ARC Energy Trust (TSX: AET-U, OTC: AETUF) is rolling back the second part of a “top-up” dividend increase, effective with the Oct. 15, 2008, payment. The new monthly rate will be 24 cents Canadian a month, consisting of a 20 cents “base distribution” and an additional 4 cents “top-up” payout.

ARC had initiated the top two ups in response to spiking energy prices earlier this year, particularly for natural gas. The first increase was a 4 cent Canadian boost in the monthly rate to 24 cents May 7. The second was another 4 cent increase June 26, the portion which has now been rolled back.

As Canadian Edge readers know, I don’t like distribution cuts. With the exception of trusts converting to corporations, they’re almost always a sign that business is softening up. In an environment of stress tests—tight credit, rising raw material costs and a weak US economy—they can also be early warning signs of an impending crackup for a company/trust and corresponding blowup in the share price.

Energy production is an inherently volatile business, particularly for natural gas. This year, gas prices began the year well under $5 per million British thermal units (Btu), surged to the low teens and have since crashed back to around $7.

The natural gas trading market is commonly referred to as the “widow maker” for this reason. And the price volatility has made it very difficult for any producer to do efficient, long-term planning. That’s a reason why supplies are likely to remain tight over the long haul. But cash-intensive enterprises like Canadian trusts must have money on hand to pay distributions, service debt and follow through on production programs. That means they have to keep careful tabs on what they’re paying out and be ready to adjust that level with the market.

ARC initiated “top-up” distribution increases this year, largely because it wanted to reward shareholders but didn’t want to put in anything perceived to be permanent in such a volatile market. Over the past several months, investors have enjoyed a higher cash return. But management has consistently stated that the top-ups would be periodically reviewed on the basis of energy prices.

In its release this morning, management cited the 22 percent decline in oil prices and the 45 percent drop in natural gas, since the June 26 increase. Given the focus on enterprise sustainability, it seems to me the prudent course was to take down the “top-up” at least one level. Further, my view is that unless gas prices rebound a bit, ARC will likely take down the first half as well, leaving the 20-cent base.

The good news is that ARC was able to pay that base distribution with a comfortable margin at oil and gas prices far below those of today. In addition, the massive cash influx from higher oil and gas prices this year has allowed it to follow through on new projects without significant new debt, thereby improving sustainability and ability to weather a return in gas and oil at least to where they began 2008.

In my view, despite today’s selling, that’s plenty of reason to continue holding ARC. I’m also maintaining a buy rating on it up to USD32 for those without a position. The trust’s cash flows will continue to be hugely affected by ups and downs in oil and gas. That’s why it and the other energy production trusts are all in the CE “Aggressive Portfolio.” The trusts in the “Conservative Portfolio,” in contrast, are not tied to energy price cycles.

Should energy prices return to their levels at the start of the decade ($2 gas, $20 oil), we would definitely see lower distributions for producing trusts. If I thought that was likely, I wouldn’t recommend anyone own trusts. At this point, however, that looks about as likely as the Washington Nationals making the playoffs this year.

Perhaps more important, all of the CE selections have been stress tested over the past two years. All have proven their ability to rely on their own resources with energy prices at much lower prices than now, even despite much challenged access to capital. All have benefited from the surge in energy prices this year to strengthen balance sheets and improve production and reserve profiles, hence their long-term strength and sustainability.

There are going to be ups and downs, as ARC has shown by reversing its top-up dividend increase. But these trusts are survivors that, moreover, are on track to be generous dividend payers beyond 2011. And all are also in better shape than ever to profit from what I believe the more likely scenario over the next several years: Surging demand for natural gas coupled with still-challenged supply in North America, despite the promise of shale deposits in the US.

We’re still net up in our producer trusts for the full year. But a lot of downside risk is now priced into the group, including ARC. As a result, danger is limited, and there’s a tremendous upside if, for example, we see cold weather, a hurricane or unexpected drawdown of gas reserves nationally.

I’ll be focusing on oil and gas producers more closely in the October issue of Canadian Edge, and I’ll be keeping you posted in Flash Alerts in the meantime. The most comprehensive information on how they stack up is in the “Oil & Gas Reserve Life” section, which can be accessed from the Canadian Edge Web site from the menu on the left-hand side of the homepage. Scroll to the bottom of the document for the table.