Oil and natural gas royalty trusts have had a simply fabulous run since crude prices recovered from their last slump in 1999. Their popularity, alongside other types of income trusts, has been a testament to public hunger for income-producing investments.

Evidence of the unsatisfactory tax treatment of dividends in Canada — soon to be exacerbated by pending U.S. tax reform — also reflects the strong performance and seemingly low risk of energy trusts.

But do investors really know what they’re sitting on? The rolling on of the good times has obscured the innate differences between energy trusts and other income trusts. The strength of cash distributions suggests to investors that distributions are just like income. The very stability — and even growth — of unit values suggests to investors that investing in energy trusts is just like investing in other trusts, or even common equities.

I’m not predicting an imminent energy trust shock. I am concerned that the investing public is unprepared for even modestly bad news, because it misjudges the nature of oil and gas royalty trusts.

Admittedly, I was an early skeptic of energy trusts. Mediocre producing assets; often worse than mediocre and self-serving contract managers; pricey acquisitions piling on still crappier assets that dilute production, reserves and cash flow per unit — all to provide the appearance of growth.
Then something amazing happened:
Canadian energy trust managers cleverly
modified the U.S. royalty trust model, crafting an approach better suited to human nature.

Seen through the eyes of a neophyte, an energy trust’s basic defect is that its units, over time, lose their underlying value.
Worse, they’re supposed to do so. Unlike, say, pipeline funds or real estate trusts, energy trusts produce finite oil and gas reserves. Eventually, the wells will peter out.
In the U.S., energy trusts were historically known, rather inelegantly, as a “blowdown scenario.” Monthly cash distributions recognize this depletion by designating part of each payment as return of capital. A traditional energy trust’s units should gradually lose their value, reaching zero when the producing fields are finally shut down.

Canadian energy trust managers recognized that it just isn’t in human nature to invest in something for which the value will evaporate before one’s eyes. So, spurred by the most effective motivator of all — keeping their jobs — trust managers created a business model that transforms energy trusts into something like a sustainable business.

The model can work. As long as sufficient suitable asset packages can be created by exploration companies for sale to trusts to replace declining reserves. As long as commodity prices remain strong. And as long as investors keep propping up trust unit values, enabling trusts to make acquisitions that bolster production, reserves and cash flow. The very success of Canada’s energy trust sector, however, masks the reality that “sustainable energy trust” is, ultimately, an oxymoron.

Meanwhile, many retail investors may have lost any awareness that energy trust units are fundamentally unlike bank stocks or GICs. Indeed, the excessive and even absurd punishment that investors meted out on trusts that, last year, cut their monthly distributions suggests that, for too many retail investors, energy trusts are supposed to be a sure thing.

Enjoy the good times while they last — but know that you simply can’t bank on that $40 energy trust unit. The strong possibility that many investors don’t grasp this basic reality leaves energy trusts highly vulnerable to a psychotic overcorrection. IE