Cheap Energy
Enterra was the victim of overly aggressive management, which bought aggressively when natural gas sold for more than twice current levels. It was also plagued by conflict of interest issues, high management turnover, crushing debt and the soaring Canadian dollar, which crimped cash flow from US operations.
More than anything else, however, Enterra was hit hard by the plunge in natural gas prices. Soaring oil has grabbed the headlines. But since Hurricane Katrina, gas has fallen much further than oil has risen. Enterra currently derives nearly two-thirds of its production from gas, so it’s been hurt more than most.
Coupled with the fallout from last year’s Halloween trust taxation plan, the trust has been virtually shut out of capital markets. As a result, it’s no great surprise management is struggling to service debt or that Chapter 11 risk looms large.
Unfortunately, Enterra’s hardly alone. Falling natural gas prices have bashed virtually all trusts to some extent. Yet at the same time Enterra is failing, the industry’s stronger fare are heating up as takeover bets.
Barely a week after Enterra’s meltdown, two wholly owned units of Abu Dhabi National Energy Co offered CD5 billion in cash (approximately USD26.75 per share) for PrimeWest Energy Trust (PWI.UN, NYSE: PWI). The offer was nearly 40 percent above PrimeWest’s pre-deal trading range, and it immediately triggered a sharp surge in stronger oil and gas trusts.
Seeing Value
That cash-rich Arabs are looking for a place to put their money is nothing new. That they’d choose to buy a gas-reliant Canadian income trust—at a time when gas prices are slumping—is noteworthy, to say the least.
Before the PrimeWest deal, there had been three dozen buyouts of trusts outside the energy patch since November 2006, at premiums ranging as high as 50 percent to pre-deal prices. Oil and gas mergers, however, had been restricted to buyouts of basket cases like the former Thunder Energy or to midsized companies bulking up, like Advantage Energy’s (AVN.UN, NYSE: AAV) takeover of the former Sound Energy. Another deal of that ilk hit the wires in late September, with Penn West Energy Trust (PWT.UN, NYSE: PWE) buying floundering Vault Energy (VNG.UN, VNGFF).
None of these deals conferred much of a premium on the targets. In fact, all were very close to book value. Acquirers will make out quite nicely because they add reserves and production cheaply. Shareholders of the targets, however, were largely cashed out for big losses.
The huge premium paid for PrimeWest is the first indication we’ve seen of what prospective buyers outside the sector are willing to pay for more solid fare. The price was still just 1.6 times book value. But it’s far above what similar trusts are going for. Advantage, for example, sells for just 1.2 times book value. Even Penn West—one of the biggest and strongest trusts—is going for 1.6 times book. And gas-rich Progress Energy (PGX.UN, PGXFF) is trading at less than 1.3 times book.
You’d be hard-pressed to find any energy producer selling that cheaply anywhere in the world, let alone one that’s actually making money and paying double-digit distributions. But Abu Dhabi’s move likely has other motives than price.
Last month, the Alberta Provincial government sent a minor shockwave through its local oil and gas industry, as a long-awaited report it commissioned advocated dramatic increases in royalty rates on energy production. (See Canadian Currents.) The biggest target was the oil sands sector, but new conventional fields were also singled out.
At this point, it’s uncertain whether any of the report’s recommendations will be adopted. Clearly, there are incentives for politicians to boost the public’s take. But with a huge chunk of voters drawing their paychecks from the energy sector, there’s also a very strong incentive not to do anything to short out the boom.
The ruling Conservative Party is already battling discontent on the trust taxation issue. The last thing it needs to do is pick a fight with the rest of the sector. The matter is to be decided by Oct. 15, when the provincial government will announce what, if any, recommendations it intends to take.
No matter what’s decided, oil and gas trusts should pay little additional royalty by virtue of their focus on mature reserves. In fact, one of the report’s recommendations could actually reduce the royalties they pay. But until this issue is laid to rest, it means considerable uncertainty for any energy producer, trusts included.
That the Abu Dhabi National Energy Co would buy a trust in the face of royalty tax uncertainty is a pretty clear indication it’s willing to take its chances—and that low prices are only one of the attractions. These are well-run businesses loaded with valuable reserves, and this energy-savvy enterprise wants in while prices are low.
Some on Wall Street and Bay Street Canada have quickly dismissed the idea that there will be more mergers and acquisitions of oil and gas producer trusts. In my view, the kind of values present in the sector can’t help but invite future bids. But I’m not counting on deals to earn trust profit.
It’s true that shareholders of the former Shiningbank Energy Income Fund who held on following the trust’s purchase by PrimeWest earlier this year have been rewarded for their patience. But guessing who’s going to pair up with whom—and what price will be paid—is pure speculation.
That’s why the only takeovers worth betting on are for trusts you’d want to hold on their own anyway. The good news is those are also the trusts likely to fetch the best premiums in any prospective deals and to continue to pay their lofty distributions while you wait.
Conversely, if you lie down with the sector’s dogs, you’re most definitely going to get fleas. As the Enterra meltdown proved yet again, the odds are just too stacked against small trusts, particularly those with higher cost reserves and production that are weighted toward natural gas.
Enterra may by some miracle avoid Chapter 11. But the damage to shareholders has already been done, and no deal is going to undo it. In short, there’s nothing to be gained buying the weak and an awful lot to lose.
Price Sensitive
The table under Oil and Gas Reserve Life is Canadian Edge’s databank for oil and gas trusts. It’s accessible from the Canadian Edge Web site home page on the lefthand side menu and includes data on reserves, costs, finances and production.
My criteria are all designed to measure one thing: trust sustainability. Oil and gas production is an extremely cyclical business that’s highly sensitive to changes in energy prices. When prices are rising, cash flow is abundant and trusts can easily invest in new output and pay generous distributions. But if management fails to prepare, a prolonged drop in prices will force it to trim dividends, add debt or curtail production.
Because adding debt and slowing production weaken the basic business, management will almost always choose a dividend cut. That preserves output and financial strength but invariably craters the shares.
One question I’ve received from many investors is why their oil and gas producer trusts haven’t really rallied with oil prices in recent months. The answer is trusts have benefited, but oil is priced in US dollars. As a result, some of those gains have been diluted by the buck’s drop against the Canadian dollar, which is currently near parity.
Moreover, aside from Canadian Oil Sands (COS.UN, COSWF), all trusts produce natural gas. In fact, many are weighted toward gas output and away from oil. As the graph shows, the drop in gas prices during the past two years has been greater than gains in oil. Consequently, most trusts have been hurt far more by falling gas prices than they’ve been helped by rising oil.
The takeover offer for PrimeWest has lifted prices of all oil and gas producer trusts to some extent. But only trusts with sustainable business models will keep their momentum in the months ahead. And the most important element of sustainability now is being able to deal with weak gas prices.
Ultimately, I continue to look for gas to recover. It looks like this hurricane season has again passed without a major disruption in Gulf gas supplies. Moreover, nationwide inventories were still 8.2 percent above the five-year average at last count.
The imbalances, however, appear to be working out. That’s largely because of the collapse in Canadian natural gas output. But we’re starting to see production cut elsewhere as well, for example, from Chesapeake Energy’s decision to slash output by 6 percent.
I’m not going to call a bottom for the fuel yet. But in the words of one trust executive, gas is a self-correcting commodity. Producers can’t drill it economically at these prices. A demand spike because of a cold winter or unexpected hot stretch would tighten things up sooner. But even if the weather stays mild, prices are going to head up in the coming months. And that’s good news indeed for the entire trust sector.
Until gas recovers, my focus is going to be just where it’s been since the peak in summer 2006: on the trusts with the greatest sustainability. That’s the way to weather this crisis and position for the profits ahead, while collecting a steady stream of dividends.
The hallmarks of a strong oil and gas producer trust are same as they’ve been from the sector’s beginnings. On the financial side, the optimal combination is a payout ratio of 70 percent or lower of distributable cash flow, along with a debt-to-cash-flow ratio of no more than 1.2-to-1.
A balance between oil and natural gas production is still preferable to a mix slanted in one direction or another. A trust should have rising or at least steady production year-over-year. And operating costs should be CD10 per barrel of oil equivalent or lower.
Reserves are best measured in terms of the “proven” category, which are rated with a 90 percent or better chance of being developed. In contrast, “probable” has only a 60 percent chance. I calculate “reserve life index” by dividing total proven reserves by the current rate of production. This isn’t a static measure. But generally, a reserve life index (RLI) of seven years or better indicates the trust will be able to maintain output and reserves at a steady rate, even if its access to capital is restrained by the market.
Keep in mind that trusts can no longer issue as many new units as they want, whenever they want. First, market conditions aren’t ideal, so new issues result in dilution. Second, Canadian law restricts additions to 40 percent of current shares outstanding for 2007 and 20 percent per year thereafter. Note this doesn’t include share increases brought about by mergers between trusts, one reason why this method of growth is increasingly attractive.
The Solid Core
The table “Pumping Profits” shows how the producer trusts in the Canadian Edge universe stack up as we enter the fourth quarter of 2007. Not surprising, the six core trusts in the CE Aggressive Portfolio continue to measure up best.
None have cut distributions during this down cycle for trust cash flow, and none are likely to. Moreover, all of them have affirmed their intention to remain income trusts at least until 2011.
ARC Energy (AET.UN, AETUF) has kept a generally low profile this year on the acquisition front, holding stock issues basically to its dividend reinvestment plan while paring its debt-to-annual cash flow ratio back to just 0.95-to-1. But with a balanced production mix, operating costs below CD10 per barrel of oil equivalent (BOE) and reserve life of nearly 10 years, it can afford to.
The trust is up for 2007, down slightly for the last 12 months and up sharply during the past three years. I’m looking for solid gains in the next 12 month, in addition to the lofty dividend. ARC Energy remains a buy up to USD23.
Enerplus Resources (ERF.UN, NYSE: ERF) is basically flat for 2007 and the past 12 months—a solid performance given the overall turbulence. Like ARC, the payout ratio is low and debt-to-cash flow is even lower at just 0.7-to-1. The trust continues to spend heavily in two areas that won’t bear fruit for several years: the rich, conventional reserves in the US Baaken region and a massive oil sands find.
Both projects will ramp up output in coming years. Meanwhile, production from current reserves—RLI of more than 10 years—is stable and low cost, ensuring the distribution. The New York Stock Exchange (NYSE) listing generally keeps this one volatile because it’s traded by US institutions and hedge funds. But that will work to our advantage as gas prices recover. Enerplus Resources is a strong buy up to USD50.
Penn West has been considerably more aggressive on the acquisition front. The trust had no sooner wrapped up an offer for junior producer C1 Energy than it announced a takeover of battered Vault Energy at a price below book value. Vault must also pay Penn West CD10 million if it walks away from the deal, which is extremely unlikely because the alternative is resuming the trust’s death spiral of the past year.
The Vault deal will immediately boost Penn West’s cash flow, reserves and production per share when it’s completed later this year. A shareholder vote is expected in November. Meanwhile, cash costs are nil because the deal is entirely funded by new Penn West shares. That should help reduce the debt ratio of 1.5-to-1, as well as its payout ratio.
Penn West shares have been relatively weak in the past few months. The combination of this deal and the takeover of PrimeWest have turned that around for the moment. But the important thing is all fundamental measures of strength remain solid, from operating costs to reserve life. As long as that’s the case, it matters not what volatility hedge funds and traders cause in the near term. Penn West Energy Trust is a solid buy all the way up to USD38.
Despite its heavy focus on natural gas production, Peyto Energy Trust’s (PEY.UN, PEYUF) cash flow has held firm during the past year and its dividend has remained secure. That’s completely opposite of other gas-oriented trusts, which have universally had to cut at least once. Peyto’s strength is a low-cost development strategy and a vast reserve base with production that can be ramped up or down depending on market conditions. The trust dropped output by 10 percent in the second quarter year-over-year but still maintained a payout ratio of just 64 percent.
Steady business performance is in stark contrast to the volatility in the share price. That will continue as long as gas prices remain depressed. But with management well prepared, there’s little risk to buying Peyto Energy Trust up to USD20.
Provident Energy’s (PVE.UN, NYSE: PVX) substantial natural gas liquids (NGLs) operation provides a natural hedge to falling gas prices. That’s because gas is the primary input for NGLs, which sell at prices more akin to oil. Swelling NGL profit margins offset lower net from gas production.
The trust’s biggest strategic move this year is to dramatically expand its US operations, using the BreitBurn Energy limited partnership (LP) as a vehicle. As general partner, Provident gets the lion’s share of the LP’s cash and directs its moves. Meanwhile, it’s selling shares into the high-priced LP market to raise capital for further expansion.
Last month, management announced its most aggressive deal yet: the USD1.45 billion purchase of energy reserves and midstream assets in four US states from Quicksilver Resources. The move triples Provident’s operations in this country and is expected to be immediately accretive to cash flow. That’s very good news for the 11 percent-plus distribution, up to 2011 and beyond. Buy Provident Energy Trust up to USD14.
Investors got another opportunity to buy solid Vermilion Energy Trust (VET.UN, VETMF) last month, as the shares slid in reaction to an interruption in drilling at a project off the French coast. Ironically, the incident demonstrated the strength and diversification of the trust’s operations because it will scarcely put a dent in rising production and cash flow. The only truly international trust, Vermilion’s distribution is protected from corporate taxation by a diverse, growing reserve base and solid balance sheet.
The yield is below its peers, but superior total returns have left most in the dust. That should continue; Vermilion Energy Trust remains a strong buy up to USD38.
Getting Aggressive
The six core oil and gas producer trusts above are suitable for even the most conservative investor. They’re not immune from volatility. But as long as this energy bull market lasts—and it will until there’s a lot more conservation, use of real alternatives (not biofuels), new conventional reserve discoveries and likely a global recession—they’re headed a lot higher in coming years. And should Ottawa come to its senses on trust taxation or one of them receive a high-premium takeover offer, those big returns will come more quickly.
For those willing to take on a little more risk, the best bets are still in the gas-leveraged producer group. Survivors have shown their ability to weather even the worst conditions in the gas market. And they’re poised for monster gains when the fuel’s price does ultimately recover.
Advantage Energy has now completed its purchase of Sound Energy, swelling its reserve base, tax pools—noncash expenses that can be used to reduce future tax liability—and production at a price of only 87 percent of book value. The deal will cut operating costs per BOE and hold down debt, thanks to the use of equity financing. And it will reduce the trust’s reliance on gas output.
Of all the trusts in the CE universe, Advantage most closely resembles PrimeWest and is, therefore, a logical candidate for a high-premium takeover. It’s also selling cheaply at just 1.18 times book value.
The real reason to buy it, however, is its aggressive management, which continues to put its solid base of assets to good use. Advantage Energy remains a buy up to USD14.
Paramount Energy (PMT.UN, PMGYF) is by far my riskiest energy trust pick, deriving 100 percent of its cash flow from gas. In the past year, it’s clearly demonstrated the downside, trimming its distribution twice to shepherd cash flow and suffering a steep share price decline.
Throughout, however, the management team of Susan Riddell Rose has shown its mettle. The acquisition of Dominion Resources’ Canadian gas properties this summer dramatically enhanced reserves and productive capacity, while preserving financial flexibility. As a result, it’s in better shape than ever to prosper when gas does recover.
The question, of course, is when gas will recover and whether there’s more pain to be felt beforehand. And Paramount is a unique situation; it’s tough to envision what kind of takeover offer it would attract. Paramount Energy is a buy up to USD10 for patient and risk-tolerant investors only.
The Rest
Whether it winds up paying the Alberta government higher royalties or not, Canadian Oil Sands Trust will raise its distribution in coming quarters as production expands. Oil prices are the key to profitability, particularly with second quarter operating costs at more than USD30 per BOE. But under USD33 per share, it’s hard to go wrong taking a flyer for Canadian Oil Sands Trust.
In contrast, Harvest Energy’s (HTE.UN, NYSE: HTE) dividend risk has ratcheted up in recent weeks by what appear to be shrinking margins at its refinery (half of second quarter income). The trust has cut output at the facility to push up needed maintenance to October from next year as originally planned. That’s certain to strain near-term cash flow. The yield of 17 percent is definitely pricing in a distribution cut, which reduces risk. But in my view, investors are far better off with my core producer trusts. Hold Harvest Energy.
The conventional oil-weighted trusts–Baytex Energy (BTE.UN, NYSE: BTE), Bonterra Energy Fund (BNE.UN, BNEUF), Crescent Point Energy Trust (CPG.UN, CPGCF) and Zargon Energy Trust (ZAR.UN, ZARFF)–should continue to see improvement in cash flows and payout ratios for the rest of this year, largely on the strength of rising oil prices.
I’m still convinced Crescent Point Energy Trusts’s deep reserve base will earn it a high-premium takeover and continue to recommend it up to USD22. Also, Zargon Energy Trust’s deeply conservative approach makes it safe enough for even the most conservative and rates it a buy up to USD28.
Baytex, however, appears to be suffering from rising costs, while Bonterra’s small size and high operating costs mean it’s be viewed as a proxy for oil. That’s not a bad space to occupy. But it does mean risk; both Baytex Energy and Bonterra Energy Fund are holds for the aggressive only.
Of the dividend cut companies, I’ve warmed most to Canetic Energy (CNE.UN, NYSE: CNE). The trust dished out more in capital costs and distributions than it earned in second quarter cash flow. Nonetheless, the yield of nearly 15 is pricing in a modest distribution cut that’s less likely than a few months ago. Canetic Energy is a buy for the aggressive up to USD15.
Focus Energy’s (FET.UN, FETUF) production gains, cost controls and small distribution cut this year have shored up its dividend, despite weak gas prices. But all the same, I’d rather own Peyto, which yields basically the same. NAL Oil and Gas Trust (NAE.UN, NOIGF) has stabilized, and the purchase of National Fuel Gas’ Canadian properties is a plus. NAL Oil and Gas Trust is a buy up to USD12 for aggressive investors.
Fairborne Energy (FEL.UN, FRHLF) and Pengrowth Energy Trust (PGF.UN, NYSE: PGH) are pricing in dividend cuts and operations are getting traction. Hold both Fairborne Energy and Pengrowth Energy Trust. Progress Energy is in better shape and has reserves that would be attractive in a takeover. Buy Progress Energy up to USD15.
Avenir Diversified Income Trust (AVF.UN, AVNDF) is more of a financial services and real estate company than a producer. Avenir Diversified Income Trust still a buy up to USD8, but I’d be happier if management bowed to the inevitable and sold the production arm.
With Sound and Vault gone, Daylight Resources (DAY.UN, DAYFF), Enterra Energy, Trilogy Energy (TET.UN, TETFF) and True Energy (TUI.UN, TUIJF) are the last of the very high risk, small trusts remaining. Unfortunately, their only realistic road to survival is to be taken over by a larger, more powerful trust. And given the deals made for weaklings so far, none are likely to command the kind of premium that would justify the growing risk of holding them now. Consequently, I now advise selling this quartet and putting the proceeds into Canadian Edge Portfolio picks.