Perpetual Energy (TSX: PMT, OTC: PMGYF) is cutting its distribution again, this time to a monthly rate of CAD0.03 per share. The already-converted corporation announced the move along with third-quarter earnings that clearly show the strain of the plunge in natural gas futures prices since summer.

As I wrote in the November Canadian Edge Feature Article, these lower futures prices have prevented the company from locking in selling prices for output that support current levels of cash flow. In its Oct. 13 press release Perpetual stated it had locked in about half of its projected November-December output at a selling price of USD7.54 per gigajoule, a measure roughly equivalent to a thousand cubic feet or million British thermal units. But it had locked in only 39 percent at USD4.39 for January through March 2011 and just 25 percent at USD5.21 for April though October 2011.

The upshot: Despite the past couple weeks’ spike in gas prices back above USD4, that’s not enough cash flow locked in to maintain the current distribution. As a result Perpetual will reduce the payout by 40 percent, from the current monthly level of CAD0.05 to CAD0.03, effective with the Dec. 15 payment.

The key question anytime a company cuts its dividend is whether there’s hope of recovery, or if shareholders are just better off unloading. As I wrote in the November Feature, my view is conservative investors are better off in my other oil and gas producer selections. The company’s high debt levels, small size and near complete reliance on natural gas output make it a far more aggressive bet on gas than, for example, Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), which announced third-quarter results this morning.

Peyto grew third-quarter output per unit by 25 percent, as it continued to develop its Deep Basin tight gas shale plays. Debt-adjusted production per unit surged 36 percent, while production costs per unit were slashed by 17 percent. The current cost of USD2.04 per barrel of oil equivalent is by far the lowest in the industry and is likely to go lower still as low-cost output continues to rise. Management also spent 123 percent more money during the quarter on new development.

The output gains pushed overall funds from operations per unit up a robust 21, despite a 10 percent drop in realized selling prices for natural gas. That reduced Peyto’s payout ratio to 77 percent, including the impact of a 6 percent boost in outstanding shares to fund growth. Interest expense was trimmed 15 percent, reflecting both low borrowing rates and management’s general aversion to taking on hefty levels of debt.

Peyto’s distribution will come down by half beginning with the January payment, as part of the company’s conversion to a corporation. That’s in part a response to low natural gas prices but also to raise capital to fund growth plans.

It’s almost certainly going to take a revival in gas prices to push distributions higher again. But these numbers are a good reason to keep holding Peyto units, as a low-risk way to play such a recovery in gas. Peyto Energy Trust is also a buy anytime it trades at USD16 or lower, for those who don’t already own it.

As for Perpetual, even after the distribution cut, the shares still yield well over 8 percent as of today’s open. Some readers have asked me if the company is viable. That’s still very much my belief.

In fact, I continue to find management to be among the industry’s best in terms of sharing information for depth, clarity and timeliness. For example, it’s consistently provided details about hedging positions and supportable levels of dividends and debt at various levels of natural gas prices.

Where the case for Perpetual has fallen down this year–and if you want to fault my bullishness–has been precisely on price levels for natural gas, specifically in the futures market. But there’s plenty of reason to continue betting on a turnaround, at least for investors who can tolerate the risk and stand the waiting.

First, as the previous quarter’s numbers make clear, the company isn’t under any real financial stress, despite very low gas prices. Coincident with the dividend cut and earnings release, for example, is an announcement that management is ramping up its capital budget. Development capital for 2010, for example, has been increased from CAD81 million to CAD112 million. Some of that was spent in the third quarter, and management now expects to dish out CAD35 million in the fourth along with another CAD48 million in the first quarter of 2011–taking full advantage of the winter freeze.

This new spending will be heavily directed at developing reserves that are rich in natural gas liquids, which are better priced than dry gas because they can be substituted for higher-priced oil. The company also plans to explore what it calls “high potential bitumen opportunities,” which it could try to develop on its own or sell to a company with deeper pockets.

This new development is something of a departure from the prior 100 percent natural gas strategy. But it’s very much in line with the flexibility Perpetual has demonstrated historically to leverage the value of its lands and expertise, which still rank among the most formidable in the sector. And the result should be a continuation of the third-quarter trend of rising production, reversing flat to falling output of recent years. Encouragingly, operating costs per unit of output fell 11 percent from year-earlier levels, 14 percent excluding gas storage costs.

The key question is when realized selling prices will recover. The company reported an 18 percent decline in the quarter from 2009 but still netted CAD6.18 per thousand cubic feet, a level roughly 50 percent above spot market prices. That was still enough to sustain a payout ratio of just 47.3 percent and pay off another CD38.6 million in net bank debt, a 13 percent reduction from 2009 levels.

The netback–or realized price less costs–came in a CAD3.31 per thousand cubic foot from CAD4.25. That implies a breakeven price of CAD2.87 for Perpetual, based on the CAD6.18 average selling price in the third quarter. And with that average realized selling price likely to drop a couple bucks in the next quarter or two, management took the proactive move of cutting the cash payout before it couldn’t afford to dish it out.

Output gains are the key to my recommendations’ ability to weather this weak environment for natural gas pricing. Unlike larger producers, these companies’ decisions aren’t going to affect the supply-demand balance meaningfully in the overall market. Meanwhile, higher production from shale drives down operating costs, making them more profitable at lower prices.

Perpetual’s announced moves should accomplish that, and management has proven highly adept in the past at execution. That ensures higher cash flows, dividends and the share price when gas prices move higher from what most industry observers consider “unsustainably low levels.”

That is the basis for continuing to hold Perpetual, even after its sixth dividend cut since mid-2006. But the game here is natural gas prices, of which Perpetual is a leveraged way to play gas that also pays a dividend.

I’m keeping Perpetual Energy in the Portfolio, but it’s only for very aggressive investors who can patiently wait for gas demand in North America to recover and new uses–such as electric power and truck transport–to ramp up. If your goal is yield, focus on the other producers highlighted in the November Feature–or better on the Conservative Holdings. And if you don’t want to bet on gas, there’s no reason to own Perpetual.

I’ll have more on CE Portfolio earnings later this week.

Editor’s Note: For additional information on this topic, check out Roger Conrad’s latest report on Top Canadian Income Trusts.