Happy Saturday IBC…

I’ve been thinking about this trade all week that *should* yield 12-15%, and has an awesome hedge. Feel free to poke holes in it…

If you’re not familiar with Canadian Oil/Gas Trusts, get up to speed here

The sector has been consolidating, which is expected to persist into 2011. Most people that follow these trusts are aware that Canada’s minister of finance, Jim Flaherty, is a supreme fucktard for reneging on his party’s promise not to remove the MLP’s tax free operating trust status. As such, the trusts will be taxed on their income in 2011 & will have to lower their dividends. One solution that I have read about is to convert to U.S. MLPs (master limited partnerships) in order to retain the tax-free status. Until then, the trusts will continue to pay a monthly dividend - taxed at 15% which the Canadians withhold, forcing your CPA to work a little harder to account for this. You are not double taxed.

If you take a basket of three high yielding Trusts (PWE, HTE, PGH), you’ve got an average dividend yield of 15.56%. HTE has a market cap of 3.49B (canadian), PGH: 4.43B, and PWE: 12.9B. Dividends have been consistent, and have risen with oil. All three companies have also been hedging their production volumes for dividend stability. PWE is 32% hedged for the rest of 2008, with 28% set aside for 2009. PGH is 44% hedged for ‘08/26% for ‘09. HTE is the most volatile of the three, and has the lowest % of production hedged at 14% for the rest of ‘08 & 0% for ‘09. It also has the highest current div yield. If you’re worried about it getting clipped, substitute PVX, which has a 13.9% div yield (which will bring avg. dividend yield to 14.13%). They are hedged up to 20%.

Since these trusts were formed, they have had a relatively strong correlation with the price of oil, and with oil under the spotlight, the correlation has grown stronger. As such, you should be able to hedge a basket of Canadian Oil/Gas trusts with a 50% position in DUG (which pays a dividend of 2.47%). In theory, this pair trade keeps your principal hedged, while extracting 14-15% (+ 2.5%) ROI taxed at 15%. If oil falls so low that the trusts can’t maintain their dividend, DUG should balance out the losses. Your opportunity cost on the DUG money is of course whatever else you could do with it less 2.5%.

Things that could fuck up this trade:

- The basket’s correlation to the U.S. Dow Jones Oil Index weakens. Remember, DUG doesn’t track the price of oil. It tracks an index that tracks oil stocks. So you are essentially betting a basket of 3 oil & gas stocks against double the inverse of BIG basket of oil & gas stocks. You can download the components of DUG here, directly from the Dow Jones website.

- Corporate fuckery by the trusts (not likely, as these trusts are well managed)

- Oil spikes, sending your hedge down more than the trusts appreciate. This could be mitigated by graduated stops to keep your long/short ratio in balance, or you can just hold on until the trusts catch up and normalize. Keep in mind that the trusts will raise their dividends if they make more $ due to oil going up.

- Oil falls to $70/bbl on slipping demand (a-la Donny), and the trusts cut dividends so much that even though your principal would be hedged, and the trade yields less.

If you have a high degree of conviction that oil is on its way back up over the next 12 months, you can just buy the stocks without DUG, ride them up, and collect the dividends. This could become a 30-40% trade if there is war in Iran.

Finally, I’m not really an options guy, but someone suggested to me that you could sell calls & buy puts on the basket for a more direct hedge. Maybe someone could pencil out some options hedging strategies on this trade (without DUG)?