Raising the Rent

Let’s start with the bad news. Alberta Premier Ed Stelmach has spoken, and it’s official: Royalty levies are going up for most producers of oil and natural gas in Alberta.

Now the good news: The vast majority of Canadian income trusts are either marginally or wholly unaffected by the move. Moreover, several of the best and brightest–including ARC Energy Trust, Enerplus Resources and Penn West Energy Trust–stand to see their royalty rates drop substantially, providing a substantial boost to their cash flow and net asset value.

The government’s response to the commissioned report released last month was only 19 pages, a fraction of the size of the report itself. The boost in royalty rates fell well short of what the panel had initially proposed and proponents wanted. And the boost was somewhat more than what the industry would have preferred as well.

Here are the essential details in brief.

First of all, as is the case now, mature reserves or those with lower well productivity rates are assessed at a far lower rate than rich reserves. This has been considered essential to assure mature fields continue to have the economics to be developed. Mr. Stelmach’s ruling actually reduces royalty rates on mature fields, even as it raises rates on richer wells.

Natural gas royalties will range from a low rate of 5 percent to a top rate of 50 percent, up from a current high level of 35 percent. The rate will be capped when gas prices hit CAD16.59 per gigajoule. Rates won’t begin rising until gas hits CAD7 per gigajoule, rather than the CAD6 per gigajoule recommended by the panel.

The government projects additional revenue of CAD470 million for the province in 2010, versus CAD740 million recommended in the panel’s report. However, royalties will only increase if natural gas prices rise considerably from here–in other words, if there’s a recovery in the gas patch. Put another way, until there’s a recovery, there won’t be any additional burden on gas producers.

The top royalty rate on conventional oil will also rise from 35 percent to 50 percent, though with oil at close to $90 a barrel, producers are likely to see higher rates sooner. As for oil sands development, the 1 percent royalty assessed until projects are paid out will rise to more than 4 percent and could hit 9 percent if oil reaches $120 a barrel. Meanwhile, the 25 percent royalty rate for projects that are already paid out will rise to a cap of 40 percent, again if oil reaches $120 a barrel.

In all, only 13 of the panel’s 26 recommendations were taken. Among the more important rulings, there will be no new tax on oil sands production. Finally, the changes will be delayed 14 months–until 2009–rather than beginning next summer as the panel had recommended.

Stelmach adopted the panel’s recommendation not to grandfather existing projects. However, he also pledged to rely on negotiations–rather than edicts–to reach a new royalty deal with Suncor and Syncrude, which currently have agreements that run through 2015. These companies’ projects currently produce nearly 40 percent of Alberta’s bitumen. Failure to reach an accord would take a serious dent out of projected additional royalty revenue.

Suncor’s CEO has already staked out a position that oil sands development economics could be affected by the decision. Nonetheless, it appears he will negotiate, as will other major players.

How Trusts Are Affected

Thus far, the reaction in the market to Stelmach’s announcement has been decidedly muted. Even Suncor and Canadian Oil Sands–which owns roughly a third of the Syncrude project–have been spared big declines. Other trusts have mostly been flat.

Over the next several days, it’s still possible we’ll see some selling, including in the trusts. On the balance, however, the trusts have come out winners. That includes those involved in the oil sands, such as Enerplus and Penn West.

The biggest factor is the drop in royalty rates on mature or less productive wells, which are trusts’ bread and butter. Not only will this increase cash flows, it also signals the province is sympathetic to the plight of trusts in the wake of the national government’s plan to tax them as corporations beginning in 2011.

Barring a still very possible change in that policy, the end game for oil and gas producer trusts will be to become high dividend-paying intermediates. Lower royalty rates in Alberta will make that transition easier, though trust managements are unlikely to move in that direction precipitously. Based on the new rules of the game, Harvest Energy Trust stands to see the biggest decline in royalty rates.

More exciting is the projected decline in royalty rates for ARC Energy, Enerplus and Penn West. These should translate into substantial cash flow gains when the lower rates take effect in 2009.

No change is expected for royalty rates paid by Vermilion Energy Trust or Progress Energy Trust. A small drop in royalty rates is expected for Canetic Resources.

Falling royalty rates will also increase the net asset value of trusts. ARC Energy, Enerplus and Penn West stand to gain substantial value. So do Canetic, Crescent Point and Focus Energy Trust.

Besides Canadian Oil Sands–which will be hit by greater oil sands levies–the only trust that appears to have a significant additional liability is Baytex Energy Trust.

There’s another way oil and gas producer trusts could benefit from the higher royalty scheme. Next to oil sands-focused companies and trusts, the other group to be hit hard from the change in royalty rates is the junior producers.

In the past, this has been the group trusts have drawn from to make acquisitions to increase assets. High royalty rates on juniors could open up more opportunities for purchases to extend reserve life and expand production on the cheap. Both are critical for trusts to gain the scale needed to become high dividend-paying intermediates in the post-2011 world.

No matter how they come out on the royalty front, the ability to sustain business in an environment of volatile costs and energy prices remains the key to oil and gas producer trusts’ success. Those that can sustain will surge. Those that can’t will sink.

In the unfortunate latter camp, Fairborne Energy has now capitulated, launching a proposal to convert to a corporation and gut its distribution. Management of the small, gas-focused trust has decided it no longer has what it takes to survive as a trust.

Other weaklings may be forced to follow suit in coming months, unless they’re able to find a suitable merger partner. Ironically, as a converted junior, Fairborne may wind up paying higher royalty rates than it would have as a trust.

For the core of sustainable trusts in the Canadian Edge Aggressive Portfolio, however, this royalty decision is another reason why they should hold their own for a long time to come. There’s no cheaper group in the energy patch anywhere in the world.

The Roundup

Oil & Gas

Enterra Energy Trust’s (ENT.UN, NYSE: ENT) unraveling continues. The trust suspended its distribution in September so it could use the cash to pay down debt. Now, two board members–including the chairman–have quit, and CEO Keith Conrad has announced he will retire in 2008.

The changes at the top occurred “following directors’ meetings focused on certain decisions relating to the strategic direction of the trust,” Enterra said in a statement. Sell Enterra Energy Trust.

Progress Energy Trust (PGX.UN, PGXFF) reported a 41 percent decline in third quarter profit from year-ago levels because of higher operating costs and lower natural gas prices. Net income for the period ended Sept. 30, 2007, was CAD11.9 million (12 cents Canadian per unit), down from CAD20.3 million (27 cents Canadian per unit) during the third quarter of 2006.

Cash flow from operations of CAD48.0 million (43 cents Canadian per unit) compared to CAD47.2 million (54 cents Canadian per unit) in 2006. Cash distributions declared totaled CAD31 million (10 cents Canadian per unit) for a payout ratio of 64 percent.

Average production was up 35 percent to 23,772 barrels of oil equivalent per day (boe/d), including 120.8 million cubic feet per day of natural gas and 3,638 barrels of light and medium oil and natural gas liquids, because of acquisitions. Progress expects fourth quarter production to average approximately 24,000 boe/d.

Total debt-to-12-month trailing cash flow was two times at Sept. 30, 2007. Progress is sitting on tax pools in excess of CAD1 billion. Progress Energy Trust is a buy up to USD15.

Provident Energy Trust (PVE.UN, NYSE: PVX) is buying a privately held, Saskatchewan-based oil producer for CAD79 million in trust units. The trust will acquire about 1,300 barrels a day of oil output in the Steelman, Crystal Hills and Ingoldsby areas for 6.25 million of its units. It expects that volume to increase by 20 percent next year.

Proved plus probable reserves are pegged at 3.6 million barrels. The deal includes 17,900 net acres of undeveloped land. Provident will assume CAD13 million of debt and working capital, bringing the total value of the deal to CAD92 million. Provident expects the deal to be immediately accretive to cash flow per unit. Buy Provident Energy Trust up to USD14.

Electric Power

Algonquin Power Income Fund (APF.UN, AGQNF) affiliate Algonquin Power Fund is selling six landfill-gas-powered generating stations and related assets to Fortistar LLC for USD11.69 million. The transaction is expected to close in November.

According to Algonquin, the landfill gas assets, which account for approximately 18 megawatts (MW) of installed generating capacity, are “no longer considered strategic to the ongoing operations of the fund.” Algonquin Power Income Fund is a buy up to USD9.50.

Innergex Power Income Fund (IEF.UN, INRGF) has reached an agreement with privately held affiliate Innergex II Income Fund to acquire a 38 percent interest in the 109.5 MW Baie-des-Sables wind farm and a 38 percent interest in the 100.5 MW Anse-à-Valleau wind farm for CAD172.9 million. Both facilities operate under 20-year power purchase agreements with Hydro-Quebec.

Innergex will increase its distribution by CAD1 on an annualized basis starting Jan. 1, 2008. The acquisition boosts the fund’s total installed capacity by 61 percent to 210 MW and is projected to increase net annual production by 37 percent to 835 gigawatt hours and 2008 revenue by 44 percent to approximately CAD59 million.

Innergex will finance the acquisition by issuing 4,724,409 units to Innergex II, representing an amount of CAD61.7 million, by assuming CAD107.6 million in nonrecourse debts and by increasing the fund’s debt by CAD3.6 million. Innergex Power Income Fund is a buy up to USD12.

Gas/Propane

Precision Drilling Trust (PD.UN, NYSE: PDS) reported net earnings of CAD73 million (58 cents Canadian per unit) for the third quarter, down 48 percent from CAD140 million (CAD1.11 per unit) a year ago. Revenue was down 35 percent to CAD228 million.

In the contract drilling segment, revenue for the quarter decreased by 35 percent to CAD160 million; operating earnings decreased by 49 percent to CAD59 million compared to the same period in 2006. Average drilling rig operating day rates declined 12 percent to CD17,112.

In the completion and production segment, revenue for the third quarter decreased by 33 percent from 2006 to CAD72 million, while operating earnings decreased by 42 percent to CAD23 million. Service rig activity declined 32 percent from last year, with the fleet generating 84,490 operating hours compared with 123,783 hours in 2006.

Utilization fell to 38 percent in the quarter compared to 57 percent a year ago. Operating expenses increased from 48 percent of revenue in the third quarter of 2006 to 54 percent in 2007 because of lower customer pricing, higher labor costs and fixed overhead costs.

Conditions in Canada deteriorated even further during the period, but Precision continued to shift focus to the US land drilling market. It saw a sixfold increase in US drilling days quarter-over-quarter; as of Sept. 30, the trust had eight rigs operating in the lower 48 states at a utilization rate near 100 percent. Precision Drilling is a buy up to USD25.

Business Trusts

Chemtrade Logistics Income Fund’s (CHE.UN, CGIFF) reported earnings before interest, income taxes, depreciation and amortization (EBITDA) of CAD24.1 million, up from CAD20 million in the third quarter of 2006. Distributable cash for the period was CAD14.3 million (42 cents Canadian per unit), up from CAD13.3 million (40 cents Canadian per unit) a year ago.

Chemtrade generated revenue of CAD143.2 million, up from CAD148.7 million. Net earnings for the third quarter were CAD7.1 million compared with a net loss of CAD10.2 million in the same period in 2006. Chemtrade Logistics Income Fund is a buy up to USD10.

CI Financial Income Fund (CIX.UN, CIXUF) won’t be mailing the takeover bid information circular in respect of its unsolicited offer for money manager DundeeWealth in October, as originally intended. CI said in a Sept. 26 press release that its proposed bid of 0.75 of a CI unit for each DundeeWealth share was contingent upon getting a positive recommendation from DundeeWealth’s board, but DundeeWealth hasn’t commented either way on CI’s bid. CI Financial Income Fund is a buy up to USD28.

Cinram International Income Fund (CRW.UN, CRWFF) announced last Friday that, “based on preliminary financial information and discussions to date between management and the trustees, it is likely that a decision to cut distributions will be made at the trustees’ meeting” on Nov. 5. Last Friday, TSX Market Surveillance directed an inquiry at Cinram based on heavy trading in its units.

Cinram issues its third quarter financial results after the markets close on Nov. 5. Hold Cinram International Income Fund.

Oceanex Income Fund (OAX.UN, OCNXF) reported net income of CAD4 million (46 cents Canadian per unit) for the third quarter, up from CAD2.1 million (24 cents Canadian per unit) a year ago. Operating income rose to CAD5.3 million from CAD2.0 million in the third quarter of 2006. Revenue was up 4.2 percent to CAD35.1 million.

Higher freight rates and a 3.8 percent increase in shipments to Newfoundland accounted for the higher revenue. Container volume was marginally lower at 24,061 twenty-foot equivalent units (TEU) compared to 24,506 TEU a year ago. Vehicle shipments increased 12.7 percent to 5,302 units because of continuing strong vehicle sales. Hold Oceanex Income Fund.

Royal LePage Franchise Services Fund (RSF.UN, RYPGF) is changing its name to Brookfield Real Estate Services Fund. Fund units will trade under the TSX symbol BRE.UN as of Oct. 31, 2007. Brookfield Asset Management has a 25 percent subordinated interest in the fund and owns the fund’s manager, which has been renamed Brookfield Real Estate Services. Buy Royal LePage Franchise Services Fund up to USD14.

Sleep Country Canada Income Fund (Z.UN, SLPCF) reported a 14 percent rise in net income to CAD10.9 million (78 cents Canadian per unit) from CAD9.65 million (69 cents Canadian per unit) a year ago. Sales in the quarter were CAD104.7 million, up from CAD97.75 million in the 2006 period.

Sleep Country also announced a distribution increase to CAD1.45 per trust unit per year from the current annual rate of CAD1.40 per unit, starting with the November distribution to be paid on Dec. 20. Sleep Country Canada Income Fund is a buy up to USD22.

TransForce Income Fund (TIF.UN, TIFUF) reported an 8 percent rise in revenue to CAD486.2 million from CAD448.7 million on the strength of acquisitions. EBITDA was flat at CAD65.1 million.

Parcel delivery continued to grow, but volume for TranForce’s less-than-truckload segment was lower because of the strong Canadian dollar’s impact on the country’s manufacturing and automotive sectors. And dramatically lower drilling activity in Western Canada also held down the numbers.

TransForce could face additional pressure going forward, depending upon how Alberta oil and gas operators respond to the recently announced adjustments to provincial royalties. Cash flow from operating activities was CAD50.8 million in the third quarter, down from CAD57.4 million in the third quarter of 2006. Distributable cash from ongoing operations was CAD54.6 million, down from CAD60.4 million in the same quarter of 2006.

The fund’s payout ratio was 81.9 percent, up from 68.9 percent. Transforce Income Fund is a buy up to USD14.

Real Estate Trusts

Morguard REIT (MRT.UN, MGRUF) reported third quarter funds from operations of CAD17.1 million (29 cents Canadian per unit), up from CAD13.9 million (11 cents Canadian per unit) a year ago. Net income rose to CAD7.1 million (12 cents Canadian per unit) from CAD5.8 million (11 cents Canadian per unit).

Distributable income increased to CAD14.9 million (25 cents Canadian per unit), up from CAD12.3 (24 cents Canadian per unit). Occupancy was 95 percent, the same rate it was at Sept. 30, 2006. Hold Morguard REIT.

Natural Resource Trusts

Canfor Pulp Income Fund (CFX.UN) reported net income of CAD16.5 million (46 cents Canadian per unit) for the third quarter, compared to CAD8.4 million (59 cents Canadian per unit) in the same period of 2006. The fund’s results are based on its 49.8 percent ownership stake in Canfor Pulp LP.

The limited partnership reported sales of CAD228.9 million and net income of CAD33.2 million (46 cents Canadian per unit), compared to third quarter 2006 sales of CAD213.6 million and net income of CAD41.9 million (59 cents Canadian per unit). Pulp prices continued to rise in US dollar terms but not enough to offset the impact of a rising Canadian dollar and increased fiber costs.

The fund also announced a distribution cut to 14 cents Canadian per unit from 18 cents Canadian per unit because of the impact of the rising loonie. Pulp production was up 7,400 tons quarter-over-quarter to 265,700 tons on productivity increases and shorter scheduled maintenance downtime periods. Hold Canfor Pulp Income Fund.