High-dividend-paying corporations. Since Halloween 2006, that’s been the likely model for today’s Canadian income trusts in 2011 and beyond. Two moves made by Portfolio trusts this week have given us at least a cursory idea of what that might look like.

Penn West Energy Trust (NYSE: PWE, TSX: PWT-U) has won final approval from shareholders and regulators for its mergers with Canetic Resources Trust (NYSE: CNE, TSX: CNE-U) and Vault Energy Trust (TSX: VNG-U, OTC: VNGFF). The deals are now slated to be completed on Jan. 10 for Vault and Jan. 11 for Canetic.

Vault shareholders will get 0.14 shares of Penn West for every Vault unit they own. Canetic owners will get 0.515 units of Penn West, plus a special cash distribution of 9 cents Canadian per share of Canetic exchanged. The transaction will take place automatically, and the Penn West shares should show up in accounts almost immediately.

As I pointed out in the January issue of Canadian Edge, these deals make Penn West a major producer, with more than 200,000 barrels of oil equivalent in daily output. It’s now the largest trust by conventional oil and gas output by about a 2-to-1 margin, with abundant potential to ramp up production dramatically as the Peace River oil sands project comes on stream over the next few years. It also has huge undeveloped land reserves to increase conventional production.

In addition, Penn West’s merger activity has driven down its share price over the past few months from the low 30s to the mid-20s. As a result, it now trades for a very modest 1.35 times book value and a massive yield of nearly 16 percent. Management has said it plans to maintain that distribution rate for the foreseeable future and should get a boost in its efforts from higher oil prices, which averaged around USD30 per barrel on the fourth quarter spot market above the trust’s realized selling price in the third quarter.

Penn West’s low valuation and rich reserves also make it a very possible takeover target, with overseas buyers the primary candidates to make a bid. More important, however, these mergers have set the trust up to remain highly prosperous well past 2011, when Canadian trusts are slated to be taxed just like ordinary Canadian corporations. And it’s likely to expand its advantage with more mergers as 2011 approaches because the Canetic and Vault deals expand its ability to issue new shares.

Oil and gas, of course, is an inherently volatile business, and cash flows can change dramatically from quarter to quarter. But with these deals, Penn West is well set to deal with whatever comes down the pike. And provided the energy bull market lasts, as I expect, it’s headed a lot higher. Buy Penn West Energy Trust up to USD38 if you haven’t already taken a position.

The other transforming deal involves Aggressive Portfolio holding Trinidad Energy Services Income Trust (TSX: TDG-U, OTC: TDGNF). I first entered this trust in December 2006 as a replacement for a pair of riskier energy services selections. Since then, it’s dramatically outperformed its rivals—most of which have gone down in flames—and held its distribution as well.

Trinidad’s ability to weather what’s become a true depression in Canadian natural gas production is largely a result of two things: First, its rigs are primarily located in the US, where the drilling market remains steady. Second, its rigs are state-of-the-art deep drillers, the market for which has also remained robust. Further, most of its fleet is signed under long-term contracts to financially strong producers.

The result is by far the lowest payout ratio for drillers—approximately 62 percent of distributable cash flow for the first nine months of 2007—and stable finances as well. The trust’s share price is well off its 52-week highs, which has slowed its ability to issue new capital for growth.

And there’s the possibility of slowing demand for rigs even in the US if a recession really takes hold here. But the trust remains the best suited of drillers to hold its own no matter what happens this year.

Energy services, however, is an aggressive business that’s, at the root, even more volatile than energy production itself. And Trinidad management has growth on its mind in the current weak environment.

The result: Management is proposing a conversion from an income trust to a high-dividend-paying corporation. The plan’s chief drawback from a shareholder point of view is a reduction in Trinidad’s distribution from the current annual rate of CAD1.40 a share to 60 cents Canadian. Also, upon approval of the plan, the frequency of the payout will be quarterly rather than monthly.

A shareholder vote is slated for March 8. Here’s how I see it.

I don’t like distribution cuts any more than most income investors. In fact, I often use them as a reason to sell, particularly in volatile industries. However, there are some pretty huge differences between Trinidad’s move and those made by other energy services trusts over the past year.

The main difference is this move isn’t being forced by circumstances. We don’t yet have fourth quarter data on the trust’s rig rates. But indications are cash flows and distribution coverage were again steady.

Rather, this is a move made by management to invest in growth at a time when the energy services industry is critically weak and opportunities for acquisitions abound. Moves made now will boost Trinidad’s growth substantially when the cycle inevitably shifts.

Based on distribution coverage for the first nine months of 2007, the new payout ratio for Trinidad is somewhere between 25 and 30 percent of distributable cash flow. That leaves a lot of room to finance growth, as well as to boost the distribution when conditions turn more positive and the trust-turned corporation expands.

Finally, Trinidad’s new dividend will be about 7 percent. That’s the highest yield in the energy services patch, and it’s the safest as well. Not only is it well covered by cash flows, but it’s now entirely immune from the 2011 tax change for trusts.

As for the tax change itself, here’s what Trinidad management has to say: “Trinidad believes that it will be able to shelter the majority of its income from cash taxes prior to, and potentially beyond, 2011. Due to the tax efficiencies created by Trinidad’s tax pools, the need to create tax shelter through the Trust structure was substantially mitigated. Furthermore, under a corporate structure wherein a larger percentage of cash flow will be reinvested in capital assets, tax pool balances will be further enhanced, thereby providing additional shelter against taxable income.”

The bottom line is Trinidad intends to remain a high-dividend-paying corporation from this point forward and well past 2011. The amount of those dividends will depend on market conditions as well as management’s assessment of its capital needs for growth, which at this point are best financed by internally generated cash flows.
 
Energy services remains a volatile industry, and conditions aren’t likely to improve much until natural gas inventories drop a lot more than they have in recent months—and Canadian producers start to think about ramping up output. That, unfortunately, may be some time in the future.

In the meantime, Trinidad will keep paying us what’s still a pretty hefty distribution, even as it uses the cash saved from this dividend cut to expand operations and build future growth.

In my view, that makes Trinidad Energy Services Income Trust worth continuing to hold for the long haul, albeit as an aggressive play. I intend to keep the shares in the Aggressive Portfolio up to the proposed conversion and beyond. I am, however, lowering my buy target to USD15 for those who don’t already have positions.

Note there’s one other major potential additional benefit for Trinidad unitholders from this conversion: The trust’s charter currently limits ownership by non-Canadians to less than 50 percent of shares. That will be eliminated by the conversion, which makes the trust even more attractive as a takeover.

For more information on the proposed conversion, visit Trinidad’s Web site (www.trinidaddrilling.com). Note you can access all covered trusts’ Web sites from the Canadian Edge How They Rate Table by clicking on the underlined name of each trust.