Canada's oil and natural gas royalty trusts this year should see higher returns on stronger commodity prices and softer oil services costs, but they have to balance capital spending and unitholder distributions with more balance, CIBC World Markets said in a report.

Canada has more than 30 oil and gas royalty trusts with a combined market capitalization of C$72 billion.

According to CIBC, the royalty trusts delivered a total return of minus 4% following a big drop in gas prices, an average 14% hike in operating costs and government tax changes announced last fall. Many trusts sharply dropped in value for a brief period after the federal government said it was studying a plan to begin taxing trusts on par with corporations (see Daily GPI, Nov. 2, 2006). In addition, the CIBC said less than half of the energy trusts added reserves below cost in 2006.

"It is a little bit worrisome going forward that not everybody can see that," said CIBC analyst Mark Bridges, one of the report's authors.

Capital efficiencies are expected to improve this year, but investors should be wary of sector inefficiencies, the report noted. If development costs remain flat this year, CIBC is forecasting zero growth in the sector. Oil and gas sector standouts in 2006 included trusts with lower payout ratios, which outperformed their peers and delivered returns 22% higher on average.

"While we expect trusts with a strong focus on development to outperform over time, it cannot be stressed enough that we believe these capital projects must meet positive economic return requirements in order to justify the expenditures," CIBC analysts said. "We expect that a more critical driver of return performance will relate to the profitability of capital being reinvested and management's ability to utilize the appropriate payout/reinvestment level."

The ability to increase reserves up to 2011 without tax penalties should encourage stronger energy trusts to acquire production rather than develop it, according to CIBC.

"In the end, we see no reason for a trust to convert to an (exploration and production) company prior to 2011, with the possible exception that the government's safe harbour rules are restricting expansion potential," the report noted. "We calculate the value of the four-year window adds 11% to the average trust's net asset value, versus a corporation that would be taxable immediately."

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