Energy producer trusts have been on a wild ride this year, as oil and gas prices have surged and plunged. But the journey for energy service trusts—which provide equipment and services that make production possible—has been even more of a rollercoaster.

Service companies depend on one thing for their profits: drilling activity by energy producers. When producers prosper, they utilize more drilling rigs and related services. Service companies rent out a higher percentage of their rig fleet and charge more rent. And demand for ancillary services such as hauling, cleanup and catering rises, too. When energy prices fall, producers eventually cut back output. That slashes demand for rigs and services and cuts rents.

The upshot is service companies’ profits are doubly leveraged to energy prices. Earnings, cash flows and share prices explode to the upside when oil and gas prices are rising and energy patch activity is booming. And they take a dive when energy prices tumble, drying up activity. That’s not necessarily the kind of business that lends itself to big, reliable cash payouts. Rather, it’s a volatile business that ebbs and flows with energy prices.

Trinidad Drilling (TSX: TDG, OTC: TDGCF)—the lone pure service company in the CE Aggressive Portfolio—has been the exception to the rule, thanks to its concentration in the US and focus on long-term contracts for its popular deep-drilling rigs. The shares are up more than 50 percent since the company converted from an income trust in January. That’s even despite a steep reduction in the distribution, which also went from monthly to quarterly.

In contrast, every other energy services trust tracked in the How They Rate Table has been dragged down by the tough industry conditions. Over the past two years, all have been forced to cut distributions at least once and some altogether. During the recent selloff, they were quick to give up the gains they scored earlier this year. Even industry giant Precision Drilling (NYSE: PDS, TSX: PD.UN) is back to where it traded in 2003, and smaller fare is scraping all-time lows.

Ironically, even as the market is pummeling most Canadian energy service trusts and companies, industry conditions have started to improve. For one thing, producer trusts are starting to ramp up drilling again as their profits swell.

ARC Energy Trust (TSX: AET.UN, OTC: AETUF) posted higher realized selling prices, increased production of natural gas and held down costs, triggering a 47.7 percent jump in second quarter cash flow from operations per share. That took its payout ratio down to just 53 percent, despite an effective 40 percent boost in distributions and a CAD26.2 million writedown in potential exposure from the meltdown of energy marketer SemGroup LP. (See Portfolio.)

Producer results may worsen again if bears are correct about a further plunge in energy prices. And no one should buy energy services trusts without first being prepared for considerable fluctuations in cash flows, distributions and share prices.

History shows that the best time to buy this sector is when business conditions are starting to bottom and the bears are out in force in the energy patch. At this point, the numbers are turning up, while the sentiment couldn’t be worse.

Ups and Downs

The last big boom for energy services was back in the 1970s. Rapidly rising energy prices put a premium on getting available output to market, and activity soared. The rapid decline of energy prices—especially in inflation-adjusted terms—started taking the wind out of the sector’s sails in the mid-’80s. And by the late ’90s, only the strongest players were left standing.

Services sector fortunes began to reverse when oil and natural gas prices bottomed and moved higher early this decade. And by mid-decade, surging drilling activity was pushing up both rig utilization and rig rates.



Precision Drilling’s fourth quarter 2005 earnings were triple year-earlier levels, not including onetime items. Much-smaller Peak Energy Services (TSX: PES.UN, OTC: PKGFF) saw sales rise 55 percent and cash flow margins surge from 41 percent to 56 percent of revenue. Trinidad, meanwhile, posted a 39.4 percent jump in distributable cash flow per share as it increased its rigs in service to 71, up from just 21 in 2003.

By the first quarter of 2006, natural gas prices had already come off their peak. Drilling activity, however, was still on the rise, as producers anticipated continued strength in prices because of demand forecasts, as well as the potential for more Hurricane Katrina-like events.

As a result, the sector enjoyed even better returns in the first quarter of 2006. Precision boosted its distribution 15 percent as earnings from continuing operations soared 152 percent. The key was an increase in rig utilization to 80 percent of available days, up from an already high level of 68 percent a year ago. Peak’s funds from operations soared 51 percent, despite a rise in maintenance costs at its expanding rig fleet.

Essential Energy Services (TSX: ESN.UN, OTC: EEYUF), meanwhile, enjoyed 363 percent revenue growth, largely from acquisitions it made after spinning off from Avenir Diversified Income Fund (TSX: AVF.UN, OTC: AVNDF). Wellco Energy Services—now merged into Peak—actually recorded a 92 percent rig utilization rate. Finally, Trinidad hiked its distribution a full 21.1 percent as it increased its rigs in service to 77, upped utilization to 85 percent and more than doubled revenue.

Despite further erosion in gas prices, sector revenue was higher again in the seasonally weak second quarter. By the third quarter, however, the combination of high rig rates, the dramatic buildout of new rigs and falling energy prices began to take a toll. Trinidad’s strategy of building out deep-drilling rigs—mostly in the US—and signing on long-term contracts was still paying off, with funds from operations (FFO) per share rising 54 percent. Precision, meanwhile, scored a 27 percent boost in operating earnings.

The smaller players, however, were seeing little or no growth in profits. Peak’s FFO per unit slipped nearly 30 percent as margins dipped on reduced customer demand, and payout ratios rose across the board despite revenue gains. And by the time fourth quarter 2006 earnings were posted, revenues had begun falling sharply as producers cut back spending.

More than any other trust sector, the Halloween 2006 trust taxation announcement was the coup de grace for energy services. The resulting plunge in share prices and new restrictions on share issues all but shut off access to capital. The result was a wave of distribution cuts, which continued into early 2008. Even relatively stable Trinidad dropped more than 20 percent from 2006 through 2007. And as the table “Sector Slide” shows, the rest fared far worse.

The survivors did stage an impressive rally in the first half of 2008. Most of the gains, however, vanished with the July selling. The question is: Will the 2006-07 slump resume, or is this just another buying opportunity for the long-awaited sector recovery?

If it’s the latter, then now is the time to get a lot more positive on the energy service sector. For one thing, the gains the group made in the years prior to the 2006 collapse were easily the biggest in the Canadian trust universe, if not that country’s market. If this is a train leaving the station, we definitely want to be aboard. On the other hand, if energy prices are headed lower in a big way, the sector will be dead money at best for some time.

To be sure, the past two years’ stress tests have shaken out the weaker fare already. Survivors’ distributions and debt have been cut back to levels that can be sustained amid horrendous conditions. And management has refocused on the stronger areas of the energy patch such as oil sands, new finds like Montney and Bakken, and in the US. Coupled with very low valuations, that makes a meltdown of 2006-07 proportions highly unlikely.

More important, despite the recent weakness, the energy bull market remains very much intact. For one thing, there’s still relatively little permanent demand destruction globally. Americans are driving less this year, and sales of small cars are stronger than that of larger vehicles. But few are abandoning their sport utility vehicles, trucks, minivans or other heavy gasoline-guzzling vehicles. And if gasoline prices do drop meaningfully now, demand is likely to accelerate again, even as more and more people start driving in developing Asia.

As for natural gas, there’s dramatic growth in drilling in new plays, particularly in the US. But older fields are in rapid decline. North American demand is expected to rise a whopping 8 percent a year into the next decade as utilities build new units to replace coal-fired power and gear up for expected regulation of carbon-dioxide emissions. Gas plants emit less than half the carbon dioxide that coal plants emit. They’re far cheaper and more reliable than wind power, and they can be built far more quickly than new nuclear units.

Finally, liquefied natural gas (LNG) imports are unreliable; ships always go to the global market with the highest price. That was the US in 2007, but now it’s Europe and developing Asia. LNG imports are also burdened by extreme difficulty locating new terminals and restrictions on existing ones.

The bottom line is that we’re nowhere close to shifting the balance of world energy market power from producers back to the consumers. And to the extent prices do fall in the near term, it will only slow the investment and permanent demand destruction needed for the shift to occur.

We could still see a further pullback in energy prices, particularly if the US economic situation worsens markedly. That would almost surely inflict more pain on owners of Canadian energy service plays, even though much of the bad news has been priced in already. As a result, I advocate sticking with the strongest in the sector. I’m also cautious on the weaker fare, at least until we get a clearer indication of where energy prices are headed near term.

Best of the Bigger

Since late 2006, the CE Portfolio has held just one pure services company, Trinidad Drilling. Despite the sizeable gain in the shares this year following its conversion to a corporation, it remains my top choice.

First, the company’s revenue base–deep-drilling rigs in the US that are locked up under long-term contracts–is considerably more secure than that of its rivals. Management’s stated reason for converting to a corporation was basically to free up cash flow to grow this business, and it’s already delivering on that.

Last month, the company announced a new construction program for seven drilling rigs, in addition to the nine drilling rigs and six service rigs already begun this year. All of the new rigs are backed by long-term, take-or-pay contracts, which essentially obligate the customer to pony up the cash whether the rigs are actively used or not.

The new rigs are basically “built for purpose” and represent the industry’s technological cutting edge, tapping into demand for producing from increasingly tough-to-access reserves. They’re all slated to be deployed in the Haynesville Shale region of northern Louisiana and will be built at the company’s own facilities, allowing it to control construction costs.

The rigs’ depth capacity is 18,000 feet (more than three miles), and they will be deployed by the end of 2009. Once operational, they’re expected to immediately increase cash flow, reduce overall leverage and boost exposure to less-seasonal markets, thereby further leavening quarterly fluctuations in earnings.

The biggest drawback to holding Trinidad this year is the reduced yield, now paid quarterly. But the payout is still well above that of any non-trust driller, and the potential for robust, stable growth is huge. Trinidad Drilling remains a buy up to USD15.



Precision Drilling hasn’t been in the Portfolio since last December, when I recommended selling for the tax loss and buying it back in January. Anyone who executed that strategy has since done well, despite the recent pullback. Now back in the low-20s again, the stock is again a strong buy for patient, risk-tolerant investors.

Boosted by 374 percent growth in drilling rig operating days outside Canada, second quarter revenue grew 14 percent. That’s a long way from the heady growth rates of a couple years ago. And it points to continued weakness in its core Canadian operation, where contract drilling rig days slipped another 3 percent in the quarter and 9 percent for the first half. Operating earnings margin—a measure of profitability—slipped to 16 percent from 22 percent a year earlier, largely on the cost of management incentives.



Important, however, there are clear signs even the Canadian business is stabilizing. Rig rates in Canada fell only 4 percent from year-earlier levels, while service rig rates fell just 5 percent. That’s a sharp improvement from the waterfall declines of prior periods. In addition, the Completion and Production Service rig fleet saw a 6 percent increase in working hours in Canada, a dramatic turnaround from the first quarter’s decline.

Precision continues to be quite aggressive transferring assets out of sluggish regions and into faster-growing ones, such as southeastern Saskatchewan and southwestern Manitoba. The company expanded its presence there with a major acquisition in July. Even the Western Sedimentary Basin—the source of much of its woes the past two-plus years—is improving, as producers accelerate drilling plans in line with higher natural gas prices.

Precision’s biggest ongoing strategic move is an attempted takeover of Grey Wolf Drilling, which, with 122 rigs, is the fourth-largest onshore driller in the US. Thus far, Grey Wolf has rebuffed its offers but may be vulnerable after the collapse of a deal with would-be acquirer Basic Energy.

Whether it’s ultimately successful or not, this USD1.5 billion takeover attempt is a clear sign of Precision’s underlying strength and ability to wield the buying power of the Canadian dollar to its advantage. So is second quarter cash flow from operations, which covered capital spending and the distribution by a nearly 3-to-1 margin in a seasonally weak period. Precision Drilling is a buy again up to USD30.

For those in search of high stakes, Eveready Income Fund (TSX: EIS.UN, OTC: EISFF) is a top choice. In January, the trust converted its monthly cash payout into a quarterly in-kind stock distribution at an annual rate of 72 cents. The result was an immediate, dramatic hit to its shares, with a solid spring recovery followed by a drop to even lower lows this month.

Ironically, the trust’s underlying business has been heading in the opposite direction, with the focus on the still-fast-growing oil sands region (45 percent of second quarter revenue), spurring rapid growth in revenue and expanding margins. Funds from operations (FFO) per share rose 14 percent in the second quarter on a 28% jump in revenue. Eveready provides a range of services from chemical and vacuum trucks and specialized equipment such as directional boring rigs to a range of portable camps and industrial lodges. All are in rising demand in the oil sands area, which now accounts for nearly half of overall revenue.



At current prices, Eveready’s stock dividend adds up to a yield of 23 percent. Given the recent rout of the energy patch, it’s not surprising investors would attach such a low value to a payout that diminishes as the share price dips. But this leverage definitely cuts both ways: Any increase in Eveready’s share price will multiply the value of the distribution.

This one isn’t for the risk averse. But the 72-cents-Canadian value of the stock distribution would be covered by cash flow were it paid in cash, so it’s not dilutive. Expect volatility, but the most aggressive can still buy Eveready Income Fund up to USD4.

For those in search of slightly lower-octane bets, I’m also reiterating buys on CE Portfolio pick Newalta Income Fund (TSX: NAL.UN, OTC: NALUF) and transporter Mullen Group Income Fund (TSX: MTL.UN, OTC: MNTZF). Neither is purely an energy services play, but the energy patch plays a vital role in their profitability.

That’s definitely been a drag in recent years, but both have shown strong improvement in 2008. This summer Mullen boosted its capital spending by 50 percent, with the majority going toward the energy patch. One of its targets is the buyout of Essential Energy Services’ fluid hauling and oilfield transportation operations.

Buying assets cheap almost always pays big dividends when conditions improve. That’s what should lie in store for Mullen, whose cash flows continue to cover its nearly 9 percent yield by a comfortable margin. Also encouraging, while management has yet to issue anything definitive in regards its post-2011 strategy, it’s affirmed its intention to remain a high-payout entity, regardless of how it’s organized. Mullen Group Income Fund remains a buy up to USD23.



Newalta’s concerted effort to expand outside the energy patch has paid off over the past couple years, as gains from industrial eastern Canada operations have largely offset weakness in the west. Now Canada’s leading industrial waste management and environmental services company has a new avenue for expansion in the energy patch: oil sands.

At its core, oil sands development is an extremely dirty business, evidenced by the frequent calls for a crackdown on its pollution of land, water and the air. Newalta is uniquely positioned to profit from the cleanup, given its specialty of recycling waste into salable products, as well as its wealth of conventional oil and gas projects in Alberta. The company has already demonstrated success at several commercial scale oil sands projects and expects division revenue to more than quintuple by 2012.

During the first quarter, Newalta’s cash flow covered its distribution for the first time in more than a year, vindicating management’s policy of “growing its way out” of energy patch weakness. Second quarter marked a further improvement, as 67 percent growth in FFO took the payout ratio down to 84 percent. Management hasn’t yet said what it will do with the now 12 percent-plus yield as 2011 trust taxation nears. But with its underlying business stronger and more resilient than ever, it’s hard to see it not commanding more than its current multiple of 1.5 book value and annual sales. Newalta Income Fund remains a buy up to USD25.

The Small

The How They Rate Table tracks four other energy services trusts: Cathedral Energy Services Trust (TSX: CET.UN, OTC: CEUNF), Essential Energy Services, Peak Energy Services and new addition Phoenix Technology Income Fund (TSX: PHX.UN, OTC: PHXHF). Of the four, Cathedral and Phoenix have had by far the steadiest results over the past year.

In Cathedral’s case, success is due to expansion in the US Rocky Mountain region and specialization in specialized “directional drilling.” Revenue, gross margins, net income, cash flow, distributions and the payout ratio were all basically flat with year-earlier totals in the most recent quarter. So were outstanding shares and long-term debt, illustrating that the trust has been capable of sustaining operations and even expanding on its own resources, despite exceptionally difficult operating conditions.

The trust did trim distributions by roughly 20 percent in early 2007, reversing a period of strong growth in prior quarters. The current dividend rate, however, is well covered with cash flow and earnings. And coverage ratios are expected to improve in the second half of 2008, as the company’s directional drilling services remain in demand and it expands geographically and with acquisitions. The second quarter payout ratio is high due o the seasonal nature of the business.

The trust is relatively small, with a market cap of around USD400 million, and is certainly not immune from negative market pressures. But with a solid niche, steady management and generally conservative finances–long-term debt is just 20 percent of equity–Cathedral looks well positioned for growth. Buy Cathedral Energy Services Trust up to USD16.



Phoenix’s second quarter results were positively robust, featuring 30 percent revenue growth and a 90 percent increase in cash flow per share. In stark contrast to other small service trusts, cash distributions were actually raised over the past year by 10 percent. That rate exceeded distributable cash in the seasonally weak second quarter, but the six-month tally was a considerably more comfortable 71 percent. Interesting, the fund has paid off all its long-term debt, while boosting working capital by 56 percent and holding new share issues to just 8 percent.

Like Cathedral, Phoenix’s focus is on the hard-to-get reserves. Consolidated operating days rose by more than 50 percent in the second quarter over year-earlier levels, with 52 percent of Canadian and 48 percent of US wells drilled utilizing a range of horizontal and directional drilling techniques. Overall, 42 percent of jobs are in the US, with the rest in Canada.

Phoenix has been particularly active in the fast-growing Bakken region in southeast Saskatchewan, where it has 46 ongoing wells. Some 62 percent of the trust’s total drilling activity is oil wells. Those are major reasons why second quarter Canadian drilling days and revenue rose 33 percent and 14 percent, respectively, over 2007 levels, even while overall Canadian horizontal and directional drilling activity was basically flat.

Also like Cathedral, Phoenix is relatively small, with a total market capitalization of less than USD400 million. And as second quarter results indicate, its geographic focus on northern climes makes it vulnerable to seasonal pressures that limit cash flow at certain times of the year, such as the spring breakup season. That said, however, management has been proving its ability to weather tough conditions for its industry. Phoenix Technology Income Fund shares are a buy for aggressive investors up to USD18.

Cathedral’s and Phoenix’s size, technical expertise and healthy operations raise one other potentially very profitable possibility: takeover targets. The most likely acquirers are from inside Canada, where the industry is consolidating rapidly and players can pay in Canadian dollars. But the more they grow, the more eligible they’ll become.

That’s also true of small fry Essential and Peak. The key difference, however, is the latter pair has yet to report a meaningful turn in its numbers.

Essential, for example, slashed its distribution 70 percent in June and sold off a good chunk of its business for cash. Peak, meanwhile, has yet to resume paying any dividend and has also been selling assets. It also generated negative operations cash flow in the second quarter.

The good news for both trusts is the damage has largely been done to their share prices, and both appear to have put the pieces in place to at least stay solvent. That could change in a hurry, however, if industry conditions dramatically weaken again. Both Essential Energy Services and Peak Energy Services rate holds for speculators, but fresh money is far better spent on the much-stronger fare discussed above.