Half a month is far too soon to call a trend. But so far 2012 is following the same script for Canadian dividend-paying stocks as the one from 2011.

Two-thirds of Canadian Edge Portfolio picks are ahead for the year and several are already off to the races. Provident Energy Ltd’s (TSX: PVE, NYSE: PVX) takeover offer from Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF) sharply reversed an early year decline, pushing the stock up more than 17 percent for the year to date.

That’s on top of total returns of 53.7 and 29.8 percent the past two years. Given the promise of the Pembina merger (see the Jan. 17 Flash Alert), there are more gains ahead. And that’s in addition to the immediate 27.5 percent boost in monthly dividends Provident’s current shareholders will enjoy when the deal closes this spring. The stock’s now a hold, pending the success of the merger.

TransForce Inc (TSX: TFI, OTC: TFIFF), a laggard last year, has been an even bigger winner, pushing out to a gain of nearly 19 percent. That’s largely due to improved conditions in the North American trucking industry as well as the successful close of the Quik X Transportation acquisition. TransForce is now bumping up towards my buy target of USD16, a gain of nearly 70 percent from its Oct. 4, 2011, low.

Bird Construction Inc (TSX: BDT, OTC: BIRDF) is also riding a wave of good feelings, up more than 12 percent for the year. That’s nearly 60 percent above its October low and well above my target of USD12. Finally, Artis REIT (TSX: AX-U, OTC: ARESF), Colabor Group (TSX: GCL, OTC: COLFF), Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF), IBI Group Inc (TSX: IBG, OTC: IBIBF), Just Energy Group Inc (TSX: JE, OTC: JSTEF) and Newalta Corp (TSX: NAL, OTC: NWLTF)–all given up for dead by investors at some point in 2011–continue to add to gains achieved in end-year rallies.

These stocks’ ability to rally after steep selloffs is entirely due to underlying businesses that stayed strong during last year’s market storms. Investors eventually noticed their staying power, and poured back into their stocks as perceived risks to dividends diminished.

That’s very much food for thought for owners of the stocks that have taken a hit in 2012’s opening days. In the Conservative Holdings, the three biggest losers thus far were not coincidentally three of the biggest winners in 2011, mainly pipeline/energy infrastructure stocks AltaGas Ltd (TSX: ALA, OTC: ATGFF), Keyera Corp (TSX: KEY, OTC: KEYUF) and Pembina Pipeline.

It’s important to note that absolutely nothing negative has happened to these companies’ underlying businesses. In fact the only significant news for any of them has been resoundingly positive. Keyera announced a new venture with Enbridge Inc (TSX: ENB, NYSE: ENB) to build and operate a rail and truck terminal and long haul pipeline to provide diluent to oil sands producers. Pembina’s merger with Provident, meanwhile, will restart dividend growth at the company and will accelerate long-term cash flow growth. Pembina’s still a buy at USD27 or lower for those who don’t yet own it.

Stock prices, however, don’t grow to the sky and even the best occasionally will take a rest. If you own these stocks at good prices, keep them. If you don’t, be patient but don’t chase.

In the Aggressive Holdings Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE) is off to a good start, continuing a rally that began after the stock fell all the way to USD12.45 on Oct. 4, 2011. It’s now up 70 percent from that point, and the oil-weighted producer will very likely add to those gains if it can maintain positive momentum in its production plans. The same is true of Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF) and Vermilion Energy Inc (TSX: VET, OTC: VEMTF), both of which are oil-weighted and up by lesser amounts this year. The three are buys up to USD48, USD25 and USD50, respectively.

Our oil-weighted picks’ performance is, unfortunately, in stark contrast to the losses rung up so far this year by our three producer stocks that are more weighted to natural gas. ARC Resources Ltd (TSX: ARX, OTC: AETUF) and Enerplus Corp (TSX: ERF, NYSE: ERF) are both down a little less than 7 percent year-to-date. Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF), meanwhile, has understandably raised red flags by sliding roughly 18 percent and is now down 24 percent from the 52-week high hit in early December 2011.

The reason for the trio’s drop is, quite simply, the steep drop in natural gas prices since last summer. Front-month natural gas futures traded on the New York Mercantile Exchange (NYMEX) dropped to less than USD2.50 per million British thermal units this week. Alberta gas for February delivery, meanwhile, fell to just CAD2.255 per gigajoule, a roughly equivalent measure. The NYMEX price is the lowest settlement since March 2002 and the lowest mid-winter price since the late 1990s. NYMEX gas is down from over USD4 in summer 2011, Alberta gas from well over CAD3 at the beginning of the year.

Gas’ steep drop is in part due to a winter that’s shaping up as much warmer than normal, coupled with industrial demand that’s still below 2007 levels in some areas of North America. The impact on demand is at least partly offset by gas’ rising share of electricity output, which hit close to 30 percent last month up from an average of 20 percent in recent years. But it’s dwarfed by the massive increase in supply due to development of reserves from shale across North America.

Unfortunately, as I pointed out in the January Canadian Edge Feature Article, there’s every indication the gas glut is going to be with us for some time. That’s going to keep pressure on producers’ earnings, particularly on their stocks.

Portfolio Exposure

The good news is the CE Portfolio isn’t exposed to the most vulnerable producers, such as Advantage Oil & Gas Inc (TSX: AAV, NYSE: AAV), Bellatrix Exploration Ltd (TSX: BXE, OTC: BLLXF) and Perpetual Energy Inc (TSX: PMT, OTC: PMGYF). ARC, Enerplus and Peyto, however, are all virtually certain to take a fourth-quarter earnings hit from lower gas prices. And barring a steep gas price recovery by the end of March, they’ll likely feel some pain well into 2012 as well.

The key question is just how much they’re affected. And until that’s answered, we can expect the trio to be volatile.

Judging from feedback we’ve received from CE readers, Peyto’s sizeable year-to-date drop has caused the most consternation. Dry natural gas does account for nearly 90 percent of the company’s total energy output. That’s a similar number to Perpetual Energy, a former Portfolio Holding that increasingly looks like a bankruptcy candidate.

It’s critical for investors to realize, however, that there are immense differences between the two companies. First, Peyto’s operating costs are just CAD2.16 per barrel of oil equivalent (boe), or just CAD0.36 per MMBtu. That’s one of the lowest cost structures on the planet. In contrast, Perpetual’s costs are nearly five times higher at CAD10.86 per boe.

Peyto also has no maturing debt in 2012. Perpetual has CAD98.07 million drawn on a credit line maturing May 29, 2012, as well as CAD75 million in debt maturing Jun. 30, 2012. That’s versus a total market capitalization of just CAD143.9 million.

Peyto, in other words, is plenty strong to ride out this crisis. That fact was underscored by management’s confirmation of first-quarter dividends this week. The stock could well fall further if sliding gas prices spook enough investors. And a sustained drop in gas below CAD1.50 or so per MMBtu would almost surely cause management to reevaluate its capital spending and dividend policies.

What we’ve seen so far in the stock price, however, appears to be simply an unwinding of the exuberance that made Peyto the second-best performing dividend-paying Canadian energy producer last year. Remember that this stock routinely traded well above my buy targets in the latter part of 2011.

Those unwilling to ride out a drop in Peyto to at least CD18–a level seen several times in 2011–may want to lighten up on the stock. Ditto anyone under the illusion that this company is immune from the ups and downs of natural gas prices. But Peyto’s immense reserves and extremely low costs continue to make it the lowest-risk of the gas producers. And don’t be surprised to see the stock take out its late 2011 highs and then some over the next six to 12 months. I rate it a buy up to USD22 for those who don’t already own it.

Enerplus’ management has also taken pains to assure investors it can ride out this gas price drop. This week, the company announced a CAD800 million capital spending plan to “deliver production growth over 10 percent in 2012,” in the words of CEO Gordon Kerr. To that end it also announced the issuance of CAD300 million in equity through a bought deal offering, providing cash to deliver that plan without excessive leverage despite lower cash flow from gas sales.

Kerr also stated that Enerplus does “not plan to make any changes” to the company’s monthly dividend. That appears to be in large part due to the focus on ramping up liquids output, and the fact that gas drilling will be relatively modest. The company is a major holder of lands in the Bakken light oil trend. Oil and gas liquids output is projected to rise to 50 percent of total output in 2012.

The company has hedged 64 percent of net oil output expected for 2012 at an average floor price of more than USD96. It has not hedged any natural gas output, a fact that’s scared some investors and probably accounts for the split decision on Bay Street (five “buys,” six “holds,” three “sells”). Interestingly, though, there’s been only one downgrade in the past two months when the bulk of the gas price decline has occurred, and the most recent insider trades are buys.

I cut Enerplus to a hold in the January issue because of its exposure to a possible continued drop in natural gas. I am impressed by the company’s ability to stick to its capital spending and dividend plans as well as the equity issuance. Until gas stabilizes, however, I’m keeping the stock as a hold. And no one should own it without fully realizing that earnings are exposed to changing gas prices. Note fourth-quarter earnings are scheduled for release on or about Feb. 24.

Finally, I have my doubts that ARC Resources will be able to raise fourth-quarter earnings in the face of falling gas prices by lifting production, as it was able to do in the first three quarters of the year. And if gas stays at these levels, the task will only get more difficult in 2012.

The company, however, has been able to boost output of oil and natural gas liquids and has kept debt at just 90 percent of annualized cash flow, among the lowest in the industry. Coupled with immense reserves and corresponding ability to ramp up low-cost production, that’s a formidable weapon for the company, whose distributable cash flow covered its third-quarter dividend by nearly a 2.5-to-1 margin.

That’s very likely a big reason Bay Street remains relatively bullish, with 10 “buys,” seven “holds” and just one “sell,” despite the big drop in natural gas, and the fact that 64 percent of ARC’s current output comes from the fuel. It’s why nearly all the insider action over the past year has been on the buy side, and it’s why management recently confirmed the current dividend rate of CAD0.10 per share. I continue to rate ARC a buy up to USD26 for those who don’t already own it and can shoulder the risk.

Again, as it the case with Enerplus and Peyto, falling natural gas prices will almost surely have an impact on fourth-quarter profits, and very likely will the rest of the year. And if gas prices fall enough, these companies have shown in the past they will not continue to pay a dividend at the cost of their financial integrity. In fact they’ll almost certainly cut dividends if it’s necessary to preserve capital spending.

I’m also not about to try to predict a bottom for natural gas prices here. Nor will I rule out selling any of these three stocks from the Portfolio if the numbers indicate that’s the best course. That could include selling any one of these three stocks after a dividend cut that clips another 25 to 30 percent of their value.

Of course, my outlook for all three of these companies is they’re headed a lot higher in coming years, as they ramp up output particularly of liquids. And I’m willing to accept the risks I’ve discussed above in pursuit of those returns. But they are at their core producers of commodities and are therefore subject to volatility of profits, dividends and share prices that other companies aren’t.

If you’re not willing to ride out the ups and downs and shoulder the risk, you’re best off in a stock with less commodity price exposure. Alternatives include the bulk of my Conservative Holdings, so long as they trade below buy targets.