Why you won’t miss the income trust
Goodbye, and Good Riddance
by Fabrice Taylor
S&P/Tsx Capped ENergy Trust Index Level Performance
(as of 27-Oct-2010)
Of all the great fibs to roll off the Bay Street assembly line, none is more laughable than the assertion that income trusts didn’t cost the government anything. The claim was usually made – and in fact still is – by the people who sold and ran trusts and funds, even though it’s demonstrably not true.
After all, every time a publicly traded company announced that it was becoming a trust, its stock market value would shoot up 20 to 30 per cent. Where did that extra value come from? Obviously, it represented the government’s share of the company’s cash flow. What the company used to pay to its silent partner in Ottawa it was now paying to investors, who were therefore willing to pay more for the shares.
Now, of course, the shoe is on the other foot. Trusts and funds are converting back into corporations and, inevitably, their stock market values are falling, along with their distributions.
Should investors mourn the loss of income trusts? The knee-jerk answer is yes, especially in a yield-starved environment. But even a cursory analysis shows that while income trusts and funds appeared to create a lot of value, many of them actually managed to destroy it.
Let’s take a look at oil and gas royalty trusts. Invented by the late Marcel Tremblay, the father of Enerplus Resources Fund, in 1986 they caught on slowly at first before exploding in popularity. They became so popular, in fact, that at one point there were more than 200 of them, constituting 20 per cent of the Canadian economy.
These vehicles, on the surface, look like winning investments for much of the asset class’s history. But while there were winners, there were also enough losers to show that this idea is something of an illusion. The fact is that most oil and gas royalty trusts were born at the beginning of a great and long boom in oil and gas prices, which boosted the revenues and profits of even those with the most incompetent management teams. Distributions rose but only because oil and gas prices thrived.
How do we know this? Because almost without exception, the reserves of these trusts fell over time on a per-unit basis. Investors were holding finite assets that had no chance of being around for the long term. Yes, distributions went up, but they wouldn’t have if commodity prices hadn’t gone up. They would have fallen and, given the trend, these trusts would have disappeared.
In some cases, production per unit also fell along with reserves. Again, commodity prices – and in some cases debt – put these investments back on side. Now, of course, the tide has gone out and we can see who’s been skinny-dipping.
Pengrowth Energy Trust, for instance, took on a lot of debt and issued lots of units to buy up assets and grow. It didn’t do so in an accretive way to shareholders but got away with it because of higher energy prices. When these fell, the trust brought in a new CEO who promptly cut distributions and sold a bunch of new units to pay down debt. Investors were not only diluted by new units, but they also lost a big chunk of their income.
What’s more, Pengrowth used to have a contract with an external management team that sucked tens of millions of dollars away from investors for doing little else than riding a wave in commodity prices that the management team had no control over. And yet that contract, along with the desire to be bigger, encouraged the trust, and others, to make large acquisitions at high prices without creating value. In 2000, Pengrowth had three barrels of oil equivalent for every unit. Eight years later it had less than half that.
The oil patch decries the loss of the trust structure, and why not? Exploration and production companies loved them because they could sell them tired old wells at a high price. We know this because of the fact that few trusts could build reserves on a per-unit basis, the benchmark of success in oil and gas. We don’t need to explain why the trust sector itself loved it.
You would have been better off holding Imperial Oil, a big, diversified and conservative oil company, than a basket of oil and gas trusts over the past decade. First, many trusts have large tax pools that they’ll use to shelter income. These will eventually disappear. Second, trusts are not run by people who know how to run an E&P business. Most are run by financial engineers, not reservoir engineers. Many will stumble, and some will fail outright.
As such, there’s no need to mourn the loss of the income trust, especially when you consider that government coffers are going to get a healthy injection that will (one hopes) help pay down deficits and debts. As an investor, you’re probably better off without them anyway.
Fabrice Taylor is the Prairie Trader. He is an award-winning journalist and equity analyst.
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