High Yield of the Month
There are two main ways to play insatiable global energy demand with Canadian trusts. The more aggressive is to buy oil and gas producers: Cash flows, distributions and share prices track energy closely, and the smaller the trust, the more leveraged the bet.
The more conservative option—and best for those seeking dividends—is to pick up shares of owners and operators of infrastructure, such as pipelines, processors and storage facilities. Here profits follow activity. The more energy that flows out of Canada, the higher cash flows, distributions and share prices go.
This month, I feature one of each as CE’s High Yield of the Month. In the producer camp is my new addition to the Aggressive Portfolio, Daylight Resources Trust (TSX: DAY.UN, OTC: DAYYF).
Daylight is first and foremost a leveraged bet on natural gas prices. The trust expects to derive 59 percent of its barrel of oil equivalent (boe) production from gas in 2008, with 24 percent from “light” oil, 12 percent from heavy oil and 5 percent from natural gas liquids.
Important, management has been particularly successful over the past few years at increasing the trust’s scale without pushing up debt and operating costs. Overall daily output is expected to average between 20,000 to 20,500 boe, 43 percent above levels of just two years ago. The trust was able to replace 83 percent of full-year 2007 output with a CAD96.4 million “organic” drilling program, i.e., without major new development or acquisitions.
Reserve additions overall have exceeded production additions by a 1.55-to-1 margin over the past three years. And despite rapid labor and operating cost inflation industrywide, the cost of adding reserves has risen less than 3 percent over the past three years, while the cost of added production has actually fallen 3.6 percent.
Cost management is also evident in the payout ratio. Based on full-year price estimates for oil and gas that are roughly 25 percent below current spot prices, Daylight expects to generate a payout ratio of just 48 percent in calendar year 2008. That will enable the trust to cover all its capital costs with current cash flow, eliminating the need to issue more shares and debt. First quarter results were even better as funds from operations per share rose 37 percent year-over-year, driving down the payout ratio to just 40 percent.
Better still, when we spoke with company reps last month, management indicated its strong desire to pay down a sizeable chunk of its debt. The worthy goal is to take down the total debt-to-cash flow ratio to less than 1.5-to-1 this year and the trust looks certain to beat that, as debt-to-cash flow was just 1.4-to-1 in the first quarter.
The flipside of conservative financial policies is less money can be spent on exploration and production, as well as distribution growth. Daylight, however, already yields more than 12 percent. And more important, it’s rapidly building the structure to at least hold that level well beyond 2011, when trust taxation is slated to kick in.
Part of that is a low payout ratio and the fact that the trust is structured so it doesn’t have to pay out essentially all earnings to investors every year. The trust also has CAD800 million in tax pools, or prior noncash expenses, on its books that it can write off dollar-for-dollar against future tax liability. That’s enough to cover nearly seven years of distributions at the current level and based on the number of shares outstanding, and management maintains it can replenish those pools into perpetuity.
The upshot is management expects no change to its distribution in 2011 and beyond resulting from the prospective trust tax. Moreover, they expect to be able to grow Daylight considerably larger by then, utilizing the trust structure’s favorable tax arrangement and pursuing organic growth opportunities, again primarily funded by internally-generated cash flow.
Recognizing its small size, Daylight has pursued a different growth strategy than larger trusts, such as Enerplus Resources (NYSE: ERF, TSX: ERF.UN). Rather than try to do everything itself, the trust is first focused on acquiring land in a wide range of areas, primarily in the Western Canadian Sedimentary Basin. The current land base is now 603,000 net acres, nearly half of which is undeveloped.
Areas are categorized as near-term oil prospects, near-term natural gas opportunities, medium- to long-term resource play opportunities and larger original-oil-in-place pools. Each requires different techniques and technologies to develop. And to that end, the trust employs a full-time petrophysicist.
Virtually all of the opportunity areas, however, have one thing in common: at least one much larger player in the area that’s hard at work to prove the value of what’s underground and test the technology needed to develop it. As a result, Daylight is able to hold down its own costs and maximize its chances of success when it does put down its own money. It also has an active farm-out program, in which it allows others to develop its lands in return for a royalty—as well as valuable knowledge about what’s there, and the dos and don’ts for developing it.
Of course, getting appreciably larger will ultimately require Daylight to do some very real capital spending. And there’s no assurance the price of the oil and gas it sells will be high enough to fund it, as well as hold down debt.
That’s the biggest risk of buying smaller trusts in general. And we only have to go back to last year to see the consequences of falling natural gas prices on small trusts that are overextended. Important, however, Daylight has already proven its mettle over the past couple years, as it’s continued to grow even while rivals were caught in a death spiral. That, plus management’s conservative financial strategies, is a good reason for confidence it will continue to succeed.
At its current price of just under CAD10 a share, Daylight sells for around 1.8 times book value but only a slight premium to its assets underground. And on a price-to-cash flow basis, it’s the cheapest major trust. That makes it a perpetual takeover target.
Management’s unique strategy may deter some buyers. But with or without a deal, this one looks set to reward us richly in coming months and years. Buy Daylight Resources Trust up to USD12.
Piped in Profits
Pembina Pipeline Income Fund (TSX: PIF.UN, OTC: PMBIF) is this month’s best bet on energy infrastructure. The trust has three basic lines of business. Conventional pipelines transport conventional oil and gas primarily in Alberta. Management’s goal here is to generate reliable income from tolls for use of its network, as well as other related services. The focus is on boosting throughput and controlling costs.
The midstream and marketing business consists of the trust’s 50 percent nonoperated interest in the Fort Saskatchewan Ethylene Storage facility. It also includes wholly owned terminaling, storage and hub services either currently operated or under development at Pembina’s conventional oil and gas pipeline system. Here the focus is on low-risk, organic growth by providing more services to the conventional network.
The most exciting part of Pembina is its oil sands business. The core asset is the exclusive franchise on transportation for the Syncrude venture, a partnership between major oil companies on both sides of the border and operated by Exxon Mobil’s Canadian unit.
The trading stock of Syncrude is Canadian Oil Sands Trust (TSX: COS.UN, OTC: COSWF). Unlike that trust or the Syncrude partners, however, Pembina’s profits don’t depend on oil prices or even Syncrude’s overall output for a given quarter or year. Rather, they grow as Syncrude’s output does over time, as the venture requires additional pipeline and transport capacity. Fees are earned based on capacity purchases and don’t vary even if Oil Sands isn’t filling it up.
Starting July 1, Pembina will roughly double its operating income from oil sands infrastructure when it completes the Horizon Pipeline. Beginning 70 kilometers north of Fort McMurray, Horizon will run south to Edmonton and will serve the needs of another major customer, Canadian Natural Resources.
Like other trusts, Pembina took a hit in the wake of the Halloween 2006 trust taxation announcement. Since then, it’s already increased its distribution three times by a total of more than 25 percent. Completing Horizon on schedule and budget will almost certainly bring another large boost to the payout. The first quarter payout ratio slipped to just 81 percent, or 94 percent after taking out a “notional reserve” to safeguard future distributions.
The jig will be up for pipeline and energy infrastructure companies and trusts when operators start building speculatively—that is, building without first lining up customers. The good news for Pembina is, despite an aggressive buildout, its projects are fully contracted, both those in service and under development. In fact, it’s certain they’ll be able to do a lot more, boosting cash flow and distributions along with way.
First quarter earnings were further affirmation of the trust’s strength. Overall distributable cash flow rose 7 percent, as operating income rose at 5 percent at the conventional pipelines and 23 percent for the midstream business. Oil sands income rose just 1 percent but again will double after Horizon comes on stream.
The Dominion Bond Ratings Service continues to give the trust a STA-2 (low) stability rating, among the very highest. That’s a sound affirmation of what we already know: Pembina is a very strong trust, with a rapidly growing 8 percent-plus yield that should be locked away. Buy Pembina Pipeline Income Fund up to USD18.
For more information on both Daylight Resources Trust and Pembina Pipeline Income Fund, visit the How They Rate Table. Click on the “.UN” symbol to go to the Web site of our Canadian partner MPL Communications for press releases, charts and other data. These are substantial companies, so any broker should be able to buy them, either with their Toronto or over-the-counter (OTC) symbols. Ask which way is cheapest.
Note that both trusts’ dividends are considered qualified for tax purposes in the US. Tax information to use as backup for filing them as qualified—whether or not there are errors on your 1099—is listed in the Income Trust Tax Guide.
Also, as is customary for virtually all foreign-based companies, Canada withholds 15 percent of distributions to US investors at the border. This tax can be recovered by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation, though unrecovered amounts can be carried forward to future years.
*Recent USD Price as of 05/07/08
The more conservative option—and best for those seeking dividends—is to pick up shares of owners and operators of infrastructure, such as pipelines, processors and storage facilities. Here profits follow activity. The more energy that flows out of Canada, the higher cash flows, distributions and share prices go.
This month, I feature one of each as CE’s High Yield of the Month. In the producer camp is my new addition to the Aggressive Portfolio, Daylight Resources Trust (TSX: DAY.UN, OTC: DAYYF).
Daylight is first and foremost a leveraged bet on natural gas prices. The trust expects to derive 59 percent of its barrel of oil equivalent (boe) production from gas in 2008, with 24 percent from “light” oil, 12 percent from heavy oil and 5 percent from natural gas liquids.
Important, management has been particularly successful over the past few years at increasing the trust’s scale without pushing up debt and operating costs. Overall daily output is expected to average between 20,000 to 20,500 boe, 43 percent above levels of just two years ago. The trust was able to replace 83 percent of full-year 2007 output with a CAD96.4 million “organic” drilling program, i.e., without major new development or acquisitions.
Reserve additions overall have exceeded production additions by a 1.55-to-1 margin over the past three years. And despite rapid labor and operating cost inflation industrywide, the cost of adding reserves has risen less than 3 percent over the past three years, while the cost of added production has actually fallen 3.6 percent.
Cost management is also evident in the payout ratio. Based on full-year price estimates for oil and gas that are roughly 25 percent below current spot prices, Daylight expects to generate a payout ratio of just 48 percent in calendar year 2008. That will enable the trust to cover all its capital costs with current cash flow, eliminating the need to issue more shares and debt. First quarter results were even better as funds from operations per share rose 37 percent year-over-year, driving down the payout ratio to just 40 percent.
Better still, when we spoke with company reps last month, management indicated its strong desire to pay down a sizeable chunk of its debt. The worthy goal is to take down the total debt-to-cash flow ratio to less than 1.5-to-1 this year and the trust looks certain to beat that, as debt-to-cash flow was just 1.4-to-1 in the first quarter.
The flipside of conservative financial policies is less money can be spent on exploration and production, as well as distribution growth. Daylight, however, already yields more than 12 percent. And more important, it’s rapidly building the structure to at least hold that level well beyond 2011, when trust taxation is slated to kick in.
Part of that is a low payout ratio and the fact that the trust is structured so it doesn’t have to pay out essentially all earnings to investors every year. The trust also has CAD800 million in tax pools, or prior noncash expenses, on its books that it can write off dollar-for-dollar against future tax liability. That’s enough to cover nearly seven years of distributions at the current level and based on the number of shares outstanding, and management maintains it can replenish those pools into perpetuity.
The upshot is management expects no change to its distribution in 2011 and beyond resulting from the prospective trust tax. Moreover, they expect to be able to grow Daylight considerably larger by then, utilizing the trust structure’s favorable tax arrangement and pursuing organic growth opportunities, again primarily funded by internally-generated cash flow.
Recognizing its small size, Daylight has pursued a different growth strategy than larger trusts, such as Enerplus Resources (NYSE: ERF, TSX: ERF.UN). Rather than try to do everything itself, the trust is first focused on acquiring land in a wide range of areas, primarily in the Western Canadian Sedimentary Basin. The current land base is now 603,000 net acres, nearly half of which is undeveloped.
Areas are categorized as near-term oil prospects, near-term natural gas opportunities, medium- to long-term resource play opportunities and larger original-oil-in-place pools. Each requires different techniques and technologies to develop. And to that end, the trust employs a full-time petrophysicist.
Virtually all of the opportunity areas, however, have one thing in common: at least one much larger player in the area that’s hard at work to prove the value of what’s underground and test the technology needed to develop it. As a result, Daylight is able to hold down its own costs and maximize its chances of success when it does put down its own money. It also has an active farm-out program, in which it allows others to develop its lands in return for a royalty—as well as valuable knowledge about what’s there, and the dos and don’ts for developing it.
Of course, getting appreciably larger will ultimately require Daylight to do some very real capital spending. And there’s no assurance the price of the oil and gas it sells will be high enough to fund it, as well as hold down debt.
That’s the biggest risk of buying smaller trusts in general. And we only have to go back to last year to see the consequences of falling natural gas prices on small trusts that are overextended. Important, however, Daylight has already proven its mettle over the past couple years, as it’s continued to grow even while rivals were caught in a death spiral. That, plus management’s conservative financial strategies, is a good reason for confidence it will continue to succeed.
At its current price of just under CAD10 a share, Daylight sells for around 1.8 times book value but only a slight premium to its assets underground. And on a price-to-cash flow basis, it’s the cheapest major trust. That makes it a perpetual takeover target.
Management’s unique strategy may deter some buyers. But with or without a deal, this one looks set to reward us richly in coming months and years. Buy Daylight Resources Trust up to USD12.
Piped in Profits
Pembina Pipeline Income Fund (TSX: PIF.UN, OTC: PMBIF) is this month’s best bet on energy infrastructure. The trust has three basic lines of business. Conventional pipelines transport conventional oil and gas primarily in Alberta. Management’s goal here is to generate reliable income from tolls for use of its network, as well as other related services. The focus is on boosting throughput and controlling costs.
The midstream and marketing business consists of the trust’s 50 percent nonoperated interest in the Fort Saskatchewan Ethylene Storage facility. It also includes wholly owned terminaling, storage and hub services either currently operated or under development at Pembina’s conventional oil and gas pipeline system. Here the focus is on low-risk, organic growth by providing more services to the conventional network.
The most exciting part of Pembina is its oil sands business. The core asset is the exclusive franchise on transportation for the Syncrude venture, a partnership between major oil companies on both sides of the border and operated by Exxon Mobil’s Canadian unit.
The trading stock of Syncrude is Canadian Oil Sands Trust (TSX: COS.UN, OTC: COSWF). Unlike that trust or the Syncrude partners, however, Pembina’s profits don’t depend on oil prices or even Syncrude’s overall output for a given quarter or year. Rather, they grow as Syncrude’s output does over time, as the venture requires additional pipeline and transport capacity. Fees are earned based on capacity purchases and don’t vary even if Oil Sands isn’t filling it up.
Starting July 1, Pembina will roughly double its operating income from oil sands infrastructure when it completes the Horizon Pipeline. Beginning 70 kilometers north of Fort McMurray, Horizon will run south to Edmonton and will serve the needs of another major customer, Canadian Natural Resources.
Like other trusts, Pembina took a hit in the wake of the Halloween 2006 trust taxation announcement. Since then, it’s already increased its distribution three times by a total of more than 25 percent. Completing Horizon on schedule and budget will almost certainly bring another large boost to the payout. The first quarter payout ratio slipped to just 81 percent, or 94 percent after taking out a “notional reserve” to safeguard future distributions.
The jig will be up for pipeline and energy infrastructure companies and trusts when operators start building speculatively—that is, building without first lining up customers. The good news for Pembina is, despite an aggressive buildout, its projects are fully contracted, both those in service and under development. In fact, it’s certain they’ll be able to do a lot more, boosting cash flow and distributions along with way.
First quarter earnings were further affirmation of the trust’s strength. Overall distributable cash flow rose 7 percent, as operating income rose at 5 percent at the conventional pipelines and 23 percent for the midstream business. Oil sands income rose just 1 percent but again will double after Horizon comes on stream.
The Dominion Bond Ratings Service continues to give the trust a STA-2 (low) stability rating, among the very highest. That’s a sound affirmation of what we already know: Pembina is a very strong trust, with a rapidly growing 8 percent-plus yield that should be locked away. Buy Pembina Pipeline Income Fund up to USD18.
For more information on both Daylight Resources Trust and Pembina Pipeline Income Fund, visit the How They Rate Table. Click on the “.UN” symbol to go to the Web site of our Canadian partner MPL Communications for press releases, charts and other data. These are substantial companies, so any broker should be able to buy them, either with their Toronto or over-the-counter (OTC) symbols. Ask which way is cheapest.
Note that both trusts’ dividends are considered qualified for tax purposes in the US. Tax information to use as backup for filing them as qualified—whether or not there are errors on your 1099—is listed in the Income Trust Tax Guide.
Also, as is customary for virtually all foreign-based companies, Canada withholds 15 percent of distributions to US investors at the border. This tax can be recovered by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation, though unrecovered amounts can be carried forward to future years.
| Daylight Resources Trust & Pembina Pipeline Income Fund | ||
| Toronto Symbol | DAY.UN | PIF.UN |
| US Symbol |
DAYYF
|
PMBIF
|
| Recent USD Price* |
10.00
|
17.70
|
| Yield |
11.9%
|
8.1%
|
| Price/Book Value |
1.78
|
2.63
|
| Market Capitalization (bil) |
CAD0.781
|
CAD2.360
|
| DBRS Stability Rating |
none
|
STA-2 (low)
|
| Canadian Edge Rating | 5 |
1 |
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