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Background > Cost of Capital to Royalty Trusts
“Cost of capital” is a finance term that refers to the percentage that it costs a company to maintain its capital structure which “funds” its assets and is generally a combination of debt and equity. The cost of debt is generally the interest rate the company pays to maintain it. The cost of equity is essentially the rate of return demanded by investors to buy or hold a share or unit. Generally, the riskier an equity investment is, the higher the rate of return investors will demand to hold it. Although the cost of borrowing (debt capital) for royalty trusts is generally comparable to conventional exploration and production (“E&P”) companies of similar size, the cost of equity capital to royalty trusts has historically been lower, prior to the October 31, 2006 Federal Government tax proposals.
There are several reasons why royalty trust investors were willing to accept lower returns than E&P investors. One factor is the higher relative demand for the royalty trust units as compared to E&P company shares due to a lower risk profile. It should be noted that both entities are in essence oil and gas companies and operate under the same regulatory environment.
A primary difference between the business models is that royalty trusts have tended to focus their re-investment opportunities into predictable, lower return, lower risk development opportunities on mature assets and have generally minimized the risk of exploration activities. Another difference is that royalty trust investors receive a distribution stream that further lowers their investment risk. Lower risk generally translates into higher relative valuations and thus lowers the cost of capital. Given the relatively mature nature of conventional oil and natural gas fields in Canada, royalty trusts have tended to reinvest less than their total cash flow and have distributed the remaining funds to their unitholders. This makes economic sense because capital invested, beyond certain thresholds, into the mature assets in the Western Canadian Sedimentary Basin (“WCSB”) is becoming more and more inefficient. Although some larger E&P companies may also pay a dividend, depending on their need for capital and opportunities to re-invest, they have tended to spend a high percentage of their cash flow in higher risk, capital-intensive projects in the oil sands, in the remote North, deep-basin foothills, offshore or outside of Canada. These projects tend to be in high-impact exploration areas located outside of the WCSB.
The royalty trust concept appeals to a segment of the capital markets interested in a relatively low risk income stream from their investments. This market segment was broad based and growing, particularly with an aging population focused on supporting current living expenses in an environment of low interest rates. In addition, the market has reacted to investment losses in conventional growth-oriented corporations both within and outside the energy sector as witnessed in the dot-com market correction. The returns on capital invested into conventional Canadian oil and natural gas activities is expected to continually decrease as the WCSB continues to mature. Instead of investing exclusively in growth stocks, some investors are also investing in entities in mature industries where a more disciplined approach to reinvestment provides reasonable “risk-adjusted” returns. Rather than companies reinvesting cash flow into higher risk activities, these investors prefer that this cash be distributed back to them so they can reallocate the after-tax amounts into other sectors of the market.
In Canada, the major E&P companies have been divesting mature WCSB assets for many years because investing in these properties is no longer of sufficient scale to be economic to them and because there is limited likelihood of significant enough production and reserves growth. Royalty trusts have played an important role in Canada’s conventional oil and natural gas industry by purchasing mature oil and gas assets from the large E&P corporations and investing in these assets to create a market for ordinary Canadians to invest in the sector at reasonable risk levels. In essence, the trust investors have been enabling royalty trusts to economically purchase or hold WCSB assets as the requirement to meet distributions forces them to be disciplined in their capital re-investment thus placing the investor’s capital at less risk.
In summary, the cost of capital is generally lower for royalty trusts than conventional E&P companies due to the lower risk profile of the trusts. This lower cost of capital allows royalty trusts to in turn keep Canada’s oil industry vibrant by prolonging the economic life of mature oil and natural gas properties that would otherwise remain under-exploited.
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