A USD100 per barrel decline in oil prices, a similar drop in natural gas, frozen credit markets, the falling Canadian dollar, 50 percent-plus declines in major stock market averages and a sharply contracting North American economy: Fourth quarter 2008 and first quarter 2009 are hardly the best of times for the 33 trusts, funds and high-dividend-paying corporations in the Canadian Edge Portfolio.

It’s no great surprise that our energy producer and service trusts–as the most leveraged to these trends–have fared worst. All but Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) have now cut distributions at least once during this down cycle.

As I pointed out in the February issue, Vermilion has been shielded from the worst of the crisis by virtue of operating in Europe and Australia, where natural gas prices are much stronger than in North America. It’s also benefited from exceptionally conservative financial practices, which have minimized the use of debt and have held its payout ratio in a range of 25 to 35 percent of distributable income over the past year.

Management estimates cash flow will cover both its distribution and capital spending based on a global selling price of CAD7 (roughly USD5.60) for natural gas and USD50 for oil. Should energy prices plunge much below that, however, even Vermilion would have to make adjustments.

Thus far several trusts have announced earnings and/or reserve information for 2008. And based on what we’ve seen thus far, it was a good year as far as building long-term sustainability. By and large, our trusts used the cash windfall from the energy spike during the first half of 2008 to fund projects and expand reserves without taking on significant debt.

ARC Energy Trust (TSX: AET-U, OTC: AETUF) increased its proved-plus-probable reserves per unit by 9 percent and its proved reserves per unit by 5 percent, largely thanks to its successful development of discoveries in the Montney shale play. It replaced 248 percent of 2008 production at an average FD&A (Finding, Development and Acquisition) cost of just CAD10.13 per barrel. That’s down from CAD17 per barrel in 2007, an exceptionally bullish number for the trust’s longevity. Proved Reserve Life Index (RLI) rose to 10.4 years, based on production guidance of 64,000 barrels of oil equivalent (boe) per day.

Looking ahead to the rest of 2009, management is very excited about the potential of Montney, sentiment also shared by Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV). But ARC has definitely felt the pain of falling energy prices. Realized selling prices for oil tumbled to USD56.26 and gas to CAD7 per thousand cubic feet (USD5.60). Cash flow per share rose 17 percent over year-earlier totals. But expectations for lower selling prices this year–and the trust’s need for development capital–have triggered four distribution cuts since mid-2008.

The good news is debt is very low at just 1.15 times annualized cash flow. And operating costs of barely USD8/boe mean production will still be profitable even if energy prices fall a lot further from here. The current distribution and level of capital spending will be well covered if oil and gas hit bottom somewhere around current levels.

On the other hand, if oil and gas should plummet to their late 1990s lows of around USD10/boe, there will definitely be more dividend cuts. The good news is these numbers show that ARC would survive. And barring a return to the stone ages for the global economy, there’s no way energy prices could remain that low for long.

Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) has been suffering a crisis of investor confidence in recent weeks. The latest flap concerns unsubstantiated rumors that its lender banks are about to cut the trust’s credit lines, threatening its very survival.

I’m no mind reader, and I caution against anyone doubling down in Penn West, or any stock or trust for that matter. But the trust’s sale of USD250 million of its shares, asset sales of USD150 million slated to close this week and CAD 1.4 billion of unused credit lines would seem to debunk the credit crunch theory.

Moreover, the trust still has plenty of room to ratchet down both capital spending and its distribution to shelter additional cash, and management is committed to continuing debt reduction and reducing dependence on bank credit lines by rolling them over into longer-term obligations. And its current bank line won’t expire until 2011, by which time with any luck energy prices will have rebounded.

One of the larger concerns about Penn West coming into energy’s meltdown was very high FD&A costs of CAD29.05/boe in 2007, a legacy of its aggressive acquisitions. One of the more promising signs from 2008 was a reduction in FD&A to CAD18.94/boe, as the trust developed more from its own lands. And management expects to take that figure lower still in 2009. The trust has found ways to cut operating costs as well, trimming its staff by 10 percent over the past year.

Again, the name of the game here is survival and sustainability, and Penn West has plenty of weapons at its disposal even if energy prices move dramatically lower from here. That doesn’t mean its current distribution level is safe at lower energy prices. But it does mean, whatever is happening to its share price now, Penn West is still very much in the game for recovery when energy prices do finally turn up again.

Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) isn’t scheduled to report earnings until early March. It, too, has issued some good news on the reserves front that should ensure survival, even if energy prices crash further. Specifically, the trust grew the value of its proved and producing reserve assets after debt by 9 percent. Net present value per unit rose 10 percent. That’s the result of careful allocation of capital that’s been management’s strategy from the beginning.

Rounding out the numbers, the trust replaced 139 percent of total proved reserves at a cost of CAD19.02/boe (USD15.22). Proved RLI rose to a superior 17 years, and production costs were anticipated again at barely USD2/boe. Again, a drop to that level would trigger more dividend cuts, such as the 20 percent cut effective with the March payment. But survival looks like a sure bet, and that’s what the shares are currently priced for.

Over the next several weeks, the remainder of our energy producer trusts will announce earnings and reserve information. I expect to see similar results as they do–in other words, solid information in reserves and costs that points to the ability to survive the unprecedented crash in energy prices, as well as vulnerability to further dividend cuts until prices bottom and again head higher.

That’s basically what Advantage Energy, Daylight Energy Trust (TSX: DAY-U, OTC: DAYYF), Enerplus Resources (TSX: ERF-U, NYSE: ERF), Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) and Provident Energy Trust (TSX: PVE-U, NYSE: PVX) have telegraphed over the past couple weeks by cutting distributions and capital spending projections.

All of these cuts were based on management’s forecast of further drops in energy prices and a determination to avoid adding debt to finance either capital spending or distributions. They’re determined to survive this downcycle in energy prices whatever it takes, and they’re prepared to take dramatic action to ensure they do.

As we’ve seen by the market action of the past several weeks, this means painful dividend cuts as long as energy prices are falling. The bet is that falling prices won’t last forever. In fact, my view is the supply destruction we’ve seen over the past several months all but guarantees a spike to new highs, once demand returns to normal levels.

A recovery in oil and gas even to reserve replacement costs (USD80 per barrel oil, USD8 per million British thermal units gas) would ensure a dramatic recovery in energy trusts’ prices, just as it did in the first half of 2008. That’s what we’re playing for here. It’s why I’m still recommending investors hold what they’ve got–though NOT averaging down losses. But it’s not a game to play if you’re not willing to be patient. And as I’ve advised since the first issue of Canadian Edge, oil and gas producer trusts are certainly not a place for you to have the majority of your portfolio.

One other energy-price-sensitive CE Portfolio trust deserves discussion now: Trinidad Drilling (TSX: TDG, OTC: TDGCF). Trinidad was able to dodge the worst of the natural gas price slump of late 2006-07, when drilling activity slowed to a crawl in the key Western Sedimentary Basin. That was because of its focus in the US, its concentration in deep drilling rigs and its insistence on locking up capacity under long-term contracts with the industry’s strongest players.

That left the company in good stead when it converted from trust to corporation in early 2008. The shares slumped initially following the conversion announcement, but then proceeded to blast off to a new all-time high by the time energy prices peaked in mid-summer.

Not even Trinidad’s conservative business plan, however, has been enough to fully weather this sector-wide meltdown. We don’t have fourth quarter earnings in yet. But on Feb. 19, the company cut its dividend by two-thirds to just CAD0.05 a share. It also announced a halving of its projected 2009 capital expenditures to CAD165 million, as it delayed construction of six rigs as part of an agreement with major customers.

Energy services companies are doubly leveraged to swings in energy prices. When times are good, demand for rigs rises, which pushes up both rig utilization rates and fees charged for their use. On the other hand, when energy prices fall, producers put plans on hold, driving down both usage and eventually rental rates.

That’s where Trinidad is now. On the one hand, it is one of the best-shielded players in North America from the tsunami that’s struck the energy production industry. The trust has 71 percent of its CAD160 million credit line unused. Based on ongoing project costs, it looks for the used portion to peak at CAD120 million and then fall to CAD60 million by the end of the year, actually below current levels.

Some 45 percent of the company’s rig fleet is contracted under long-term take-or-pay terms, which pay it even if the lessee doesn’t use them. That leaves a very conservative baseline for cash flow, even if energy patch conditions deteriorate further, as again they’re with very large creditworthy players who won’t default.

These factors should ensure Trinidad’s long-run survival. Further, the company is still moving ahead on projects–albeit at a slower pace–that are building future market share when the cycle again reverts to positive. No one should expect anything but weakness in the shares until the energy patch returns to health again. But the company is still very much in the game to recover the past few months’ losses, which would make for a truly staggering gain for new buyers.

Outside Energy

While our energy patch picks are in survival mode, all of our Conservative Holdings reporting thus far have come in with very strong numbers. There’s no guarantee things won’t get bad enough to derail them in 2009. But thanks to low leverage and recession-resistant niches, they’re holding up well as businesses–and either maintaining or increasing distributions.

In the February issue, I highlighted the strong earnings posted by Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) that back up its yield of nearly 12 percent. Since then, six more Conservative Holdings have reported fourth quarter numbers: Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF), Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF), Great Lakes Hydro Income Fund (TSX: GLH-U, OTC: GLHIF), Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF), RioCan REIT (TSX: REI-U, OTC: RIOCF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

We’ve also heard from Aggressive Holding Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF). The trust doesn’t produce energy and has therefore been spared the fallout from falling energy prices. But it’s nonetheless in a commodity related business and is therefore is not a Conservative Holding.

The numbers from all of these trusts are discussed in detail in the past several weeks’ issues of Maple Leaf Memo. But there are several points worth repeating here.

First, all of these trusts not only have maintained their distributions at the current rate, but most have affirmed them at least through 2009. Management of much-maligned Yellow Pages Income Fund, for example, continues to maintain its assertion that it will be able to pay at least its current distribution rate in 2011, when it will convert to a corporation. And the drop in its payout ratio to 81 percent in the fourth quarter, very strong Internet services growth, rising print directory margins and expansion of its credit agreement on favorable terms are pretty compelling evidence that it’s succeeding, despite the recession.

Second, there’s no evidence in the fourth quarter operating numbers of any of these trusts that their underlying businesses are weakening. Yellow’s fourth quarter growth in distributable cash flow (dcf) per share actually accelerated over its full-year growth rate. Energy Savings’ management affirmed the trust “was trending toward the top end” of its “5 to 10 percent target growth range for gross margin and distributable cash,” as management “confirmed the safety of distributions.”

Consumers’ Waterheater cut its 2008 payout ratio to 92.2 percent from 98.9 percent a year ago and posted steady cash flow and sales growth in the fourth quarter. It also pushed through a 3.9 percent rental rate increase for its water heaters while growing its customer base by a slower but still steady 1.4 percent. And cash flow covered interest expense by a lofty 6.6-to-1 margin. Those are pretty compelling statistics auguring for stability at this utility-like trust.

That Great Lakes Hydro posted very strong fourth quarter results is no great surprise, given its high-quality portfolio and reliance on contracts with only the most creditworthy big utilities and government entities. That Macquarie Power & Infrastructure did as well was likely a shock to many investors, with the exception of CE readers.

The fund met management’s target for a 100 percent full-year payout ratio, as its plants generally ran well and its minority investment in LeisureWorld continued to dish out solid cash flow. Overall, the power plant portfolio demonstrated strength through diversity, as management looks ahead toward operating in the post-2010 taxation environment. The trust stated it will maintain the current rate through 2009, though a cut of 10 percent or so may be necessary when taxation kicks in. The need for that could be mitigated considerably if management is successful in pursuing “growth initiatives” as it plans to.

Immediately following Yellow’s earnings announcement, there was a flurry of changes in analysts’ projections, most to the upside. That contrasted sharply with the press coverage doled out on the company in the weeks prior to the announcement. An article that appeared Feb. 5 in the Toronto Globe and Mail, for example, was headlined “Yellow Pages Faces Reckoning,” and postulated that the trust “will soon bow to economic and fiscal realities and cut its payout.”

The article was citing an opinion from a BMO Nesbitt Burns analyst, which the day before had triggered a 15 percent one-day drop in Yellow’s shares. But the author went several steps further, alleging that the analyst’s forecast of flat revenue and cash flow growth the next three years was “optimistic” and that “CEO Marc Tellier could probably cut the distribution in half.”

None of those alleged signs of weakness, of course, were present in Yellow’s fourth quarter numbers. But the idea that this trust has to fall has nonetheless become implanted in the minds of investors on both sides of the border. And even 9.1 percent fourth quarter growth in dcf per unit–and rising margins in both print and Internet media–could shake it.

That, incidentally, was also the case with the audience reaction to RioCan REIT’s numbers. The REIT’s funds from operations were off slightly due to the relocation of its office and fewer one-time gains from property sales and lease cancellations. But its rents from properties rose, its occupancy rate remained an enviable 96.9 percent, and it continued to successfully pursue new development opportunities, demonstrating undimmed ability to access capital along the way. Finally, debt leverage remained low, and management was able to refinance higher-cost debt, despite very tight credit conditions that have crippled rivals.

None of that, however, was enough to keep RioCan shares from plunging to their lowest levels in many years in the past few days. Basically, investors seem to have decided that even the strongest, low-leverage players in recession resistant niches are vulnerable to the current stress tests now sweeping North America. And they’re pricing everything accordingly.

Finally, Chemtrade’s fourth quarter results did show some impact of the unfolding global recession and were also hurt by the shut-in of a key facility for repairs. Nonetheless, it posted record 2008 DCF of CAD2.50 a share, meeting management projections and covering the distribution by more than 2-to-1. And despite the one-time costs and challenges, even fourth quarter dcf covered the payout by a 1.17-to-1 margin, with management verifying the same for 2009, thanks to efficiencies and strong contracts.

The Upshot

When we came into this earnings season, my greatest concern was that the underlying businesses behind our Canadian trusts and high-yielding corporations remain solid. Market history shows that if the underlying business stays strong, share price recovery will ultimately follow when the cycle inevitably shifts.

The good news is all of the trusts to report outside the energy production sector are still performing very well as businesses. Not only were fourth quarter numbers steady. But management has universally pointed to more of the same in 2009. And they’re backing up their words by maintaining and even increasing dividends, as well as with insider buying.

As for the energy producers, the historic crash in energy prices has brought with it the inconvenient truth that dividend cuts are necessary for their survival. But the low debt, low costs and solid reserves of our picks are still very good assurance that they will survive to see the ultimate recovery of their industry, when demand returns to normal levels and the full effects of ongoing dramatic supply destruction are seen.

The bad news is everything we hold could well go lower, depending on what happens to the economy. That particularly applies to the stressed energy producers. But it’s also quite possible that even the non-producer trusts could succumb, no matter how well they’ve done thus far.

I remain governed by the numbers, and I’ll hold a non-producer trust unless its business does break down. That goes for any of the trusts that have yet to report their fourth quarters. And I’ll also be reviewing all of them for weakness every time they report.

Unless that happens, however, I’ll be holding onto these trusts and facing whatever punishment the market metes out in the near term, while this broader market continues. Keep in mind that this isn’t a recommendation for everyone to double up on my favorites. Rather, it’s the same advice we’ve been giving for the past several months: Hold the good business and avoid everything else.

If you can’t stand the market action–and I certainly don’t blame anyone for that–my best advice is to go ahead and take enough cash off the table for now so you can remain unemotional. You may have to re-invest it at higher prices than we’re seeing now. But if that’s what it takes to keep following the numbers, that’s the best way out of this and into the eventual recovery that we will see, whenever it occurs.