Sustainability: That’s the key to success for Canadian income trusts as well as all other dividend payers.

A high yield isn’t worth the paper it’s printed on, unless the business paying it churns out the needed cash flow, year-in, year-out. Otherwise, investors are always at risk to dividend cuts and accompanying sudden losses of principal.

Producing oil and gas is inherently a volatile business. Price action this year has been particularly erratic, with a first-half spike abruptly reversing into the historic slide since mid-summer.

Unfortunately, things are unlikely to settle down as we move into the fourth quarter. On the bullish side, inventories remain tight, both in the US and globally. The world is ever-more dependent on non-conventional sources of supply that require very high prices to be economic. And though demand for some products such as gasoline has dropped noticeably in recent months, there’s no evidence of the kind of permanent demand destruction that ended the energy bull market of the 1970s.

Once stability returns to the US financial system and global financial markets, energy prices should return to the upside. Unfortunately, we have no way of really knowing when that will occur or how much the US economy and demand for energy will slow while we wait. And until we do, energy prices will be under pressure.

When energy prices rise, so do producer trusts’ cash flows—and so does their ability to pay bigger dividends, redeem debt and fund new projects. When energy prices head down, on the other hand, trusts have less cash to do these things.

Coupled with still-rising production costs, the recent drop in energy prices can’t help but pressure energy trust distributions. We’ve already seen one very strong trust—ARC Energy Trust (TSX: AET-U, OTC: AETUF)—roll back half of its “top-up” distribution increases earlier this year. It also warned that it may cut the other half.

Given ARC’s reputation as one of the most conservatively managed trusts, its actions have sparked fears of distribution cuts throughout the sector. Worries that a weakening US economy will push energy prices much lower are what’s been behind the selloff of oil and gas trusts in recent months.

The cyclicality of energy prices has always set the oil and gas producer trusts apart from trusts in other industries. That goes for the strong and weak alike. And it’s why my nine CE Portfolio oil and gas trust recommendations are housed as “Aggressive Holdings,” while those other businesses whose fortunes aren’t directly tied to energy prices are in “Conservative Holdings.”

On the other hand, our picks also have a saving grace: Management has historically focused on business sustainability, rather than paying out as much cash as possible. That’s also been the case this year.

Earlier this year as oil and natural gas prices were spiking, Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF) tripled its payout. In contrast, my nine picks treated the higher energy prices as a welcome windfall rather than a new floor. Distributions were bumped up slightly. But the bulk of the additional cash was used to expand drilling projects and cut debt burdens to improve long-run sustainability.

The dramatic drop in oil prices will almost surely strain Canadian Oil Sands’ payout. Our picks, however, are still paying out at more or less the same level they have for the past several years, when oil and gas traded at lower prices than they do now. That’s the primary reason I feel comfortable holding them through the near-term turmoil, collecting their average yield of 14 percent-plus while we wait for this energy bull market to resume.

No oil and gas producer trust’s distribution should ever be considered as safe as, for example, a US utility’s dividend. But by deploying funds to make themselves more sustainable enterprises, the CE Portfolio trusts have also made their distributions safer.

In the long run, that will benefit shareholders more than anything else. And we can probably count on management to treat any future energy price spikes in the same way. Vermilion Energy Trust (TSX: VET-U, OTC: VETMF), for example, may wind up virtually debt-free if it’s cashed out of its 42 percent stake in increasingly profitable exploration company Verenex.

On the other hand, the laser-beam focus on business sustainability also means our picks are likely to trim distributions, should energy prices fall far enough. That will ensure their health, but it would also likely mean a further drop in share prices, which remain ahead for the year despite the volatility.

In my view, any near-term haircut would be a small price to pay to stick with strong producer trusts. Even if they’re cut, yields are still likely to be among the highest in the world. And they can easily be restored when energy prices do head higher again. Below, I show what sets my favorite trusts apart from rivals and highlight what their actual exposure may be to the continued turmoil in the markets.

What’s Sustainable

The graphs “High Quality Cheap” and “Following Gas Prices” present a wealth of clues to individual trusts’ sustainability as businesses. Others can be discovered by clicking on the item Oil & Gas Reserve Life found in the left-hand menu on the Canadian Edge Web site.

The baseline figure is the payout ratio, which is the annual distribution rate as a percentage of distributable cash flow (DCF). DCF is the equivalent of earnings for trusts, as it takes into account their ability to pass through income to investors. Note that Talisman Energy (TSX: TLM, NYSE: TLM) is a corporation whose payout ratio is distributions as a percentage of earnings per share.

I’ve compared payout ratios for two periods: the second quarter of 2008 when oil and gas prices averaged levels considerably higher than today’s and the third quarter of 2007 when prices were much lower. I’ve also shown the average selling prices for oil and gas that were realized by each of these trusts in those two periods. Not surprising, payout ratios on the whole were higher in the third quarter of 2007 (when realized selling prices were lower) than in the second quarter of 2008 (when they were higher).

Twelve-Month Dividend Growth basically shows how much cash flow from the jump in energy prices each trust used to increase distributions. Finally, I’ve shown the rate of growth in operating costs per barrel of oil equivalent (boe) produced and debt interest cost per boe over the past 12 months. That gives us a gauge of what’s happened to each trust’s costs. I’ve also made a general assessment of each trust’s hedging, based on contracts in place and the longer-term relationship of its realized selling prices to prevailing market prices.

The result is a somewhat complex picture, but it’s one that gives a pretty good general indication of the relative sustainability of distributions in the face of current price conditions. Lower payout ratios are a clear line of demarcation for safety. But the most sustainable trusts now are those that combine them with stable costs and effective hedging.

Earlier this year, a number of trusts came under fire from some investors for hedging policies. The value of forward contracts, futures contracts and options on producers’ books must be marked to the market when quarterly results are tallied, under General Accepted Accounting Principles (GAAP) accounting rules. Producers use these instruments to lock in prices for future output. Consequently, they’re always short in the hedge market.

After the spring spikes in oil and gas prices, these short positions were deep in the red. As a result, some trusts such as Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) showed a lot of red ink as the value of their hedging instruments declined. As these were 100 percent backed by future output, there was no impact on cash flow, which the hedges had essentially locked in. But it did show up as a big loss in earnings per share.

Now that prices have backed off, those hedging instruments’ losses have shrunk markedly as well. That will boost trusts’ third quarter earnings per share. But just as the mark-to-market losses on their hedges had no impact on DCF or their ability to pay dividends, neither will their reversal.

There’s one very important economic impact of hedging: Hedges put on earlier this year are almost universally at higher prices than the market is currently offering. That, in turn, should keep trusts’ overall realized selling prices higher than market, just as the hedges kept them lower than market in the second quarter.

In other words, the more a trust is hedged now, the higher its realized selling prices are likely to be in the third quarter and the better its cash flows will be protected. Just as hedging hurt in the second quarter, so it will help in the third and very likely the fourth as well.

Now let’s put the numbers together. The CE Portfolio currently holds five oil and gas producer trusts that I’ve considered “core” over the years: ARC Energy Trust, Enerplus Resources (TSX: ERF-U, NYSE: ERF), Penn West, Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) and Vermilion Energy.

All five have long life reserves, generally low costs and debt and conservative payout policies. The quintet recently weathered a very tough series of stress tests beginning in mid-2006 with falling natural gas prices–accelerating after the Halloween announcement of the pending 2011 tax on trusts and restrictions on issues of new shares–and with the US credit crunch and economic slowdown. None were forced to cut distributions over that time.

When energy prices spiked this year, ARC responded with two “top-up” distribution increases that it characterized as contingent on what happened with energy prices and has since rolled back the second boost. Enerplus, Peyto and Vermilion had very modest distribution increases, and Penn West held its dividend constant.

All five trusts, however, put the bulk of their cash toward projects that have increased future reserves and production, hence their long-run sustainability. All five held new issues of debt and equity units to a minimum, with the only increases coming at Enerplus and Penn West due to acquisitions. And all five held down operating costs per boe produced, with Enerplus and Peyto actually cutting costs per boe.

The decision of what to do with distributions is entirely at management’s discretion. And as ARC’s move to roll back its second “top-up” increase this year indicates, cash disbursements aren’t likely to take precedence over maintaining business sustainability. All five trusts, however, managed to post modest payout ratios of around 70 percent in the third quarter of 2007, which was a low water mark for realized selling prices. And coupled with cost controls, that augurs well for payout ratios staying in a similar range or even lower in the third quarter.

Again, these trusts certainly aren’t immune from energy price swings. But they are the closest thing in their sector to it. In my view, the line in the sand for oil prices for each is likely between USD70 to USD80 a barrel. Should black gold move much below that point and stay there, distribution cuts would be difficult to avoid.

The more important fuel for all of these trusts, however, is natural gas. There, the line is probably a sustained move below the USD6- to USD7-per-thousand-cubic-foot (mcf) range. The exception for both is High Yield of the Month Peyto, as its production costs are well below the others, and it produces relatively little oil. Rather, its cutting point is probably around USD5 gas.

Should these trusts actually cut distributions, it would be far from the end of the world. All would still be very healthy enterprises and in very good shape to ride a rebound in energy prices, once the US financial crisis settles.

If you can only buy and hold a few oil and gas producer trusts, these five are where you want to take your stand. All trade near the value of their assets, and their average yield is well more than 12 percent–the highest in many months.

My buy targets are now well above the current market prices for most of these, but I continue to recommend them at these levels: ARC Energy (USD30), Enerplus Resouces (USD50), Penn West Energy (USD30), Peyto Energy (USD21) and Vermilion Energy (USD40). Note that I continue to counsel against averaging down in any position, other than as part of a disciplined program of incremental investing.

Note that Zargon Energy (TSX: ZAR-U, OTC: ZARFF) also stacks up well on all of my sustainability criteria and rates a buy up to USD28. So do Bonavista Energy (TSX: BNP-U, OTC: BNPUF)—a buy up to USD32 and Bonterra Energy (TSX: BNE-U, OTC: BNEUF)—a buy up to USD35 following its decision to convert to a corporation and leave its current distribution intact.

Ultimately, Bonterra’s ability to do that will depend on energy prices, particularly oil. But its long-lived reserves (13-plus years based on proven reserves) and relatively low second quarter 2008 realized selling price for oil are good signs for sustainability.

Another CE Portfolio pick, Provident Energy Trust (TSX: PVE-U, NYSE: PVX), also has many strong characteristics. The catch is the trust has dramatically transformed its production profile this year with the sale of its US operations.

On the plus side, Provident now has a much lower debt load. That’s cut its overall risk substantially this year, particularly considering a large percentage of income is derived from a fee-based infrastructure business. On the negative side, overall operating costs per boe of production appear to have risen as a result of its moves.

The trust has basically held the same distribution level for nearly five years. That covers a lot of ups and downs in energy prices. Current market turmoil notwithstanding, it gives me a lot of confidence in management’s ability to manage a sustainable enterprise. If it can put up decent third quarter numbers, I’ll again consider Provident one of my core energy trusts. Until that time, Provident Energy is a solid buy for more aggressive investors up to USD14. Those who already own it should hold on.

Gassed for Growth

The other three producer trusts in the portfolio should all be considered more aggressive because they’re heavily focused on producing natural gas: Advantage Energy Trust (TSX: AVN-U, NYSE: AAV), Daylight Energy Trust (TSX: DAY-U, OTC: DAYYF) and Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF).

It’s been my contention for some time that natural gas will ultimately prove a better energy bet than either oil or coal. For one thing, it’s cleaner burning, emitting a fraction of the acid rain-causing gases of its rivals. Burning natural gas also releases less than half the carbon dioxide (CO₂) of the other fuels, which is likely to make it increasingly popular in power generation as the US adopts carbon regulation.

Natural gas’ second great advantage is the US has abundant potential supplies, particularly in the shale deposits. This gas requires a higher baseline price to be economic to produce. For one thing, a lot of infrastructure must be built just to get at it. But the gas is definitely there at the right price. That’s a stark contrast with oil, 38 percent of which comes from less than stable nations in the Middle East and Africa.

The problem for investors in natural gas is it’s still not truly perceived as a global market. Despite the growing importance of the liquefied natural gas (LNG) trade, prices continue to respond to inventory levels, which are heavily influenced by weather. That makes for extreme volatility in gas prices, which has been augmented further by worries about the economy.

In trading circles, natural gas is known as the widow maker. And it’s more than lived up to that reputation in the first nine months of this year.

Price fluctuations of that magnitude literally make intelligent planning impossible because they subject producers’ cash flow to deep volatility. Our picks are in large part protected by judicious use of hedging. Share prices, however, have proven to be extremely affected by gas’ ups and downs.

I’ve continued to stick with my trio throughout this drop for two main reasons. First and most important, all of them are built to last. All three treated the first half 2008 spike in natural gas prices for what it turned out to be: a temporary cash windfall. Daylight did boost its distribution 30 percent. But all three deployed the lion’s share of their cash in new projects to improve long-run sustainability as well as debt reduction. And they were also aggressive in locking in prices of future output with strategic hedging.

A further decline in natural gas prices will hurt cash flow. A drop under USD6 per mcf will put distributions under considerable pressure and would very likely trigger reductions.

On the other hand, all were able to pay out at their current rates last year when energy prices were at much lower levels. And like the “core” trusts, they’ve been stress tested over the past two years, a good portent for outlasting the current challenges.

Second, the current extreme investor bearishness for natural gas prices remains wildly out of step with market reality. Current inventories have been tightening over the past year because of growing usage in electric power and the shutdown of much of the output from conventional fields in Canada. Moreover, over half of gas production in the Gulf of Mexico has been shut in since Hurricane Ike struck last month.

The gas market, however, has largely ignored this and instead focused on expected increases in supplies for 2009 and 2010, which are expected to be pumped up by output from shale deposits in the US. That’s despite the fact that shale production requires a higher baseline price for gas to be economic. And given several producers’ plans to curtail output, a gas price under USD8 per mcf is apparently too low.

One of the things we’ve learned over the past year is how fast natural gas producer trusts’ share prices can move once market psychology shifts. From big-time losers in 2007, our trio became massive winners in the first half of 2008 and then gave up most of their gains in the third quarter.

In my view, the next move will be up, and I see two possible catalysts. The first is a calming of credit concerns. Over the past couple weeks, natural gas producer trusts have been among the biggest winners on days when the market’s credit crisis fears seem to wane. A genuine calming of the markets would have a magnified impact. The other catalyst would be an early bout of cold weather in the Northeast.

Both or either of these factors would set off a massive surge for our trio of gas-focused trusts. But even if macro conditions stay stuck in neutral, they’ll remain strong holdings.

Of the three, Daylight is perhaps the most solid, owing to a lower debt load and a larger range of projects. The closing of the Athlone Energy merger will add to cash flows immediately and, more important, it provides another low-risk expansion opportunity. The trust has affirmed it will pay its current distribution rate for the fourth quarter, which is protected by a low payout ratio, hedging and cost controls. Buy Daylight Energy Trust up to USD13.

Advantage Energy focused the lion’s share of its summer cash windfall on its key drilling projects, particularly the Montney Shale gas play in Canada. Montney continues to yield promising drilling results, auguring sizeable production gains for the trust going forward.

Advantage CEO Andy Mah also continues to express his interest in doing more mergers and acquisitions (M&A), citing a growing number of producers trading below the value of their assets in the ground. And despite the trust’s moderate size, he’s put the credit lines in place to get a reasonably large deal done.

Advantage has hedged 54 percent of its remaining natural gas sales for 2008 and an additional 30 percent for 2009. Management is comfortable it can maintain its current distribution level—and fund capital spending from cash flow—barring a much steeper decline in natural gas prices. That makes its shares deeply undervalued now. Buy Advantage Energy up to USD14 if you haven’t already.

Paramount remains my riskiest pure gas play, drawing 100 percent of cash flows from sales of the fuel. To offset risk, the trust has been aggressive in marketing as well as price hedging of its output. Management took advantage of higher prices earlier this year to lock in very attractive future levels into 2009 and to ensure it will meet aggressive debt reduction goals.

Production wise, Paramount has historically had one of the lowest reserve life measures in the industry. But management has offset this with an aggressive, developed opportunity inventory: The biggest deal to date is the July 2007 Birchwavy acquisition.

The trust is also ideally positioned to capitalize on what should be a significant increase in natural gas consumption by Alberta oil sands operations over the next five years, as its assets are entirely in that region. The trust also stands to benefit from a resolution of the “gas over bitumen” issue, which has shut in some of its production in recent years.

The bottom line here: natural gas prices. If they rally from here, Paramount will be off to the races as it was earlier this year. Should gas prices continue to weaken, the trust will languish. But again, it’s proven its ability to pay this rate of distribution even at USD5 gas.

We’ve given back this year’s gains in Paramount over the past couple months, particularly during the credit scare. But now yielding nearly 18 percent, Paramount Energy trust is a solid buy up to USD10 for those who can handle the ups and downs.