All In

Third quarter earnings reports are in for virtually all the Canadian trusts and dividend-paying corporations tracked in our How They Rate table. Current payout ratios and other relevant information on the results can now be viewed by clicking on “How They Rate” in the left-hand menu.

I’ve already recapped results for all CE Portfolio holdings in the November issue and the subsequent Flash Alerts, with the latest being Ag Growth Income Fund’s (TSX: AFN-U, OTC: AGGRF) very strong numbers. And I’ll be discussing their portents for the future in the December issue, which will be emailed on Friday, Dec. 5. Note that the trust mutual funds in How They Rate have now been updated for their use of leverage as well as payout ratios.

As always, I’ll be using year-end tax selling season to prune a handful of the holdings and replace them with more promising ones. The goal will be to best position ourselves for what I believe will be a much better year, as well to better deal with the current challenges, which are formidable market-wide.

Below, I want to share a couple more general observations. First, businesses that had done well prior to the third quarter generally posted equally strong results. And quite a few are also now guiding toward solid results in the fourth quarter and beyond. That’s my key criteria for keeping, and even adding to them, in the days ahead.

In contrast, businesses that had been languishing and not covering distributions generally didn’t once again. That doesn’t mean they won’t eventually recover, and many have been dumped to levels that in a normal market would make them bargains. But they’re struggling now, and as long as that’s the case we don’t want to own them.

Not surprisingly, the steadiest performers were mostly in businesses with the less direct exposure to the economy. The biggest underperformers were in businesses with the most exposure, with the worst generally those that had heavy US exposure. Again, that’s a generalization, and there are some notable exceptions, such as Energy Savings Income Fund (TSX: SIF, OTC: ESIUF), which, as I reported in Friday’s Flash Alert, has affirmed the economic turmoil isn’t affecting its ability to pay its current dividend.

As we’ve reported here and in the companion weekly Maple Leaf Memo over the past year, the Canadian economy has been doing somewhat better than the US economy. And though the official figures showed a slightly shrinking GDP for the country, this remained the case in the third quarter. That’s allowed a sizeable number of companies and trusts to continue covering distributions by a solid margin, even as others have continued to weaken and head inevitably toward distribution cuts.

My second observation concerns energy trusts. Given the magnitude of the decline in oil and, to a lesser extent, natural gas prices since mid-summer, I fully expected to see more trusts trim their distributions. That still may happen if energy prices continue to slide. But so far, the only real reductions we’ve seen have been at trusts that have needed to shepherd cash to develop new reserves and output, and have wanted to limit their use of debt.

That group includes Enerplus Resources (TSX: ERF-U, NYSE: ERF). The trust still has sizeable development underway in the Baaken light oil region as well as the Kirby project in the oil sands that won’t generate significant revenue for several years. It also has very low debt of only 0.4 times annual cash flow and is dedicated to keeping it that way.

One reason energy trusts haven’t been cutting more prolifically is management teams’ systematic use of hedging to lock in prices over the summer. This held back returns in the first half of the year but is proving to be a major plus in the second half. And many trusts are using the money to reduce debt further, which improves both long-term sustainability and their ability to weather the current very difficult environment.

The other reason is a bit less well known. That’s the fact that oil and gas are priced in world markets in US dollars, while Canadian trusts’ cost structures and distributions are based on Canadian dollars.

After rising sharply for several years, the Canadian dollar has fallen sharply against the US currency during the past few months of this financial crisis. The primary reason is the Loonie is considered to be a resource currency, because Canada is a major exporter of energy and other raw materials. Basically, the decline in energy prices has been accompanied by a drop in the Canadian dollar, providing a huge offset to the drop in energy prices on these businesses’ Canadian dollar cash flows.

We’ve seen the negative side of the Loonie’s decline in terms of falling share prices and a drop in the US dollar value of our distributions. The flipside, however, is that producing trusts and companies are still receiving fairly high sums for their output in the only currency that counts for them: the Canadian dollar.

A realized price of USD50 per barrel oil in Canadian dollars at an exchange rate of 80 US cents per, for example, is actually CAD62.50. The price of USD6 gas, meanwhile, is a more respectable CAD7.50. Note that the figures shown in the Oil and Gas Reserve Life table reflect Canadian dollars, and these are the numbers on which trusts base distributions.

In my view, USD50 oil and USD6 gas aren’t sustainable numbers long term, as they’re well below global reserve replacement costs. They’re also well below development costs for the non-conventional reserves that are increasingly filling the supply gap in North America.

Should low prices last well into next year or even fall further from here, I’d be surprised if most energy producing trusts didn’t have at least one more dividend cut in them. But to date, it appears most management teams have prepared their trusts for what’s otherwise been a catastrophic drop in energy prices. And this prescient positioning is clearly not reflected in their current share prices and very high dividend yields.

Answering the Bears

On a final note, a quite negative commentary on energy trusts appeared on the Seeking Alpha wire service this week that many of you read. I’m a big fan of this service, which provides a wide range of commentary as well as very easy access to conference call transcripts, which I highly recommend reading. In this case, however, I have several criticisms.

First, it should be noted that this article is basically talking about the same themes we’ve discussed repeatedly and at length in virtually every issue of Canadian Edge since Halloween 2006, when prospective 2011 trust taxation was first announced.

Yes, as we all know, a lot did change. For one thing, since that time, trusts have been basically forced to live within their means. The sudden drop in prices made it more expensive to issue new trust units literally overnight. But the provisions of the legislation enacting the Tax Fairness Plan also limited the number of shares trusts could issue to a 40 percent increase in 2007, and 20 percent in 2008, 2009 and 2010.

That was enough to weed out the weakest of the lot. And the pressures became greater still as natural gas prices continued to slump throughout 2007.

From their creation on through the issuing boom of 2005-06 and up to the Halloween 2006 announcement, trusts could basically issue as many equity units as they wanted. Many smaller ones routinely doubled and tripled their shares outstanding every year. That ended Oct. 31, 2006. But the upshot was that managements typically relied very heavily on equity and very little on debt to fund their expansion.

With the credit crisis kicking in, that debt aversion has continued and arguably intensified, particularly in the energy sector. In fact, as the third quarter numbers show definitively, most trusts have been slashing debt in earnest over the past year. That’s precisely why there weren’t more distribution increases in the first half of 2008 when oil and gas prices soared, as management used the cash as a windfall to further strengthen balance sheets and develop new projects to increase longevity.

That leads me to my first critique of this article. There are some trusts that do have high levels of debt, notably Harvest Energy Trust (TSX: HTE-U, NYSE: HTE), which borrowed heavily to finance its refinery operation. But there has simply not been a major build up of debt at trusts in general.

In fact, as I’ve pointed out, the far more common occurrence is massive debt cuts such as Provident Energy Trust’s (TSX: PVE-U, NYSE: PVX) 58 percent reduction in bank debt over the past 12 months. Provident’s 25 percent dividend cut last month is part and parcel of its commitment to keep cutting borrowing while maintaining development of several key plays.

My second critique concerns the bold statement that all energy trusts face the same choices when it comes to 2011 taxation, and the generalization drawn from a Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) statement that all trusts’ dividends are set to fall 25.1 percent and 23.8 percent and beyond “if structural or similar changes are not made.”

When the Halloween 2006 trust tax announcement was first made, one of the savviest comments I read at the time (and reported in CE) is there would be as many tax efficiency plans for trusts as there were trusts. That’s certainly been how things have played out thus far. Some trusts have been taken over, notably the former PrimeWest Energy Trust at a 40 percent premium to pre-deal prices. Some have been literally taken under, mainly the weaker trusts that couldn’t stand on their own and were headed into a death spiral due to inability to access capital markets.

Now we’re starting to see early conversions of energy trusts to corporations as well–and the pattern has followed exactly that set by non-energy producing trusts. Mainly, trusts that have laid out bold expansion plans have trimmed dividends to save cash to grow without borrowing.

Interestingly, as I pointed out in CE earlier this year, these trusts suffered an initial hit to share prices. But those backed by well-run businesses rallied sharply thereafter, at least up until the financial crisis delivered its blow to financial markets worldwide. That suggests that the conversions actually unlocked value in the market place and, despite the distribution reductions, were actually beneficial to shareholders.

There are, however, a growing number of trusts that reject the idea of dividend cuts after converting. I’ve pointed out many of the trusts that have made announcements to the effect they intend to pay the same in 2011 as they do in 2010, and many populate the Portfolio now.

We also have some examples of trusts that have made an early conversion and held their distributions. Bonterra Energy Trust (TSX: BNE-U, OTC: BNEUF) made such an announcement last summer.

The point is one size doesn’t fit all here. Broad-brush articles that condemn an entire sector are notorious for glossing over the details to make a point, particularly if they use the word “never” in the title. In case of trusts, we’ve seen plenty of similarly generalizing articles since Halloween 2006. This one is no different and no less inaccurate for it.

Again, the government withholding rate for US investors in Canadian trusts doesn’t change in 2011. The 2011 tax is levied at the trust/corporate level, and how it’s dealt with is at the discretion of management, and the trust/corporation’s ability to pay. That, in turn, is a function of the strength and nature of the underlying business. Any trust that elects not to cut its distribution in 2011 will pay the same post-withholding tax distribution to US investors it did in 2010.

My final comment on this article concerns the crux of the bear case: energy prices. As I’ve pointed out since I started recommending energy trusts years ago, energy prices are the whole ballgame.

Trusts are essentially flow-through entities for one main reason: the nature of their reserves, which are known and typically from deep pools that are long-lived. This makes them fundamentally different companies from Super Oils or developmental companies, the livelihood of which depends on continually finding prolific new reserves to produce from. As the Seeking Alpha author points out, the operating costs and finding costs per barrel are higher than for new finds because they’re mature. But they’re also very reliable, which explains why well development comes in near 100 percent (no dry holes) quarter after quarter. That, in turn, makes production levels and cash flow far more reliable than they are for any other type of energy producer, which makes them ideal for paying out cash flows as dividends.

Prior to Halloween 2006, almost unlimited access to capital for trusts made even more marginal wells cash generators under this structure. But those days have been over for more than two years. Today, only the trusts that can survive as businesses without abundant access to capital are still around. They’ve been baptized by fire and are far heartier than they were two years ago, and they continue to be hardened by the current tough conditions.

More important, the nature of their reserves–the deep pools shunned by the growth-hungry majors–won’t change. They’ll still be ideally positioned as dividend payers. The only question is at what level.

Following corporate taxation, tax pools will protect cash flows from distributions. They are substantial and are constantly regenerating as a result of producers’ operations. But they can’t protect all income from taxes forever.

The question though is what will they ultimately be protecting? Will it be newly converted corporations’ cash flows at USD50 oil and USD6 natural gas? Or will it be from USD90 oil and USD8 gas, which at this point are the industry’s costs of replacing existing reserves?

No doubt, trusts/corporations will be severely challenged to maintain current distribution levels at USD50 oil and USD6 gas. That would probably be the case even if there were no 2011 taxation. But at USD90 and USD8, the problems literally melt away and the bear case for a “blow down” or other drastic action becomes moot.

When I wrote The Case Against Oil and Gas in the June issue of CE, I advised taking profits on producer trusts because I felt oil could fall from its USD140 to USD150 range to as far as USD90. As it’s turned out, the financial crisis blew my forecast out of the water. But at the same time, it’s discouraged the kind of permanent demand destruction and new supplies–production is actually dropping off a cliff in many areas as we speak–that’s needed to shift the balance of market power from producers to consumers, where it was in the 1990s.

That’s why I continue to expect a return to a bull market for oil and gas, and prices of at least USD90 for oil and USD8 for gas. And that kind of a rally can’t help but set off another dramatic surge in oil and gas producer trusts, just as we saw in the first half of 2008.

The key underpinning of the bear argument is that this won’t happen, and that energy prices will continue to languish. If that’s the case, as I said above I think we’ll see more energy producer trust dividend cuts in the months ahead.

But even if that happens, consider this: Trusts like Enerplus and Penn West today sell at the same prices they did when oil and gas were under USD30 and USD3, respectively. That’s an awful lot of bad news already priced in, and it’s probably why even this ultra-bearish Seeking Alpha article advised US investors to stay put in their trusts, which is what we intend to do as well.