Uses and Abuses of Oil Trusts

by Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
August 15, 2007

With the energy sector continuing to get plenty of press due to the prevalence of high gasoline and oil prices and reports of supply concerns, investors have been looking for different ways to play the energy market. Investors have also retained their healthy appetite for higher-yielding investments. Attracting investor interest have been oil and gas trusts, largely from Canada, which tend to pay relatively high levels of income to shareholders.

But before jumping headfirst into these securities, which seem to offer exposure to the high-flying energy market while also supplying a nice yield, it's important to recognize what, exactly, you'd be investing in and where such instruments would fit within a diversified portfolio.

What they are
American investors can invest in two types of energy-related trusts relatively easily: U.S. and Canadian royalty trusts. Both types of trusts have the same basic structure in that they own proven reserves and pay income to the shareholders based on revenue received from the production of those reserves.

One of the main differences between the two is that U.S. royalty trusts typically own a set number of oil or gas fields, and once those are depleted, the trust is extinguished. Canadian royalty trusts, however, typically try to live on in perpetuity by obtaining new fields as older fields are depleted. To do this—given that they pay out the vast majority of their income to shareholders—they have to issue additional shares or take on additional debt, which could add to the risk that existing shareholders of the trust are taking.

When looking at any individual trust, it's important to evaluate the number of years that the reserve can continue to produce at current levels, which will provide an idea of how long the income flow may continue. Also, noting what percentage of free cash flow is paid out to investors is important, as the higher the percentage, the greater the likelihood that the trust may have trouble maintaining the current payout level should any problems arise. Below, you'll find multiyear price performance of several large oil trusts. They're displayed for informational purposes only to demonstrate representative performance history.

Graph: Energy Trusts

One final note on Canadian royalty trusts: There are new tax laws that are important to consider. Previously, the trusts didn't have to pay income tax, due to the large amount of income paid out to investors. However, the Canadian government recently changed that policy and began imposing a roughly 40% corporate tax on new trusts while delaying until 2011 the tax hit for existing trusts. To no one's surprise, the trusts took a pretty good price hit on the news, as future cash flows are now at risk of being substantially reduced.

Where do they fit?
While some would argue that the oil and gas trusts should be considered part of the fixed income portion of a portfolio, we would caution that they should actually be considered an equity investment, specifically as a segment of the energy portion of a diversified portfolio. Although the income component makes it seem like a fixed income product, the reality is that the income is far from fixed, and these instruments lack important features (such as a stated interest rate and a promise to repay principal) that are critical elements of fixed income securities.

Classifying oil trusts as part of the fixed income portion of a portfolio could result in a portfolio with a significantly higher risk profile than is appropriate for a particular investor. If oil prices were to fall sharply, undoubtedly, the income stream from the trusts based on oil reserves would decrease; this would, in turn, cause the prices of such instruments to drop. It's important to remember that these instruments are closely tied to the price of the underlying commodity when evaluating whether they have a place in your portfolio and where that place might be.

Don't let hype derail your long-term goals
In times of "frenzy" around a certain asset or asset class, it's important to remember that disciplined asset allocation is key to achieving long-term financial goals. We've become concerned about the use of these securities, as well as real estate investment trusts (REITs), as we've heard anecdotal stories about investors who've been plowing into oil trusts or REITs in order to increase their portfolio's cash flow to meet living expenses.

Needless to say, we don't advocate such a strategy and believe that investors who are doing so are not following a disciplined investment strategy that is critical to success. When looking at whether to invest in energy trusts, a small portfolio position in energy-related trusts may be appropriate for some investors who understand the risks and the appropriate positioning of such an investment in a portfolio.

Even if one were to use an oil trust as a junk bond substitute in his or her portfolio—which we would not recommend—we would caution that they be very diversified (at least 10 different bond positions) and not be overly focused on any particular sector or industry. For most investors, however, we believe it's appropriate to achieve equity exposure to the energy sector and meet fixed income portfolio needs through more conventional investment vehicles.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

Oil trust prices are for informational purposes only to demonstrate representative performance history. They are not meant to be specific recommendations or illustrative of future results.

Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk and liquidity risk.

Investing in particular sectors may involve a greater degree of risk than an investment in other securities with greater diversification. However, strategies that include proper diversification do not ensure a profit and do not protect against losses in declining markets.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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