5 Overlooked Gems of the Energy Patch

Although Britain's Queen Elizabeth II is the Queen of Canada, investors may wish to request an audience with another royal family altogether.

The Canadian royalty trusts, or Canroys, enjoyed princely popularity before Canada revised its tax laws in 2006 to strip them of their tax-exempt status. However, since pre-existing Canroys are exempt from the changes until 2011, some of these equities continue to entice investors with double-digit yields and the beauty of monthly distributions.

The massive sell-off which accompanied the energy collapse of 2008 has left the energy-producing members of the Canroy family tattered and torn. Each of the stocks in the table below touched a five-year low this month. 

Fools by nature will detect the scent of opportunity in the wake of such an exodus, and I believe this group warrants close inspection. Although dividend payments have been sharply reduced by many in the group, and the potential for further reductions cannot be ruled out, the combination of value and income is difficult to ignore.

From the outset, it must be stated that investing in these energy trusts requires substantial and sustained due diligence. Each trust possesses a unique mix of energy resources, varying liquidity situations, and, of course, varying degrees of profitability. The distributions also have tax-related implications that should be well understood. With those caveats in place, let's compare a handful of these energy trusts using some basic criteria.

* From Capital IQ and based upon intraday share prices March 19, 2009, converted to U.S. dollars.
mmboe = million barrels of oil equivalent.
^ Advantage Energy Income Fund announced March 18 that it will convert from a royalty trust to a growth-oriented corporation. The company suspended its dividend entirely, and will instead direct cash flow to capital expenditures and debt repayment.

After heading north, look west
Even after chopping more than 30% from dividend payments in recent months, Penn West Energy Trust stands tall with a yield over 22%, and boasts one of the lowest trailing dividend payout ratios in the group. The company's massive reserves of 729 million barrels of oil equivalent (mmboe) and formidable daily production of more than 189,000 barrels of oil equivalent per day make this the largest of the energy trusts. The trust grew substantially in 2008 through a couple of key acquisitions, and I believe the resulting scale of Penn West's production will aid a smooth transition away from the present tax structure as 2011 draws nearer.

CAPS All-Star Dramissed is also looking beyond 2011:

The price of oil will rise again. ... Penn West is a stong enough company that even when the tax situation changes for trusts in Canada in 2011, it will still be an excellent company to own and hold on to for future growth. Think long term and you can't go wrong buying into this right now.

Although saddled with substantial long-term debt of more than $3.4 billion (U.S.) following the acquisitions, Penn West's profitability, healthy cash flow, and $1.14 billion (U.S.) in credit remaining available provide welcome offsets to the debt load. In support of that cash flow, Penn West managed to soften the blow from low energy prices by hedging about 25% of production for the first half of 2009 at more than $80 per barrel of oil and around twice the current spot price for natural gas.

What's in your basket?
For investors looking seriously at the energy-producing Canroys, I recommend a mix of such trusts both to spread the risk of deeper dividend cuts and gain exposure to a diverse range of energy operations. Harvest Energy Trust, for example, offers both upstream and downstream exposure thanks to its refining operations. 

Provident Energy Trust offers midstream exposure for natural gas liquids with pipelines, storage tanks, and fractionating services. I urge Fools to conduct ample research of their own, but the above table corresponds to my own personal basket. A convenient shortcut to the basket approach can be achieved through the Claymore/SWM Canadian Energy Income ETF (NYSE:ENY), which yields more than 10%.

Keep in mind that some energy plays south of Niagara Falls -- although not quite as high-yielding -- might be worthy of consideration. Kinder Morgan Energy Partners (NYSE:KMP), for example, which operates a large network of natural gas pipelines, rewards investors with a 9% dividend.

Whether Fools opt for a single trust or a well-researched basket, I believe that this royal family of Canadian trusts could have investors feeling like nobles as substantial income is paired with the inevitable -- albeit potentially gradual -- resurgence in energy prices.

Further Foolishness:

• Hop aboard the midcontinent express.
• The bull case for Provident Energy Trust.
• A fellow Fool discusses Penn West in his CAPS blog.