A high-yield alternative to income trusts

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Lovers of income trusts and royalty trusts, dry your eyes. Yes, your precious investments will soon lose the tax advantages that made it easy for them to pay investors fat cash distributions every month. Most trusts will convert to dividend-paying corporations before tax rules change next January. But rest assured that something ingenious will come along to replace them. In fact, it's already here.

Investors can still find double-digit distribution yields in the energy sector. One intriguing idea is the group of royalty funds offered by Calgary-based WCSB Investment Programs. The company doesn't use investors' money to extract oil and gas itself. Instead, WCSB backs small oil and gas producers that need cash to expand their drilling programs.

Junior producers are constantly in need of capital. But many of them have a tough time raising equity because their shares trade at a stiff discount to what they're really worth, and existing owners are reluctant to dilute their stakes. Debt markets, on the other hand, are not particularly keen on lending money to small firms at low interest rates.

So the firms turn to the likes of WCSB. The company is run by several industry veterans, and it has raised more than $60 million over the past two years. The twist is that WCSB investors don't get interest payments or a share of the drillers' profits. They get a royalty-a percentage of the revenue from oil or gas produced by the well their money drilled.

What's so great about royalties? Royalty owners are paid before workers, equipment providers, lenders, corporate income tax collectors and shareholders.

There are more advantages because of tax credits that producers receive to develop oil and gas fields. In effect, governments guarantee about half of an investor's principal (see chart). So if WCSB funds churn out $1 a year in distributions for every $10 invested, investors earn a return of 20%, because they only have about half the investment in the game-the other half they get back from the Canada Revenue Agency.

The tax break will look familiar if you've ever invested in flow-through shares, but there's a key difference. Most flow-through tax breaks were designed to promote exploratory drilling-looking for undiscovered oil or gas. But finding oil and gas in Canada has been getting harder in recent years, and many flow-through vehicles have been poor investments.

WCSB, by contrast, finances development drilling-poking holes where you know there's oil and/or gas, such as between producing wells. That means a much higher success rate-well above 90% since the first WCSB fund was launched in 2008 (there are now four).

The returns speak for themselves. The first fund, which was launched during tough times, is yielding about 10%, after factoring in the tax credit. The latest one is yielding more than 20%.

Although royalty investors get first crack at revenues, there are still risks. The biggest one is that holes will come up dry. Also, WCSB's funds are limited partnerships, which don't trade on markets like stocks or mutual funds, so you have to be comfortable holding on to the units.

The funds charge relatively high fees, too. But these, I'm told, will decline as the fund grows. Besides that, WCSB is just about the only game in town, and scarcity has a lot of value.

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