By Grant Campbell
Investor's Digest of Canada
High gas prices, like high interest rates, put a brake on the economy. Expect some income trusts to run into trouble.
Crude oil hit a new high of $58.60 a barrel on June 17th, settling in at $58.47 a barrel. The average price nationwide for gasoline is $2.13 up 14.5% from a year ago. Increased prices in oil and gasoline will lead to a change in consumer confidence and spending.
The inventory levels for gasoline have been falling week after week and this is before demand really picks up during the summer driving season.
There appears to be a fair amount of complacency regarding the impact higher fuel prices will have on the consumer over the longer term.
An increase in gasoline prices acts as a tax on the consumer, taking disposable income out of his hands that would normally go to other purchases.
I think gasoline could be the story of the year for the North American consumer. The problem with a lack of refining capacity has been on the horizon for a number of years, and this may be the year when it finally hits the economy. There has not been a new refinery built in the U.S. in over 25 years.
The previous over capacity and the problems of getting environmental approvals have resulted in an industry that needs a lot of capital investment and environmental upgrades to be able to expand. There will be a long time frame required to get this in place. So, get use to higher prices at the pump and to no bids when you go to sell your SUV.
The increase in gasoline prices should be good news for Canadian companies with refining facilities such as PetroCanada (TSX PCA, 403-296-8000, www.petro-canada.ca), Shell Canada (TSX SHC, 406-691-3111, www.shell.ca), and Imperial Oil (TSX IMO, 800-567-3776, www.imperialoil.ca. The seasonal increase in demand will maintain a tight supply-demand balance over the next few months, which should be very profitable for these three companies.
The Federal Reserve in the U.S. has seemingly turned a blind eye to the fact that fuel prices are a drag on the consumer and will have a negative impact on the economy. The Fed runs the risk of pushing interest rates higher when the economy is on the verge of slowing due to the consumer being pushed to the limit by higher fuel prices, higher mortgage rates and higher borrowing costs.
A big percentage of the increase in consumer spending can be attributed to the increase in home-equity line of credit utilized over the past few years. The increase in housing prices along with low interest raters has fuelled consumer borrowing against the equity in their homes. An increase in short-term interest rates will have a much larger impact on the economy due to the higher leverage to floating-rate debt.
If the Federal Reserve moves rates too high, the economy could slow dramatically. In that event, you do not want to own the debt of highly leveraged companies. The current problems at General Motors Corp., for example, will become much more onerous if auto sales slow down even more over the next few quarters.
Investors should become much more cautious when choosing which corporate bonds to invest in or to continue to hold. If you are holding bonds in any corporations with maturities over three years, a review is in order to ensure that they are going to be able to meet their ongoing obligations. At this time, only hold bonds with at least an A rating or better. These high quality bonds will be less volatile in an uncertain market and should recover much faster on a turnaround in the economy.
The same caution should be followed in regards to income trusts, as many of them will be negatively impacted by a slowing economy. The income trusts that will be most at risk are those that are currently paying out 100 per cent or more of their cash flow.
Trusts, such as Art in Motion Income Fund (TSX AIM.UN, 604-523-2627, www.artinmotion.com) and Boyd Group Income Fund (TSX BYD.UN, 204-895-1244, www.boydgroup.com), with high distribution rates should be avoided to reduce risk of negative surprises.
The high income attached to these trusts will come under severe pressure if the business slows down at all from current levels, forcing management to reduce or suspend the distributions to maintain the business.
Income trusts with low or no debt will weather a slowdown better than those with high debt levels. Trusts such as Oceanex Income Fund (TSX OAX.UN, 514-875-9244, www.oceanex.com) or Westshore Terminals Inc. (TSX WTE.UN, 604-688-6764, www.westshore.com) are better positioned to maintain distributions due to the financial flexibility available through low debt levels.
There has been a considerable number of new income trusts brought to market over the past year. Many of these do not have a proven track record of distributions and will be under much more scrutiny if there are widespread concerns regarding credit quality or uncertainty about future economic growth.
In the trust sector, stick to trusts with a proven track record of growth and conservative distribution policy, as these will be the units of choice if the economy slows or if there are credit concerns at a company, such as GM."
Editor's Note: Grant Campbell writing in Investor's Digest of Canada, 133 Richmond St W., Toronto, ON M5H 3M8, 1 year, 24 issues, $137. Mr. Campbell of Ladysmith, B.C., publishes campbellreport.com, an Internet financial advisory.
