The wells it's drilling are pretty simple, and they have identified about 700 additional locations for drilling, so they have years of inventory ahead of them. These are pretty simple wells; they cost about $600,000 to drill, which is much less than you would pay for your typical horizontal well in a field like the Bakken shale of North Dakota.
It's earning about a 100% to 300% return on their investment from each of these wells. They are actually getting their money back, the money that they spend in capital for drilling the wells, within a year. That is a very, very, very fast payback for the energy industry. This year, it spent about $95 million on drilling. Next year, it's boosting that to $110 million.
Right now, it's paying out a monthly dividend and its equivalent to almost 7% annualized yield. You get a check every month. And they are really concentrated heavily in crude oil in this very fast growing play around Lloydminster in Canada.
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