Energy Trusts: A New Bull Market
Oil prices are up more than fivefold over the last five years. Most Canadian oil and gas producer trusts, however, have failed to follow suit. In fact, weak natural gas prices, the threat of 2011 taxation and, finally, the US credit crunch and emerging recession have made it hard for even the strongest to scratch out stock market gains.
There have been a half-dozen sector takeovers. But just one produced a windfall gain for investors, and it came from abroad: PrimeWest Energy Trust for a 40 percent premium by Abu Dhabi’s TAQA. The rest of the deals were at little or no premium, and several were merely rescues from likely bankruptcies.
Distributions have also been under attack. And as the venerable Canadian Money Reporter notes in its April 4 issue, oil and gas producing trusts have cut dividends 55 times since October 2006, versus only six increases.
By focusing on healthy businesses—rather than the highest yield—the Canadian Edge Portfolio has avoided most blowups from the sector stress tests. Thanks in part to the strong Canadian dollar, ARC Energy Trust (TSX: AET-U, OTC: AETUF), Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) all posted double-digit gains last year.
Enerplus Resources (NYSE: ERF, TSX: ERF-U) and Provident Energy Trust (NYSE: PVX, TSX: PVE-U) were slightly positive, while Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U) and Penn West Energy Trust (NYSE: PWE, TSX: PWT-U) were slightly negative. In fact, only aggressive gas play Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) was really under water.
Even the best energy trusts took a dive in the first weeks of 2008, as US recession fears began to crest. After touching a bottom of around 125 in mid-January, however, the broad-based S&P Toronto Stock Exchange Trust Composite (SPRTCM) has since moved up to the 150 mark. And in contrast to last year—when most trust winners were in sectors such as infrastructure—the charge has been led almost exclusively by energy producers.
ARC, Peyto and Vermilion have all added to last year’s gains. But the biggest winners of 2008 to date have been last year’s weakest, particularly Advantage and Paramount. In fact, almost every energy producer trust tracked in How They Rate turned in double-digit first quarter returns. That includes True Energy Trust (TSX: TUI-U, OTC: TUIJF), which halved its distribution in February. Ditto Enterra Energy Trust (NYSE: ENT, TSX: ENT-U), whose ultimate solvency is still very much in question.
What Happened
Why have oil and gas trusts turned around when much of the market has turned tail? There are two reasons: fading fears of 2011 trust taxation and signs of life at last in natural gas prices.
Little concrete action has happened since last month (see March CE Feature Article) on trust taxation legislation. The defeat of a pro-tax Alberta legislator on the issue is promising. But until the opposition Liberal Party confronts the government, all we can do is wait for the 2009 election.
The important thing is that taxation’s worst effects have been well baked into trusts’ prices since mid-November 2006. Any change would be positive, but even the status quo isn’t nearly as bad as once thought.
The best news thus far is the more-than-30-percent gain in the share price of the first strong trust to convert early to a corporation: Trinidad Drilling (TSX: TDG, OTC: TDGCF). Investors may not reap a similar windfall from every solid trust that follows its lead. But Trinidad’s example is a clear indication of the value that will be unlocked in strong trusts once 2011 tax questions are answered, one way or another.
Another plus is management clarifications of trusts’ future dividend policy. Report after report has stated the intention to remain dividend-paying entities well after 2011. Some are also providing details of how they’ll accomplish that, particularly in the energy sector regarding tax pools.
There’s still much unknown about the 2011 tax burden of trusts. Some face a possible hefty burden, others little. As details appear, however, they’re eliminating uncertainty and fear, and share prices are recovering.
Of course, it’s a lot easier to be sanguine about future taxation when business is booming. And for energy trusts, it’s all about energy prices.
I’ve run the graph “Enerplus and Oil” several times in the past to show the close relationship between the oldest energy trust and the price of oil. The correlation weakened over the past year as gas prices decoupled from black gold and 2011 tax issues dominated. Now that gas is behaving more normally and trust tax issues are receding, this relationship is key again.
Higher oil prices do flow through to the bottom line for trusts, and those most focused on the liquid have done extremely well during the past several years. Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), for example, has now ratcheted up its quarterly distribution to 75 cents Canadian a share.
Oil, however, is priced in US dollars globally. As a result, trusts’ profits are diminished by the rise in the Canadian dollar. And with the loonie’s long-term rise pegged to rising oil prices, its strength will continue to temper trusts’ oil profits going forward.
In contrast, changes in natural gas prices flow right to the bottom line. That was a downer last year. Despite locking in sales by aggressive hedging, trusts’ realized selling prices for gas in 2007 fell from 10 percent to 25 percent from year-earlier levels as gas sank to the USD5-to-USD7-per-million-British-thermal-units (MMBtu) range.
Natural gas prices closely track the level of weekly inventories. Such inventories follow the weather, which makes for volatility; this has been deeply frustrating for producers. From hurricanes Katrina and Rita in 2005 through late 2007, weather in North America was generally mild, both in summer and winter. As a result, inventories built up and prices plunged.
That’s reversed with a vengeance in early 2008, as colder weather has driven up gas demand and drawn down inventories. But a return to normal weather is only part of the story for gas.
For one thing, depressed gas has deeply depressed North American production, particularly in Canada. That’s also decreased supply, making it possible for a single weather season to dramatically tighten inventories.
More important for the rest of the year and beyond, North America is on the verge of another quantum leap in gas demand, similar to what took place at the beginning of this decade. Mainly, we’re seeing a massive “rush to gas” on the part of electric power generators as the easiest way to comply with almost certain carbon-dioxide (CO2) regulation in 2009.
Gas-fired plants emit less than half the CO2 per unit of power produced as coal plants. Moreover, they can be built in a fraction of the time and cost of new baseload clean coal and nuclear plants. And they’re far more reliable than renewable energy facilities such as wind turbines, which run on average at less than 20 percent of capacity.
In the late 1990s and early ’00s, some 90 gigawatts of natural gas-fired power plants came on line in North America. The result was a permanent jump in natural gas prices’ floor from USD1 to USD2 per MMBtu to the USD5-to-USD7-per-MMBtu range.
This year, however, gas has moved to USD9 to USD10 per MMBtu. But this new burst of gas usage promises to make that a new floor, even if expected supplies do materialize and liquid natural gas (LNG) imports mushroom. That’s 30 percent to 60 percent above the range producer trusts sold gas for last year. And that adds up to a lot more cash flow in coming quarters.
In the past six months, four energy producer trusts tracked in How They Rate have raised distributions: Baytex Energy Trust (NYSE: BTE, TSX: BTE-U), Bonterra Energy Fund (TSX: BNE-U, OTC: BNEUF), Canadian Oil Sands and Vermilion. All four benefited primarily from higher oil prices; Vermilion cashed in on higher prices for gas in Europe.
Barring a crash in gas from here, more producers will bump up payouts in coming months. That’s in part because they have to pay out in order to hold down taxes. But it’s also because trusts have proven their sustainability over the past two years and their ability to pay out rich distributions even after 2011.
To be sure, my positive assessment depends squarely on what happens to energy prices. That will be a great bet for several more years—until we see ’70s magnitude demand destruction for oil and gas with conservation and movement to alternatives.
All commodity price cycles eventually end, as higher prices depress demand and encourage more supply. What could prolong this cycle, however, is that changes in the US and the rest of the developed world are no longer enough. Rather, unlike the ’70s, developing Asia will also have to curb its appetite.
Moreover, Asia’s demand for resources appears to be increasingly independent of the US. Since the US economy began slowing in mid-2007, the Wall Street consensus has looked for weakness here to drag down Asian demand for energy. Nine months later, that’s still not happening.
We still don’t have any real visibility on how much the US economy will slow in 2008. And until then, there’s risk that Asian demand will crater and energy prices will plunge. But still trading near book value and below net asset value in many cases, strong trusts’ prices already reflect a lot of risk.
Moreover, trusts have a built-in safety cushion against even a devastating drop in oil and gas prices: They sell output in advance to lock in cash flows to finance operations and pay monthly distributions. As a result, they’ve been selling well below current spot prices for oil and gas.
We’d have to see a drop in oil prices well south of $70 a barrel and gas under $6 per MMBtu—with prices remaining at those levels for at least several quarters—to have a real negative impact on their cash flows and dividends. The longer prices stay above that, the higher selling prices they’ll be able to lock in, and the higher their cash flows will go.
That’s a super-bullish outlook in what’s otherwise a very tough year for the markets and the North American economy. Coupled with valuations at or below asset values and increasingly secure distributions, it adds up to potential for big returns for strong energy-producing trusts, in addition to those they’ve already racked up in otherwise gloomy 2008.
Rating Energy
All energy producer trusts pay generous distributions. But only those with sustainable businesses are worth owning. That’s the clear lesson of the past two years, when more than half the producer trusts were forced to cut distributions and many vanished entirely. And it’s just as true for this volatile sector today.
The Canadian Edge Web site has a permanent feature called Oil and Gas Reserve Life, highlighted by a table/databank for measuring producer trust sustainability. This month, I’m enhancing coverage with an eye to the challenges these trusts will face in the coming year.
Some of the featured data remain the same–for example, dividend history. Starting from the left, this column shows how many months ago the distribution was last changed, whether it was cut or raised and how many months it’s been since the last dividend cut. The more months since a cut, the more sustainably management is running the trust.
Then there’s the all-important payout ratio. This measures the current distribution rate as a percentage of distributable cash flow generated for the most recent quarter available. Current figures reflect the fourth quarter of 2007.
Generally, the rule here is the lower the payout ratio the better. However, consistency is equally important. Producer trusts with payout ratios of 100 percent or higher are always sells, unless there’s a very good reason (besides a pending dividend cut) for that condition to be considered temporary. Note that I’m not using earnings per share in this calculation because trusts by definition minimize that number to avoid taxes.
Trusts’ ability to issue new units is now restricted by Canadian law to 20 percent a year for the next three years. As a result, measuring dilution with the rate of share growth has become less critical. Debt growth, however, has become a good deal more important.
That’s why I’m now presenting the debt-to-annual operating cash flow ratio. As with the payout ratio, the rule is the lower the better. Anything under 1.5 should be considered extremely safe. Anything above 2 indicates a high reliance on debt, though that’s acceptable for very aggressive plays. It’s also OK if the trust owns stable infrastructure, as does Provident Energy.
Note that I’ve stopped tracking Dominion Bond Ratings Service stability ratings in the table because not every trust has one. These can still be followed by going to www.dbrs.com. Changes are infrequent, but I’ll be reporting them as they occur in the How They Rate Table and elsewhere.
The remaining criteria presented concern producer trusts’ primary asset—oil and gas reserves—and their costs of production. Canadian trusts’ reserves are typically mature, meaning they require relatively little capital cost to produce. That’s in essence why they’re able to pay such high distributions now and why the best will be able to long after 2011, should they elect to.
The flipside of this is that trust reserves tend to deplete faster than those of non-trust producers, and they must constantly invest to replace them. The longer the reserve life index (RLI) of a trust, the greater management’s flexibility to replace reserves and to pull in its horns in rough times. A high RLI (10 years or more) is one of the best gauges of superior trust sustainability.
Reserves analysis is complex. The best sources of data are the reports trusts publish once a year, which are now available for 2008. The basic calculation for RLI is total reserves divided by annual production.
I use proved reserves for my primary RLI calculations. These are reserves that have been independently assessed as having a 90 percent or better chance of being developed. I also track proved plus probable RLI, which includes anything with a 60 percent chance or better of coming on stream.
Production scale and diversity of reserves are also invaluable. Higher levels of output (at least 50,000 barrels of oil equivalent a day) mean more flexibility in the face of operating challenges, from provincial taxes to dry holes. And having a balanced production mix between gas and oil ensures against setbacks in one commodity or the other.
As for cost structure, I present two measurements. One is operating costs per barrels of oil equivalent (boe), which tracks the cost of getting the energy out of the ground. The second is the cost of finding, developing and acquiring (FD&A) new reserves per boe. The most sustainable trusts will have the lowest costs for both.
Finally, I’ve posted trusts’ realized selling prices for their oil and gas based on the fourth quarter of 2007. The lower realized prices, the more upside trusts’ cash flows have for 2008 and the more cushion they have should energy prices unexpectedly crater from here.
How They Rate
No matter how strong its sustainability credentials, every producer trust’s cash flows are ultimately going to be affected by energy price swings. Higher prices will bring prosperity, while lower prices mean challenges.
Focusing on the most sustainable trusts saved a lot of pain over the past two years. It’s also the best way to ensure your holdings will take advantage of several more years of strong energy prices and that they’ll handle the challenges of 2011 taxation as well. Investors ignore them to chase the highest yield at their peril.
The Canadian Edge ratings (see How They Rate) group trusts on an absolute scale from 1 (safest) to 6 (riskiest). Because they hail from a volatile sector, however, all producer trusts generally rate lower than trusts from other industries. Consequently, the Oil and Gas Reserve Life Table makes for a better intersector comparison.
It should come as no surprise that, based on all the criteria there, the most sustainable oil and gas trusts are the group I’ve featured for some time. That’s Aggressive Portfolio members ARC Energy, Enerplus Resources, Penn West, Peyto and Vermilion. I also include Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF).
Each of these trusts has relatively long-life reserves; balanced and scaled-up production; reasonable combined operating and FD&A costs that appear to be downtrending; low debt-to-cash flow; a low, stable payout ratio; and fourth quarter 2007 realized oil and gas prices at least a third below current spot prices.
Peyto’s heavy focus on natural gas production and smaller output level are relative weaknesses. But they’re more than made up for by very low combined operating and FD&A costs of just CAD11.67, proved RLI of 16 years and a low payout ratio.
None of these six trusts’ distributions were ever remotely threatened over the past two years, while Vermilion bumped its higher by nearly 12 percent. They remain core holdings for any portfolio. If you haven’t already, buy them up to the USD prices in parentheses: ARC Energy Trust (26), Bonavista Energy Trust (30), Enerplus Resources (50), Penn West Energy Trust (38), Peyto Energy Trust (20) and Vermilion Energy Trust (40).
On the next tier are trusts that also held their distributions firm during the stress tests and boast strong sustainability criteria overall but miss on one or two, making them slightly riskier than the first group: Avenir Diversified Income (TSX: AVF-U, OTC: AVNDF), Baytex Energy Trust, Bonterra Energy Fund, Canadian Oil Sands Trust, Crescent Point Energy Trust (TSX: CPG-U, OTC: CPGCF), Provident Energy Trust and Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF).
Baytex, Bonterra, Canadian Oil Sands and Crescent miss the top list only because they’re extremely weighted toward oil production. That’s been a real boon in the past couple years, and the first three have been able to increase distributions. It could present some risk if oil tanks, but the damage would be well contained by generally low debt, payout ratios and realized prices for oil.
Canadian Oil Sands’ current high payout ratio should come down sharply this year as new production ramps up. The trust also carries a couple more risks than other high-quality trusts.
First, royalty rates in Alberta are slated to increase in 2009. And although that won’t affect conventional trusts much, it will take a bite out of cash flows from oil sands. Second, oil sands production is slated to meet tougher environmental rules going forward, particularly regarding CO2 emissions. Neither risk is likely to derail this trust, but they do add some uncertainty not present in the top tier.
Provident’s payout ratio came down sharply in the fourth quarter as its recent purchases of infrastructure and reserves began to pay off. It missed the top group only because of an erratic payout ratio in recent quarters and the ongoing strategic review that may lead to reorganization and/or asset sales. Note its relatively high debt load is manageable because a third of cash flow comes from steady, fee-generating infrastructure.
Avenir and Zargon, meanwhile, missed only because of their small size (less than 10,000 boe per day production), which also pushed up their combined operating and FD&A costs. Zargon’s shortcomings are balanced by a very low payout ratio and the lowest debt-to-cash flow ratio in the industry (0.71). Avenir is balanced by the fact that 60 percent of cash flows are from low-risk financial services and real estate.
Nonetheless, all seven trusts are buys below USD prices in parentheses: Avenir Diversified Income (8), Baytex Energy Trust (24), Bonterra Energy Trust (28), Canadian Oil Sands Trust (45), Crescent Point Energy Trust (28), Provident Energy Trust (14) and Zargon Energy Trust (28). They’re best for those willing to take on a little more risk but are fine if held mostly with top-tier trusts.
The third group of trusts shares the ignominy of cutting distributions at least once during the stress tests. With the exception of floundering Enterra Energy Trust (sell), all appear on course for long-run sustainability. And only Harvest Energy Trust’s (NYSE: HTE, TSX: HTE-U) distribution is under pressure in early 2008. (See Tips on Trusts.)
Last year’s troubles at Advantage and Paramount can be laid squarely at the feet of slumping natural gas prices, and both trusts have actually used the environment to their betterment by acquiring good reserves on the cheap. That should pay off richly with gas prices recovering this year.
Debt is still high, but payout ratios and costs are under control. And there’s a lot of upside for realized selling prices this year for gas. As long as gas prices stay up, that should add up to big gains for those buying below recommended USD prices: Advantage Energy Trust (12) and Paramount Energy Trust (10).
Higher gas prices should also benefit gas heavy speculation Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF), which appears to have finally absorbed its acquisition of Sound Energy. More balanced NAL Oil & Gas (NAE.UN, NOIGF) and gas-weighted Progress Energy Trust (TSX: PGX-U, OTC: PGXFF) also appear to be out of the woods after recent reserve and production growth, though Progress is still carrying a relatively heavy debt load. They’re buys up to the following USD prices for more aggressive investors: Daylight Resources Trust (9), NAL Oil & Gas (14) and Progress Energy Trust (15).
As for the rest of the list, I’m lukewarm to negative. Freehold Royalty Trust (TSX: FRU-U, OTC: FRHLF) is a royalty earner rather than a producer, making it too dependent on other companies for its income. Its dividends are also ordinary income for US investors. Pengrowth Energy Trust (NYSE: PGH, TSX: PGF-U) carries tax complications as a limited partnership in the US. It’s had some success improving its asset portfolio in recent years, but costs, debt and payout ratio are still too high for comfort.
Trilogy Energy (TSX: TET-U, OTC: TETFF) appears to be on the right track after a rough couple years. But debt is lofty, and I want to see a few more quarters of low payout ratios before upgrading it to a buy. Ditto True Energy Trust (TSX: TUI-U, OTC: TUIJF). The trust carries even higher costs, and debt and production will shrink with the sale of its Saskatchewan assets. Freehold Royalty Trust, Pengrowth Energy Trust, Trilogy Energy and True Energy Trust are great swap candidates for those who still own them.
There have been a half-dozen sector takeovers. But just one produced a windfall gain for investors, and it came from abroad: PrimeWest Energy Trust for a 40 percent premium by Abu Dhabi’s TAQA. The rest of the deals were at little or no premium, and several were merely rescues from likely bankruptcies.
Distributions have also been under attack. And as the venerable Canadian Money Reporter notes in its April 4 issue, oil and gas producing trusts have cut dividends 55 times since October 2006, versus only six increases.
By focusing on healthy businesses—rather than the highest yield—the Canadian Edge Portfolio has avoided most blowups from the sector stress tests. Thanks in part to the strong Canadian dollar, ARC Energy Trust (TSX: AET-U, OTC: AETUF), Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) all posted double-digit gains last year.
Enerplus Resources (NYSE: ERF, TSX: ERF-U) and Provident Energy Trust (NYSE: PVX, TSX: PVE-U) were slightly positive, while Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U) and Penn West Energy Trust (NYSE: PWE, TSX: PWT-U) were slightly negative. In fact, only aggressive gas play Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) was really under water.
Even the best energy trusts took a dive in the first weeks of 2008, as US recession fears began to crest. After touching a bottom of around 125 in mid-January, however, the broad-based S&P Toronto Stock Exchange Trust Composite (SPRTCM) has since moved up to the 150 mark. And in contrast to last year—when most trust winners were in sectors such as infrastructure—the charge has been led almost exclusively by energy producers.
ARC, Peyto and Vermilion have all added to last year’s gains. But the biggest winners of 2008 to date have been last year’s weakest, particularly Advantage and Paramount. In fact, almost every energy producer trust tracked in How They Rate turned in double-digit first quarter returns. That includes True Energy Trust (TSX: TUI-U, OTC: TUIJF), which halved its distribution in February. Ditto Enterra Energy Trust (NYSE: ENT, TSX: ENT-U), whose ultimate solvency is still very much in question.
What Happened
Why have oil and gas trusts turned around when much of the market has turned tail? There are two reasons: fading fears of 2011 trust taxation and signs of life at last in natural gas prices.
Little concrete action has happened since last month (see March CE Feature Article) on trust taxation legislation. The defeat of a pro-tax Alberta legislator on the issue is promising. But until the opposition Liberal Party confronts the government, all we can do is wait for the 2009 election.
The important thing is that taxation’s worst effects have been well baked into trusts’ prices since mid-November 2006. Any change would be positive, but even the status quo isn’t nearly as bad as once thought.
The best news thus far is the more-than-30-percent gain in the share price of the first strong trust to convert early to a corporation: Trinidad Drilling (TSX: TDG, OTC: TDGCF). Investors may not reap a similar windfall from every solid trust that follows its lead. But Trinidad’s example is a clear indication of the value that will be unlocked in strong trusts once 2011 tax questions are answered, one way or another.
Another plus is management clarifications of trusts’ future dividend policy. Report after report has stated the intention to remain dividend-paying entities well after 2011. Some are also providing details of how they’ll accomplish that, particularly in the energy sector regarding tax pools.
There’s still much unknown about the 2011 tax burden of trusts. Some face a possible hefty burden, others little. As details appear, however, they’re eliminating uncertainty and fear, and share prices are recovering.
Of course, it’s a lot easier to be sanguine about future taxation when business is booming. And for energy trusts, it’s all about energy prices.
I’ve run the graph “Enerplus and Oil” several times in the past to show the close relationship between the oldest energy trust and the price of oil. The correlation weakened over the past year as gas prices decoupled from black gold and 2011 tax issues dominated. Now that gas is behaving more normally and trust tax issues are receding, this relationship is key again.
Higher oil prices do flow through to the bottom line for trusts, and those most focused on the liquid have done extremely well during the past several years. Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), for example, has now ratcheted up its quarterly distribution to 75 cents Canadian a share.
Oil, however, is priced in US dollars globally. As a result, trusts’ profits are diminished by the rise in the Canadian dollar. And with the loonie’s long-term rise pegged to rising oil prices, its strength will continue to temper trusts’ oil profits going forward.
In contrast, changes in natural gas prices flow right to the bottom line. That was a downer last year. Despite locking in sales by aggressive hedging, trusts’ realized selling prices for gas in 2007 fell from 10 percent to 25 percent from year-earlier levels as gas sank to the USD5-to-USD7-per-million-British-thermal-units (MMBtu) range.
Natural gas prices closely track the level of weekly inventories. Such inventories follow the weather, which makes for volatility; this has been deeply frustrating for producers. From hurricanes Katrina and Rita in 2005 through late 2007, weather in North America was generally mild, both in summer and winter. As a result, inventories built up and prices plunged.
That’s reversed with a vengeance in early 2008, as colder weather has driven up gas demand and drawn down inventories. But a return to normal weather is only part of the story for gas.
For one thing, depressed gas has deeply depressed North American production, particularly in Canada. That’s also decreased supply, making it possible for a single weather season to dramatically tighten inventories.
More important for the rest of the year and beyond, North America is on the verge of another quantum leap in gas demand, similar to what took place at the beginning of this decade. Mainly, we’re seeing a massive “rush to gas” on the part of electric power generators as the easiest way to comply with almost certain carbon-dioxide (CO2) regulation in 2009.
Gas-fired plants emit less than half the CO2 per unit of power produced as coal plants. Moreover, they can be built in a fraction of the time and cost of new baseload clean coal and nuclear plants. And they’re far more reliable than renewable energy facilities such as wind turbines, which run on average at less than 20 percent of capacity.
In the late 1990s and early ’00s, some 90 gigawatts of natural gas-fired power plants came on line in North America. The result was a permanent jump in natural gas prices’ floor from USD1 to USD2 per MMBtu to the USD5-to-USD7-per-MMBtu range.
This year, however, gas has moved to USD9 to USD10 per MMBtu. But this new burst of gas usage promises to make that a new floor, even if expected supplies do materialize and liquid natural gas (LNG) imports mushroom. That’s 30 percent to 60 percent above the range producer trusts sold gas for last year. And that adds up to a lot more cash flow in coming quarters.
In the past six months, four energy producer trusts tracked in How They Rate have raised distributions: Baytex Energy Trust (NYSE: BTE, TSX: BTE-U), Bonterra Energy Fund (TSX: BNE-U, OTC: BNEUF), Canadian Oil Sands and Vermilion. All four benefited primarily from higher oil prices; Vermilion cashed in on higher prices for gas in Europe.
Barring a crash in gas from here, more producers will bump up payouts in coming months. That’s in part because they have to pay out in order to hold down taxes. But it’s also because trusts have proven their sustainability over the past two years and their ability to pay out rich distributions even after 2011.
To be sure, my positive assessment depends squarely on what happens to energy prices. That will be a great bet for several more years—until we see ’70s magnitude demand destruction for oil and gas with conservation and movement to alternatives.
All commodity price cycles eventually end, as higher prices depress demand and encourage more supply. What could prolong this cycle, however, is that changes in the US and the rest of the developed world are no longer enough. Rather, unlike the ’70s, developing Asia will also have to curb its appetite.
Moreover, Asia’s demand for resources appears to be increasingly independent of the US. Since the US economy began slowing in mid-2007, the Wall Street consensus has looked for weakness here to drag down Asian demand for energy. Nine months later, that’s still not happening.
We still don’t have any real visibility on how much the US economy will slow in 2008. And until then, there’s risk that Asian demand will crater and energy prices will plunge. But still trading near book value and below net asset value in many cases, strong trusts’ prices already reflect a lot of risk.
Moreover, trusts have a built-in safety cushion against even a devastating drop in oil and gas prices: They sell output in advance to lock in cash flows to finance operations and pay monthly distributions. As a result, they’ve been selling well below current spot prices for oil and gas.
We’d have to see a drop in oil prices well south of $70 a barrel and gas under $6 per MMBtu—with prices remaining at those levels for at least several quarters—to have a real negative impact on their cash flows and dividends. The longer prices stay above that, the higher selling prices they’ll be able to lock in, and the higher their cash flows will go.
That’s a super-bullish outlook in what’s otherwise a very tough year for the markets and the North American economy. Coupled with valuations at or below asset values and increasingly secure distributions, it adds up to potential for big returns for strong energy-producing trusts, in addition to those they’ve already racked up in otherwise gloomy 2008.
Rating Energy
All energy producer trusts pay generous distributions. But only those with sustainable businesses are worth owning. That’s the clear lesson of the past two years, when more than half the producer trusts were forced to cut distributions and many vanished entirely. And it’s just as true for this volatile sector today.
The Canadian Edge Web site has a permanent feature called Oil and Gas Reserve Life, highlighted by a table/databank for measuring producer trust sustainability. This month, I’m enhancing coverage with an eye to the challenges these trusts will face in the coming year.
Some of the featured data remain the same–for example, dividend history. Starting from the left, this column shows how many months ago the distribution was last changed, whether it was cut or raised and how many months it’s been since the last dividend cut. The more months since a cut, the more sustainably management is running the trust.
Then there’s the all-important payout ratio. This measures the current distribution rate as a percentage of distributable cash flow generated for the most recent quarter available. Current figures reflect the fourth quarter of 2007.
Generally, the rule here is the lower the payout ratio the better. However, consistency is equally important. Producer trusts with payout ratios of 100 percent or higher are always sells, unless there’s a very good reason (besides a pending dividend cut) for that condition to be considered temporary. Note that I’m not using earnings per share in this calculation because trusts by definition minimize that number to avoid taxes.
Trusts’ ability to issue new units is now restricted by Canadian law to 20 percent a year for the next three years. As a result, measuring dilution with the rate of share growth has become less critical. Debt growth, however, has become a good deal more important.
That’s why I’m now presenting the debt-to-annual operating cash flow ratio. As with the payout ratio, the rule is the lower the better. Anything under 1.5 should be considered extremely safe. Anything above 2 indicates a high reliance on debt, though that’s acceptable for very aggressive plays. It’s also OK if the trust owns stable infrastructure, as does Provident Energy.
Note that I’ve stopped tracking Dominion Bond Ratings Service stability ratings in the table because not every trust has one. These can still be followed by going to www.dbrs.com. Changes are infrequent, but I’ll be reporting them as they occur in the How They Rate Table and elsewhere.
The remaining criteria presented concern producer trusts’ primary asset—oil and gas reserves—and their costs of production. Canadian trusts’ reserves are typically mature, meaning they require relatively little capital cost to produce. That’s in essence why they’re able to pay such high distributions now and why the best will be able to long after 2011, should they elect to.
The flipside of this is that trust reserves tend to deplete faster than those of non-trust producers, and they must constantly invest to replace them. The longer the reserve life index (RLI) of a trust, the greater management’s flexibility to replace reserves and to pull in its horns in rough times. A high RLI (10 years or more) is one of the best gauges of superior trust sustainability.
Reserves analysis is complex. The best sources of data are the reports trusts publish once a year, which are now available for 2008. The basic calculation for RLI is total reserves divided by annual production.
I use proved reserves for my primary RLI calculations. These are reserves that have been independently assessed as having a 90 percent or better chance of being developed. I also track proved plus probable RLI, which includes anything with a 60 percent chance or better of coming on stream.
Production scale and diversity of reserves are also invaluable. Higher levels of output (at least 50,000 barrels of oil equivalent a day) mean more flexibility in the face of operating challenges, from provincial taxes to dry holes. And having a balanced production mix between gas and oil ensures against setbacks in one commodity or the other.
As for cost structure, I present two measurements. One is operating costs per barrels of oil equivalent (boe), which tracks the cost of getting the energy out of the ground. The second is the cost of finding, developing and acquiring (FD&A) new reserves per boe. The most sustainable trusts will have the lowest costs for both.
Finally, I’ve posted trusts’ realized selling prices for their oil and gas based on the fourth quarter of 2007. The lower realized prices, the more upside trusts’ cash flows have for 2008 and the more cushion they have should energy prices unexpectedly crater from here.
How They Rate
No matter how strong its sustainability credentials, every producer trust’s cash flows are ultimately going to be affected by energy price swings. Higher prices will bring prosperity, while lower prices mean challenges.
Focusing on the most sustainable trusts saved a lot of pain over the past two years. It’s also the best way to ensure your holdings will take advantage of several more years of strong energy prices and that they’ll handle the challenges of 2011 taxation as well. Investors ignore them to chase the highest yield at their peril.
The Canadian Edge ratings (see How They Rate) group trusts on an absolute scale from 1 (safest) to 6 (riskiest). Because they hail from a volatile sector, however, all producer trusts generally rate lower than trusts from other industries. Consequently, the Oil and Gas Reserve Life Table makes for a better intersector comparison.
It should come as no surprise that, based on all the criteria there, the most sustainable oil and gas trusts are the group I’ve featured for some time. That’s Aggressive Portfolio members ARC Energy, Enerplus Resources, Penn West, Peyto and Vermilion. I also include Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF).
Each of these trusts has relatively long-life reserves; balanced and scaled-up production; reasonable combined operating and FD&A costs that appear to be downtrending; low debt-to-cash flow; a low, stable payout ratio; and fourth quarter 2007 realized oil and gas prices at least a third below current spot prices.
Peyto’s heavy focus on natural gas production and smaller output level are relative weaknesses. But they’re more than made up for by very low combined operating and FD&A costs of just CAD11.67, proved RLI of 16 years and a low payout ratio.
None of these six trusts’ distributions were ever remotely threatened over the past two years, while Vermilion bumped its higher by nearly 12 percent. They remain core holdings for any portfolio. If you haven’t already, buy them up to the USD prices in parentheses: ARC Energy Trust (26), Bonavista Energy Trust (30), Enerplus Resources (50), Penn West Energy Trust (38), Peyto Energy Trust (20) and Vermilion Energy Trust (40).
On the next tier are trusts that also held their distributions firm during the stress tests and boast strong sustainability criteria overall but miss on one or two, making them slightly riskier than the first group: Avenir Diversified Income (TSX: AVF-U, OTC: AVNDF), Baytex Energy Trust, Bonterra Energy Fund, Canadian Oil Sands Trust, Crescent Point Energy Trust (TSX: CPG-U, OTC: CPGCF), Provident Energy Trust and Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF).
Baytex, Bonterra, Canadian Oil Sands and Crescent miss the top list only because they’re extremely weighted toward oil production. That’s been a real boon in the past couple years, and the first three have been able to increase distributions. It could present some risk if oil tanks, but the damage would be well contained by generally low debt, payout ratios and realized prices for oil.
Canadian Oil Sands’ current high payout ratio should come down sharply this year as new production ramps up. The trust also carries a couple more risks than other high-quality trusts.
First, royalty rates in Alberta are slated to increase in 2009. And although that won’t affect conventional trusts much, it will take a bite out of cash flows from oil sands. Second, oil sands production is slated to meet tougher environmental rules going forward, particularly regarding CO2 emissions. Neither risk is likely to derail this trust, but they do add some uncertainty not present in the top tier.
Provident’s payout ratio came down sharply in the fourth quarter as its recent purchases of infrastructure and reserves began to pay off. It missed the top group only because of an erratic payout ratio in recent quarters and the ongoing strategic review that may lead to reorganization and/or asset sales. Note its relatively high debt load is manageable because a third of cash flow comes from steady, fee-generating infrastructure.
Avenir and Zargon, meanwhile, missed only because of their small size (less than 10,000 boe per day production), which also pushed up their combined operating and FD&A costs. Zargon’s shortcomings are balanced by a very low payout ratio and the lowest debt-to-cash flow ratio in the industry (0.71). Avenir is balanced by the fact that 60 percent of cash flows are from low-risk financial services and real estate.
Nonetheless, all seven trusts are buys below USD prices in parentheses: Avenir Diversified Income (8), Baytex Energy Trust (24), Bonterra Energy Trust (28), Canadian Oil Sands Trust (45), Crescent Point Energy Trust (28), Provident Energy Trust (14) and Zargon Energy Trust (28). They’re best for those willing to take on a little more risk but are fine if held mostly with top-tier trusts.
The third group of trusts shares the ignominy of cutting distributions at least once during the stress tests. With the exception of floundering Enterra Energy Trust (sell), all appear on course for long-run sustainability. And only Harvest Energy Trust’s (NYSE: HTE, TSX: HTE-U) distribution is under pressure in early 2008. (See Tips on Trusts.)
Last year’s troubles at Advantage and Paramount can be laid squarely at the feet of slumping natural gas prices, and both trusts have actually used the environment to their betterment by acquiring good reserves on the cheap. That should pay off richly with gas prices recovering this year.
Debt is still high, but payout ratios and costs are under control. And there’s a lot of upside for realized selling prices this year for gas. As long as gas prices stay up, that should add up to big gains for those buying below recommended USD prices: Advantage Energy Trust (12) and Paramount Energy Trust (10).
Higher gas prices should also benefit gas heavy speculation Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF), which appears to have finally absorbed its acquisition of Sound Energy. More balanced NAL Oil & Gas (NAE.UN, NOIGF) and gas-weighted Progress Energy Trust (TSX: PGX-U, OTC: PGXFF) also appear to be out of the woods after recent reserve and production growth, though Progress is still carrying a relatively heavy debt load. They’re buys up to the following USD prices for more aggressive investors: Daylight Resources Trust (9), NAL Oil & Gas (14) and Progress Energy Trust (15).
As for the rest of the list, I’m lukewarm to negative. Freehold Royalty Trust (TSX: FRU-U, OTC: FRHLF) is a royalty earner rather than a producer, making it too dependent on other companies for its income. Its dividends are also ordinary income for US investors. Pengrowth Energy Trust (NYSE: PGH, TSX: PGF-U) carries tax complications as a limited partnership in the US. It’s had some success improving its asset portfolio in recent years, but costs, debt and payout ratio are still too high for comfort.
Trilogy Energy (TSX: TET-U, OTC: TETFF) appears to be on the right track after a rough couple years. But debt is lofty, and I want to see a few more quarters of low payout ratios before upgrading it to a buy. Ditto True Energy Trust (TSX: TUI-U, OTC: TUIJF). The trust carries even higher costs, and debt and production will shrink with the sale of its Saskatchewan assets. Freehold Royalty Trust, Pengrowth Energy Trust, Trilogy Energy and True Energy Trust are great swap candidates for those who still own them.