It’s not hard to see why. Each of the three dozen trust takeovers announced since Halloween have come off at sizeable premiums to trusts’ pre-deal share prices. Even very weak trusts have managed to garner decent exit prices. Moreover, the majority of the takeovers have been at all-time highs or at least prices well above where these trusts traded prior to Halloween 2006.

The table “Big Deals” compares the windfalls achieved in some of the more-recent deals. Clearly, private capital is attracted by trusts’ big cash flows and is willing to pay up for it.

Quixotically but thankfully, the Canadian government has been extremely hands off when it comes to private-capital takeovers. Even the ongoing buyout of BCE—by a Kohlberg Kravis Roberts-led consortium, including an Ontario pension fund—doesn’t appear to be raising any eyebrows in Ottawa.

Quite possibly, the Conservative Party minority government sees private-capital takeovers of trusts as a way to defuse the troublesome income trust taxation issue as inevitable elections approach. But from we investors’ point of view, the only important thing is, once a trust accepts an offer, it’s money in the bank.

Trust managements and boardrooms have many levers at their disposal to block takeovers. Conversely, when they’re on board with a deal, there’s not much chance to derail the proceedings. And with Canadian politicians and regulators turning a blind eye to deals—no matter who’s buying or selling—it’s no great surprise that every private-capital buyout since Halloween has passed muster.

In contrast, mergers between individual trusts continue to be faced with intense skepticism. As is the case with US-based mergers, investors generally sell the acquirer and buy the target. If the deal is priced in cash, the acquirer’s slide won’t impact on the ultimate takeover value. If, on the other hand, it’s priced in shares—which is the case in virtually every merger between trusts—the drop in the acquirer’s share price will reduce the value of the deal and ultimately cut the target’s price as well.

The recently completed merger between PrimeWest Energy Trust (PWI.UN, NYSE: PWI) and the former Shiningbank Energy Income Trust is a good case in point. The deal made good business sense from many angles, creating a combination that was far stronger than either trust was on its own. But almost immediately after it was announced, both acquirer and target began to slip. Today, the merged company trades more than 10 percent below PrimeWest’s share price prior to the merger announcement and an equal discount to the pre-deal price of Shiningbank.

Of course, some of that drop was due to slipping natural gas prices over that time because the new entity relies heavily on gas production and sales. But mergers between trusts outside the energy patch have suffered the same result.

Take the recently completed takeover of Clean Power Income Fund by Macquarie Power & Infrastructure (MPT.UN, MCQPF). Clean was initially courted by Algonquin Power Income Fund (APF.UN, AGQNF) in what was virtually an all-stock deal. Algonquin’s share price was immediately hit when it made its offer. That, in turn, drove down Clean’s takeover value and share price as well.

Then Macquarie offered a higher bid, resulting in a decline in its share price and a renewed dip for Algonquin and Clean. Rather than try to outbid, Algonquin withdrew, and its share price bounced back. Macquarie shares then sank further.

Only after the deal was complete did investors begin to recognize that Macquarie had actually snared a bargain, thanks to a strong earnings report by Clean in its final quarter as an independent trust. Macquarie shares have since recovered a bit, though skepticism is still holding them well below their highs.

Ironically, mergers between trusts are likely to prove far more lucrative for investors in the long haul than almost any of the all-cash buyouts by private capital. And the prime place we’re likely to see them is the energy patch.

Thus far, the only private-capital deal for an oil and gas producer trust has been the now-completed buyout of the former Thunder Energy Trust. The deal went off at a premium of a little more than 10 percent to the pre-announcement price. It effectively bailed out a floundering trust and gave the new owners some very valuable reserves.

There may be more private-capital buys, with the smallest trusts such as Vault Energy (VNG.UN, VNGFF) as the most-likely targets. But private-capital takeovers of energy trusts face considerable hurdles.

Mainly, the success of any private-capital takeover depends on accurately matching the projected cash flows from the new business with the debt taken on to buy it. Oil and gas producer trust cash flows are tied to often-volatile energy prices. Consequently, it’s virtually impossible to match them up with interest obligations as reliably as you can with, for example, a real estate investment trust.

Thunder Energy was an easy deal to do because it traded at a steep discount to the value of its assets in the ground. That made it a worthwhile buy, even though cash flow from its mainly natural gas output remains extremely unpredictable. Nothing is that cheap today.

As a result, it’s far more likely that future acquisitions of oil and gas producer trusts will be made by the trusts themselves, along the lines of the PrimeWest/Shiningbank deal. They’ve hardly excited investors to date, in large part because of oil and gas trusts’ volatile performance over the past year. But over time, they’ll create stronger, more-vibrant entities.

Deal Appeal

Oil and gas trust mergers offer several advantages. First and foremost, producing oil and gas is fundamentally a scale business.

Small companies can last for a time when the market is healthy. Sooner or later, however, their operations and reserves have to be bought by a major, or they’ll inevitably lose everything they gain when the price cycle turns for the worse.

Unmatched scale is why the Super Oils are among the safest stocks for any market environment. Chevron Corp, ExxonMobil and others could probably sustain their current credit ratings and dividends even in the extremely unlikely event oil prices revisited $20 a barrel.

In contrast, virtually everyone else in the industry would take a vicious hit and many would be in bankruptcy. That, in turn, would give the Supers the opportunity to buy their assets on the cheap.

Improving ability to handle volatile energy prices is a compelling reason for oil and gas producer trusts to get bigger. Larger trusts are better able to raise capital. They can negotiate more effectively with energy services providers to keep down costs. They can also pursue more projects to grow output. And well-designed mergers create asset synergies as well, improving production.

All these motivations to join forces existed before Halloween 2006, and we’ve seen several major deals, including those that created Canetic Resources (CNE.UN, NYSE: CNE), Harvest Energy Trust (HTE.UN, NYSE: HTE) and Penn West Energy Trust (PWT.UN, NYSE: PWE), now the largest Canadian trust. But they’ve only become more urgent since, particularly with natural gas prices as weak as they’ve been the past month or so.

In addition, merging is the easiest way for trusts to get around the restrictions on the number of new shares they can issue. All-stock mergers between trusts don’t count toward the 40 percent limitation on potential increases in trusts’ shares for 2007 or the 20 percent growth limits set for 2008, 2009 and 2010. And they create a larger base to issue on as well, meaning more can be issued without breaking the 40 percent mark.

The limitation on new share issues has been particularly crippling for smaller oil and gas trusts created in the past couple years. Not only has it prevented them from following through on prior plans for growth, but coupled with the drop in share prices during the past year, it’s virtually shut them out from capital markets entirely.

Prior to the announcement of its takeover by Advantage Energy Income Fund (AVN.UN, NYSE: AAV), for example, Sound Energy Trust (SND.UN, SNDFF) had virtually crawled into its shell, relying solely on cash generated from operations to pay dividends and support capital spending to maintain production. In contrast, as part of Advantage, Sound will have the capital to develop its substantial reserves and 400,000 acres-plus of raw land.

The best mergers should have several elements. First, assets should be complementary, with a clear path to enhance overall efficiency and the ability to develop them. Sound and Advantage are both focused on natural gas production in roughly the same part of Canada. And Advantage’s management team has experience in development, brought over from the Ketch Resources Trust merger last year.

Second, it’s important the acquirer not overpay for the assets, so the combination won’t be immediately hamstrung in trying to earn a solid return. Adding Sound’s assets is projected to immediately increase Advantage’s production, cash flow, reserves and net asset value per share. That’s a good sign it didn’t overpay.

Third, the best deals will enhance trusts’ ability to deal with 2011 tax changes. The Advantage/Sound deal creates an entity with some CD1.6 billion in tax pools that can be written off dollar-for-dollar against taxable income in 2011 and beyond. And given the developing nature of the combination, that figure should rise markedly in the next three-and-a-half years.

Fourth, good mergers should strengthen balance sheets. This is particularly important in the volatile oil and gas industry and less so in more stable sectors like electric power or real estate. By offering only a small portion in cash—66 cents Canadian per share—and relying mainly on shares for the purchase, Advantage will cut its total debt-to-cash flow ratio to just 1.2. Moreover, the deal is expected to also cut the trust’s payout ratio, further increasing management’s ability to cut debt and grow the business.

Returns on Advantage Energy shares, both before and after the Sound deal is completed, will depend most of all on natural gas prices because 65 percent of production is expected to be gas. With gas prices weak this summer, that could be a drag, and the shares’ leverage could ultimately threaten its distribution if things go far enough.

It’s clear, however, that this deal makes sense. No matter what the market conditions bring, the post-merger Advantage is stronger and better able to handle them. That’s another reason I continue to rank Advantage Energy Income Fund a buy up to USD14 for those who want an aggressive bet on natural gas.

I’m slightly less high on the new PrimeWest, forged from the trust’s merger with Shiningbank. But it also stacks up well on the criteria.

Both trusts have been battered by the drop in natural gas prices during the past year and a half, so both are cheap relative to the value of their reserves and cash flows. They became cheaper still when the deal was announced.

The PrimeWest and Shiningbank assets are very complementary, focused in the western Canada. And joining forces enhances the new trust’s ability to develop them efficiently and aggressively. The deal also leaves a trust with an attractive tax situation, with an estimated CD2 billion in tax pools.

If this deal falls down anywhere, it’s on debt, which remains quite high at more than twice annual cash flow. This is more a legacy situation of PrimeWest’s aggressive acquisitions in recent years, and management is likely to work to bring it down over time.

As with Advantage/Sound, the success of the new PrimeWest will depend heavily on what happens with natural gas prices. But again, this deal has created a stronger trust better able to handle the ups and down of the market. And like Advantage/Sound, it’s a pretty good candidate for yet another enlarging merger.

Who May Merge

In my view, we’re likely to see the Canadian oil and gas producer trust universe consolidate down to a handful of giants that will be considered high-yielding intermediate producers. There will also be a few smaller ones that have the unique abilities to remain independent. With 30 trusts covered by Canadian Edge, that means a lot of mergers.

The bad news is these deals aren’t likely to command significant premiums to market prices. We’ll see modest premiums and dividend increases, as was the case in the deals for Sound and Shiningbank, respectively.

But most of the benefits from trust mergers are going to flow from long-term factors: lower costs, growth abilities, stronger balance sheets and better tax efficiency. That adds up to strong long-term capital appreciation as well as cash flow for investors.

Picking out which trusts are going to be taken over is inherently speculative. Unless you have a seat on the board yourself, the most you can do is handicap the possibilities. What I can do, however, is point out trusts that would be fine remaining independent for years to come but could be attractive to suitors at the right price.

Long-life reserves are always in demand. Two trusts that feature them are oil-weighted Crescent Point Energy Trust (CPG.UN, CPGCF) and natural gas-focused Progress Energy Trust (PGX.UN, PGXFF).

Crescent focuses on large oil pools (86 percent of output) with development potential. The trust made its biggest move to date last year, acquiring Mission Oil & Gas for CD621 million. In terms of current production, the cost was very high at about CD85,000 per barrel of oil equivalent (BOE) daily production. But it added rich assets in the prolific Baaken region, which promises to add dramatically to reserves and output in the next several years. In short, the real price per daily BOE is going to wind up a lot lower.

As a result, the trust won’t have to make significant acquisitions to continue growing in the next few years. That’s fortunate because the Mission deal basically exhausted its ability to issue new shares in 2007. The trust is also benefiting from continued strength in oil prices, though management hedges nearly half its overall output.

The balance sheet is healthy because management has relentlessly reduced debt as a percentage of cash flow. The current ratio of just 0.9-to-1 is half the level two years ago, despite the significant acquisitions. That plus the assets makes Crescent an attractive takeover candidate for a range of big trusts, including ARC Energy Trust (AET.UN, AETUF), which also focuses on deep energy pools. Crescent Point Energy Trust is a buy up to USD20.

Progress Energy’s focus on natural gas (85 percent of output) has obviously been less profitable than Crescent’s oil in the past year and a half. The trust, however, has remained highly profitable by developing its inventory of properties and made its first significant acquisition this year, picking up assets of BG Canada. Management’s next move is likely to be the purchase its development partner, ProEx, a high-growth junior oil and gas company. That’s not likely to happen soon, however, because the trust has now issued more than half the number of shares it’s allowed to in 2007.

Although most gas-focused trusts have struggled mightily—and often unsuccessfully—to maintain dividends during the past year, Progress has held its payout ratio down. Cost control is key, as is management’s policy of hedging roughly half production and sometimes more. The management team has been together more than 15 years, one of the longest records of continuity in the sector.

The BG Canada buyout did add significantly to debt levels, more than doubling the debt-to-annual cash flow ratio from just 0.5-to-1 in 2005 to its current level of 1.2-to-1. That should come down over time, however, as the assets are integrated and begin adding to cash flow this year, despite the recent dip in gas prices.

With a payout ratio of just 54 percent based on the most recent numbers, the distribution is safe and would likely be raised when gas prices recover. A very attractive prize for a wide range of potential suitors, Progress Energy Trust is a buy up to USD15.

Crescent and Progress meet my chief criterion for buying takeover targets. I don’t mind owning these high-quality trusts, even if they never receive a takeover offer. I’m considerably less sanguine about what many consider to be the most attractive bets for takeovers: small, battered trusts.

We’ve already seen one of the fry in the Canadian Edge coverage universe disappear, Thunder Energy (see above). Advantage’s deal for Sound Energy—which should be completed within the next two months at the latest—reduces their ranks further.

Small trusts have several major strikes against them here in summer 2007. The main one is a chronic shortage of cash. That’s partly because of the drop in natural gas prices in the past year and a half, which has sharply compressed operating cash flows. But it’s also due to the plunge in their share prices in the wake of gas prices and prospective 2011 taxation, which has made it prohibitively expensive for them to issue stock.

Trust managements basically have three options when cash flow is short: They can cut back on their business plans, they can take on more debt, or they can reduce distributions. Because the first two options essentially sacrifice a trust’s long-term health, dividend cuts are the only viable choice.

The problem is distribution cuts usually drag down share prices. That means trusts must issue considerably more shares to raise the same amount of money. The result is a death spiral that decreases distributions and ultimately the trust’s financial health.

In light of these circumstances, smaller, gas-focused trusts today are basically in shell mode, with management trying to service debt, pursue development and pay distributions from the same shrinking pile of cash. The easiest way out is to be acquired by a larger, more-powerful trust, as Sound is by Advantage Energy.

The deal featured a modest premium of about 11 percent for Sound’s owners. Its most attractive feature is that Sound is now part of a trust with a great deal more long-term financial viability. That ensures is a rich asset base will be unlocked over time, whereas staying alone would likely have kept it underground.

In the next few years, we’re likely to see offers made for several of the remaining smaller trusts, including NAL Oil and Gas Trust (NAE.UN, NOIGF), Trilogy Energy (TET.UN, TETFF) and Vault Energy. The most attractive is Daylight Resources Trust (DAY.UN, DAYFF).

The trust was forged from last year’s merger between a much-smaller Daylight and Sequoia. After the deal was inked, the value of the latter’s reserves and production came into question. Daylight was able to negotiate a better price, but the trust continued to be hit hard by falling gas prices, which finally forced a distribution cut in February.

Daylight today features a solid base of natural gas-focused assets (62 percent of production) and a deep reservoir of tax pools to defer post-2011 taxation. It clearly lacks the resources to continue its development over the long haul, however, and low gas prices continue to hurt it. That makes a takeover the best option. Both Advantage Energy and PrimeWest are potential suitors, as they continue to beef up their portfolios and improve their ability to issue stock.

I don’t expect a high-premium deal here, given the struggles Daylight faces. But a modest one, combined with the long-term potential presented by a deal with either trust, should add up to a generous total return.

With a dividend cut possible in the wake of the recent drop in gas prices, Daylight is for aggressive investors only. But selling for just barely book value, Daylight Resources Trust is a buy for patient, risk-tolerant investors up to USD12.

Not for Everyone

Merger logic is compelling for the oil and gas trust sector because it works to meet its operational challenges and to answer questions about future taxation. Not every trust, however, is going to want to merge. That especially goes for the handful pursuing niche-oriented strategies.

One good example is Vermilion Energy Trust (VET.UN, VETMF). For the past several years, the trust has focused its growth efforts outside Canada, particularly in Europe and Australia. Its 45 percent-owned Verenex Energy affiliate is a high-impact junior exploration company focused on newly opened Libyan reserves.

The strategy limits exposure to a single energy market or type of reserves. It also literally exempts nearly two-thirds of the trust’s overall income from prospective Canadian taxation in 2011, as foreign income is already taxed.

The trust has further ensured its long-run sustainability by keeping its payout ratio at a very low level and systematically cutting debt. The current debt-to-cash flow ratio is just 1.2-to-1 and is expected to be cut in half by 2009.

That’s a very attractive package. But it also adds up to an asset base that’s far different from any other oil and gas trust. And given Vermilion’s record of success and bright outlook, management has little incentive to sell out. Vermilion Energy Trust remains a buy up to USD36 and easily the most conservative bet in the Canadian oil and gas producer trust sector.

Other trusts have announced plans to expand more rapidly into the US, which would seem to rule out buyouts of most Canadian-based trusts. As I pointed out last issue, US assets can be packaged into a limited partnership (LP) and partly spun off to the public. This allows the trust to capture cash flow from the assets free of US taxes, while raising capital to grow them further.

Provident Energy Trust’s (PVE.UN, NYSE: PVX) BreitBurn Energy partnership in the US has proven popular with investors. As a result, it trades at a far higher valuation and lower yield than Provident.

Consequently, by issuing shares of BreitBurn, Provident has raised a great deal of capital to grow its US assets far more cheaply than it would have by issuing new trust shares or taking on debt at the parent level. It still controls the assets and the cash flow, which is enhanced by not paying US taxes as an LP.

US assets including BreitBurn currently contribute about a third of Provident’s overall cash flow. But the more they grow, the more income the trust will be able to shelter from taxes in 2011 and beyond. That’s an attractive strategy others are likely to follow, such as Enerplus Resources (ERF.UN, NYSE: ERF) and Canetic Resources.

On the higher-risk side of the spectrum, Paramount Energy Trust (PMT.UN, PMGYF) also has a unique strategy that probably doesn’t lend itself to combinations. For one thing, it’s entirely a natural gas producer, with no oil output whatsoever. The trust’s assets are geographically focused, and management’s strategy of developing its own inventory of projects on a generally small scale may not lend itself to greater economies of scale if it were bought out.

Finally, management has stated it intends to remain independent well after 2011, whether it converts to a dividend-paying corporation or some other structure. Paramount Energy Trust remains a buy up to USD13 for those who want a very aggressive natural gas bet and are willing to absorb the risk of a potential dividend cut if gas sinks further.

Even the biggest Canadian income trusts are relatively small compared to the country’s non-trust majors or even the major independents in the US. A growing number of managements, however, have stated a goal of growing their trusts into “intermediate” producers by 2011, when presumably they’ll adopt a new form of dividend-paying structure.

To make that happen, even Penn West—currently Canada’s largest energy trust—is going to have to make acquisitions. And the same definitely goes for the other high-quality energy producers in the Canadian Edge Portfolio, including ARC Energy, Enerplus Resources, Penn West Energy, Peyto Energy (PEY.UN, PEYUF) and Provident Energy.

As was the case before Halloween 2006, junior exploration and production companies are trusts’ primary targets. This year, we’ve seen several such takeovers, with buyers including Enterra Energy Trust (ENT.UN, NYSE: ENT), Focus Energy Trust (FET.UN, FETUF), Harvest Energy, Penn West Energy, Provident Energy and Vermilion Energy.

Before Halloween, being acquired by a Canadian trust was an exit strategy pursued by many juniors. Prices paid by trusts were ridiculous, and the owners and executives of the juniors made out like bandits.

The drop in natural gas prices in the past year, however, has since slashed potential sales prices sharply. As a result, they’ve become smaller mouthfuls for trusts, particularly larger and more-aggressive ones.

The bottom line is we’re going to see more mergers between trusts in coming years. It’s not the only way trusts are going to grow going forward, and takeovers of juniors are likely to remain more prevalent.

There remains the possibility of a truly large transforming deal in the industry. Penn West’s takeover of Petrofund in 2005—which made it overnight the largest trust—makes it a candidate for such a move, particularly given management’s desire to grow rapidly before 2011. One possible candidate would be ARC Energy, which has projects in many of the same regions of Canada and, like Penn West, is a major player in the technique of “carbon flooding” to harvest reserves.

Other potential deals would involve Enerplus trying to increase its stake in the Baaken region and/or oil sands. The trust currently has growing projects in both regions, and looking for complementary assets—such as Crescent Energy’s Baaken stake—would be a logical move if it can do a deal at the right price. Advantage and PrimeWest are certainly looking for more conventional natural gas production assets, such as those held by Daylight or even Progress Energy.

All this, of course, is pure conjecture and speculation. What’s not is that the best-quality oil and gas producer trusts are still cheap and well worth holding on their own, even if there’s no deal. And if there is one, it will create a stronger, more-sustainable company as ownership of this sector continues to concentrate.