Oil prices hit a low near USD33 a barrel last month, before rallying to close out 2008 around USD40. That capped an extraordinary year in which black gold surged from USD90 to nearly USD150 in the first half and then tumbled 70 percent-plus in the second.

Indications are 2009 will also be volatile. In less than a week, oil rallied to more than USD50, nearly 50 percent above its December low. Then came the Energy Information Administration’s report that US reserves are larger than expected, triggering a sudden drop back to the low 40s.

Price action in natural gas has been only slightly less volatile. The fuel began 2008 in the doldrums, soared into the summer season and crashed to barely USD5 per million British thermal units (MMBtu) in the heat of the financial crisis. A brief rally in December returned the fuel to its current range around USD6.

Volatility in the raw commodities has been directly reflected in the prices of Canadian oil and gas producer trusts. Trusts stumbled in the early months of 2008, caught fire in spring and reached new heights in mid-summer, even bursting briefly above pre-Halloween 2006 levels when the Conservative Party announced 2011 trust taxation.

Then, oil and natural gas started heading south, and producers crashed even harder. Of the 23 tracked in How They Rate that pay dividends, 10 have cut them at least once since September. Cash flow and dividends depend heavily on the price of oil and gas. And with some producer trusts yielding as much as 30 percent, the market clearly expects more cuts.

Now the good news: After the washout of the past several months, energy trusts aren’t just pricing in oil at USD40 or even USD30 but sell at basically the same prices they did when oil sold for less than USD20. Recent dividend cuts have had progressively less impact on prices. In fact, some trusts have actually rallied afterward.

Second, producer trusts have proven their ability to survive on their own resources. Debt levels are low and with a few exceptions there’s no danger of bankruptcy, even if energy prices continue to sag.

Finally, the violence of energy prices’ fall has guaranteed another upward spike, once the global economy stabilizes. And when that happens, energy trust share prices will return to last summer’s heights, and quite possibly well beyond them.

Global economic weakness means we’re going to have to be patient and possibly suffer some near-term downside. But this is no time to abandon trusts that have proven their ability to weather rough times and profit when conditions improve.

As the action of the past couple weeks demonstrates, recovery can happen in the blink of an eye. And you’ll want to be there when it happens.

When Prices Fall

As we enter 2009, demand fundamentals for energy are weak. The US economy has officially been in a recession for more than a year, and few forecast a recovery anytime soon. This week, the Federal Reserve admitted it fears a “protracted” downturn, and growth in other nations has slowed markedly as well. That’s stirring fears that global oil demand has yet to bottom for the cycle. That means low energy prices and less revenue for oil and gas producer trusts.

To date, trusts have been able to offset some of the shortfall with a range of means. The drop in the Canadian dollar versus the US dollar has cut trusts’ overall cost structure relative to energy sale revenues, which are priced in US dollars. Drilling costs are also beginning to decline, as are royalties paid to governments, which are also based on energy prices.

Trusts have also benefited from their systematic hedging, locking in lofty mid-2008 prices for a good chunk of their output. And rather than pump up distributions last summer, trusts treated the additional cash from higher energy prices as a one-time windfall, using it to cut debt and invest in projects to extend their longevity.

Three trusts have special protection by virtue of unique business strategies. Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) sells its energy in Australia and Europe, as well as North America. This year, the European market is proving to be a valuable offset to weakness on this side of the pond, due to Russia’s threats to cut gas exports.

Provident Energy Trust’s (TSX: PVE-U, NYSE: PVX) natural gas liquids business is centered on spreads between gas and oil prices, rather than raw price levels. So are profits from Harvest Energy Trust’s (TSX: HTE, NYSE: HTE) refinery business, which has benefitted from last fall’s decline in oil prices versus refined products like gasoline.

At the end of the day, however, lower energy prices mean reduced cash flows for producer trusts, regardless of what they do. The good news is they have the financial strength, reserves and conservative strategies to survive, even if energy prices head lower from here. And only two are at risk in the current environment due to small size and heavy debt: Enterra Energy Trust (TSX: ENT-U, NYSE: ENT) and True Energy Trust (TSX: TUI-U, OTC: TUIJF). The latter halved its distribution again last month, while Enterra hasn’t paid one since August 2007.

The bad news is every trust has its threshold at which it will have to cut distributions. Some are more resistant than others, but none is immune if energy prices fall far enough.

Since the first issue of CE in July 2004, I’ve urged investors to remember that energy producer trusts are not utility-like income investments. Rather, their payouts and share prices are directly tied to energy prices.

Trusts are the best way to score big dividends while betting on energy. But you’ve got to be prepared for the volatility in share prices as well as distributions that comes from making such a wager. If you’re not up for it, you’re far better off in the kind of investments that populate the Conservative Portfolio, none of which have cash flows that are tied to energy prices.

Producer trusts’ ironclad link to energy was a major plus in the first half of 2008 and a calamity in the second half, with most reaching new lows in mid-December. The question is what the relationship will bring investors in 2009, which is at least beginning with slack global demand and elevated fears of a new price crash.

What we’ve seen thus far is encouraging. All of the Aggressive Portfolio producer trusts are up at least 20 percent over the past month, not including distributions of as much as 1.5 percent (equivalent to an 18 percent annual rate).

The jump in oil prices has been a key factor. But with trusts rallying hard in the wake of distribution cuts, the market has clearly been pricing the bad news in and then some. Expectations have been so low that when the hammer actually did fall, it came as a relief and trusts rallied.

That’s certainly the message from the generally steady action in shares of ARC Energy Trust (TSX: AET-U, OTC: AETUF). Last month, the trust cut its distribution for the third time since September to a new monthly rate of CAD0.15 per unit. Yet the share price has been generally supported now for several weeks.

As I pointed out in several Flash Alerts in late 2008, washed out trust share prices reached last month don’t reflect USD40 a barrel or even USD30 oil. Rather, trusts are selling below the levels they traded when oil was selling for less than USD20 and natural gas was at barely USD1 per MMBtu.

Put another way, any bottom for energy prices above those levels would beat today’s extremely negative expectations, and is thus bullish for trusts.

Supply Shock

Will the past two weeks’ rally continue? The answer clearly depends on what happens to oil and gas prices. If worries about global demand intensify, energy prices will no doubt fall, and trusts’ rally is likely to stall.

On the other hand, if the unprecedented monetary and fiscal stimulus in countries ranging from the US and Europe to China and India shows signs of reviving growth, energy demand will begin reverting to normal levels. And at that point investors’ focus will shift from demand back to where it was when oil was pushing USD150 a barrel: supply.

Unlike demand, the energy supply situation is much the same as it was earlier this year, when speculation about peak oil was making headlines. In fact, it’s arguably more dire than ever due to ongoing supply destruction–i.e., a wave of delays and cancellations of major energy projects that were designed to bring new supply on the market over the next three to five years.

Reuters notes some two-dozen projects have been mothballed since late October, ranging from refineries and other infrastructure to new reserve development. Some were cut simply because companies didn’t want to follow through with projects that need USD80 oil or USD8 natural gas to be economic. Some were pulled because at least one of the partners was unable obtain financing in a tight credit market, still others because at least one of the partners hit financial trouble.

All of them, however, have a common result: Less energy will be produced over the next three to five years. That may not matter if the world sinks into a multiyear depression. But it certainly will when the global economy stabilizes and demand returns to normal levels.

In fact, coupled with the rapid decline of major fields like Mexico’s Cantarell, the world will be more dependent than ever on OPEC supplies and vulnerable to political turmoil in nations like Iran, Saudi Arabia and Venezuela.

This is precisely the situation that T. Boone Pickens and others have urged the US to avoid with new infrastructure investments. And it’s possible the incoming Obama administration will follow through with at least some of what’s needed.

Unfortunately, there’s no greater disincentive to conserve, develop alternatives or expand energy production than falling prices. And the emotional hangover from the massive drop in oil and gas will linger long after prices do recover. Consumers and businesses are going to be slow to accept any future energy price spike as permanent enough to warrant aggressive investment. That will delay investment in conservation, alternatives or new output.

For example, it’s highly unlikely Super Oil Total (NYSE: TOT) will follow through on its plans to develop oil sands reserves the first time crude prices hit USD80 to USD90, the minimal level it’s designated as economic to pursue the project. And USD1.50 per gallon regular unleaded gas doesn’t provide much incentive for anyone to swap their SUV for a hybrid, particularly in a weak economy where a growing number of people are worried about keeping their jobs. In fact, sales of hybrid cars have slipped recently.

It all adds up to another upward spike in energy prices that will begin in earnest when global growth starts to revive. It might not happen until the second half of 2009, or even sometime in 2010. But the crash in oil prices and gas prices last year has dramatically reversed for now the factors that are ultimately needed to restore energy market power to the consumer, where it was in the 1990s: permanent conservation, a meaningful swap to alternatives and new production outside OPEC. These were all coming along slowly before the financial crisis. But we’re going to have to see much higher energy prices for them to even make back the ground lost in recent months.

A move in oil to less than USD20 a barrel and gas to under USD2 per MMBtu is certainly possible if the world enters a prolonged depression. All the energy trusts in the CE Portfolio will definitely survive. But such a price drop would force basically all trusts to cut distributions again, including Vermilion, though it’s hard to argue they’re not pricing in some pretty horrific cuts already.

On the other hand, if the world can avoid that dire fate, there’s simply no way oil and gas prices can remain at these levels. Replacing even conventional oil reserves, for example, now costs an estimated USD80 to USD90 a barrel. That’s also the economic cut off point for oil sands development and deep undersea projects.

Meanwhile, the shale gas counted on to fuel the new fleet of natural gas power plants in the US is only economic at USD8 per MMBtu, one reason several major projects have been delayed already.

The upshot is higher energy prices and an explosive bull market for energy producing trusts lies ahead. All we have to do to capitalize is just hang onto those with the best business fundamentals. Rock bottom valuations mean downside is less than it’s been in many years.

And as we saw the last two weeks, the gains will come as fast and furious as the losses did last year.

Best of the Best

Differentiating among energy trusts on the basis of quality hasn’t saved us from losses or distribution cuts the past six months. It has kept us out of the sector’s biggest losers. And it’s the best way to ensure we will ride the inevitable recovery, no matter how long it takes to materialize.

The Truth About Oil and Gas Table tracks the vitals for each producer trust. Payout ratio presents the current distribution rate as a percentage of the last quarter’s distributable cash flow (DCF). DCF is basically the trust’s cash flow from selling its energy, less the cost of getting that energy to market.

Lower payout ratios are better than higher ones, as they indicate more cash for capital spending and to absorb falling prices. Unfortunately, the magnitude of the drop in oil and gas in recent months makes third quarter payout ratios–the most recent period for data–basically obsolete for gauging dividend safety. Low fourth quarter and first quarter 2009 ratios, however, are a good indication a trust can weather any environment.

The trust’s dividend history has three data points. The left-hand number in the column shows the number of months since the last dividend action. The middle item shows whether the dividend was increased (up) or cut (down), or if it hasn’t been changed since the trust’s inception (none). The right-hand number shows the number of months since the last dividend cut.

I like to see a lot of months between dividend cuts, as it indicates management has done a good job of navigating tough markets. But again, the extremely volatile price action of 2008 will make it very difficult for any trust to avoid a dividend cut, and by March 2009 only very extraordinary trusts will have more than a year (12 months) without a cut.

The total debt-to-annual cash flow ratio measures balance sheet strength. Debt has historically not been a big part of trust finance, mainly because before Halloween 2006 they could issue as much equity as they wanted, and after that debt markets were already tightening up. Also, Canadian managers tend to be debt averse. That’s a big reason why so many used proceeds from higher energy prices in 2008 to cut debt.

Any trust that’s earned more cash over the last 12 months than it has total debt (ratio less than 1.0) should be considered very strong financially.

Again, these figures are going to rise in the fourth quarter and first quarter 2009, as cash flow drops due to lower energy prices. But any trust that maintains a ratio under 1.5 should be considered strong enough to stay alive even if oil crashes to USD20 or less. And any trust with a ratio under 1.0 in the fourth quarter or first quarter 2009 is in prime shape for making acquisitions, which will be in ample supply if energy prices fall that far.

Over the past year, I’ve favored natural gas-focused trusts over oil-weighted ones. That’s because gas will be in greater long-term demand and has been deeply undervalued versus oil as well. This is no longer the case, however, as some of the biggest share price drops recently have been in oil-focused trusts. Even Canadian Oil Sands (TSX: COS-U, OTC: COSWF), whose shares have at times seemed almost immune from energy price swings, took a bath after cutting its quarterly dividend from CAD1.25 to CAD0.75 per unit.

Today, both oil and gas-focused trusts are cheap, with a dozen selling either at or below book value. Canadian Oil Sands sells at half the price-to-book ratio it did in mid-2008. My preference, however, is to buy trusts that roughly balance their output between oil and gas. Balance steadies cash flow and trusts can also focus their efforts on the more profitable fuel when there’s a pricing imbalance.

Costs were an afterthought when oil and gas prices were surging. But they’ve taken on new importance after energy’s crash. The Oil and Gas Reserve Life table presents two measures of costs: operating costs per barrel of oil equivalent (boe) and finding, development and acquisition costs (FD&A) per boe.

These costs vary widely from trust to trust, depending on a range of factors from quality and accessibility of reserves to drilling costs and the basic efficiency of the organization itself. The operative rule is low costs are best.

Operating costs have the most immediate import. Canadian Oil Sands’ third quarter costs were only a dollar or so per boe below where oil bottomed last year. That great risk contrasts sharply with, for example, the very low costs per boe at Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF).

FD&A gauges what it cost a trust to replenish reserves per boe over the past year. Unfortunately, these numbers are only updated once a year, and the last data we have are for 2007. Reserve replacement is key to the long term sustainability of a trust, and a very high FD&A can signal severe challenges.

These figures, however, can also be inflated by merger accounting, as has been the case with Penn West Energy Trust (TSX: PWT-U, NYSE: PWE). I suspect we’ll see much lower FD&A costs going forward than we have the past several years, largely because property values have declined with energy prices. In any case, high FD&A cost is not an immediate worry.

Another key item in the table is data for reserve life and daily production rates. The latter are the best measure of trust size. In most cases, bigger is better, as it means greater financial flexibility. Figures reflect third quarter output, which should be roughly matched in the fourth quarter.

My figure for reserve life shows the number of years a company’s “proven” reserves would last at the current level of daily output, assuming there’s no reserve replacement. Proven reserves are deemed by outside auditors to have a 90 percent or better chance of being developed. In contrast, “probable” reserves have only a 60 percent chance.

One of trusts’ greatest advantages is their ability to drill new holes at outrageous success rates. Rates of 99 or even 100 percent are not uncommon because trusts’ reserves are essentially deep, long-life pools where there’s an enormous amount of geologic intelligence.

Trust reserves generally don’t have the big strike potential that the typical exploration and production (E&P) company shoots for, including Super Oils. But they do bring unmatched predictability for output and costs, and hence cash flow to pay big and steady distributions.

In general, I like to see a reserve life of at least eight years for the trusts I recommend. Peyto Energy Trust, for example, has a 16-year reserve life, which is roughly the same as ExxonMobil’s (NYSE: XOM). It can literally continue to operate without doing any exploratory drilling for 16 years, a very valuable cushion in a volatile price environment.

Like FD&A costs, reserves and reserve life are only calculated once a year, unless there’s a major acquisition. The figures in our table therefore reflect 2007 tallies. Given the fact that trusts were able to invest a lot of additional cash mid-year, however, I don’t expect to see much if any erosion in 2008 figures, which will come out about the same time as fourth quarter results.

I present each trust’s realized selling price for oil and gas in the most recent quarter, in this case the third of 2008. The figure for oil is on the left, while that for gas is on the right. These prices are net of all hedging–i.e., measures taken to lock in selling prices ahead of time–and are in Canadian dollars. I use Canadian because the trusts’ costs are in Canadian. The greater the variance between realized prices and market prices, the more hedging management employs to smooth out cash flow. That better safeguards distributions in tough times, but cuts into cash flow when prices rise.

Even a cursory glance reveals third quarter realized prices were far above current market prices for oil and gas. Most trusts, for example, sold their oil for more than two times black gold’s current price, and gas anywhere from 30 to 40 percent higher. Obviously, realized prices will come down sharply in the fourth quarter, and very likely even more in the first quarter of 2009. And the greater the eventual gap, the bigger the hit to cash flow.

In normal times, it’s relatively easy to figure a trust’s “netback,” or what it realizes per boe sold. Given the magnitude of the drop in energy prices last year, however, such calculations aren’t reliable. And they leave out one other key factor determining dividend safety: management’s discretion.

Basically, when energy prices fall and crimp cash flow, management has three options. They can cut their capital spending on development, which may jeopardize sustainability. They can boost debt or issue new shares, a difficult task in a tight credit environment. Share issues are also restricted by “safe harbor” rules that will bring an immediate tax consequence if violated.

As major shareholders themselves, management is also loath to cut distributions. That’s one reason most have elected not to convert early to corporations and are resolved to pay big distributions well after 2011.

Unfortunately, when oil prices fall more than USD100 a barrel and gas prices are cut in half, there may be no alternative. In fact, dividend cuts are usually preferable for long-term stability, as trusts save cash for development while avoiding adding debt.

Picking Targets

Since energy prices started their plunge, 10 oil and gas trusts have cut distributions. Their ranks include several of my favorites, whose management chose that course over cutting development or adding debt.

We’ll see more cuts before energy trusts resume to the upside. Harvest Energy Trust and Penn West Energy Trust, for example, are both on the Dividend Watch List this month. Given that both are yielding around 30 percent, that shouldn’t surprise anyone.

I’m certainly no mind-reader. Management of both trusts has held the line thus far, and fourth quarter numbers may reveal strengths that enable them to keep it that way. If that proves to be the case, both trusts are in line for a quick double. But even if they’re forced to cut, it’s hard to argue that a 30 percent yield isn’t already anticipating a big reduction.

And therein lies the crux: Even if a trust does cut its distribution now, it isn’t likely to fall far. And as long as business is sustainable, its share price will recover.

That said the energy producing trusts in the Aggressive Portfolio are still my favorites in the sector. The core trusts remain ARC Energy Trust (TSX: AET-U, OTC: AETUF), Enerplus Resources (TSX: ERF-U, NYSE: ERF), Penn West Energy Trust (TSX: PWT-U, NYSE: PWE), Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF). These are large trusts with low debt, controllable costs and long-life reserves.

ARC and Enerplus have elected to cut back dividends to shepherd cash flow for promising development projects, and the others may follow. But all will survive no matter what happens to energy prices near-term. And as the past month’s rally shows, they’ll lead the recovery.

If you haven’t yet purchased ARC Energy, Enerplus, Penn West, Peyto and Vermilion, this is another golden opportunity to do so.

Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV), Daylight Resources (TSX: DAY-U, OTC: DAYYF) and Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) are my bets on natural gas.

Interestingly, only Advantage has cut its distribution this cycle, though all three are pricing in further cuts yielding around 20 percent. These trusts did well over the past month but are less than half their summer highs. They’re unlikely to rally until the economy shows some life. But with far less debt than they had a year ago, survival isn’t in question.

The trio’s roller-coaster ride over the past year demonstrates they’re not for the risk averse. And the next time they run big, I’ll be inclined to take profits. But at this point, there’s no cheaper way to play North America’s fuel of the future. Advantage, Daylight and Paramount are all buys.

Conversely, Provident Energy Trust (TSX: PVE-U, NYSE: PVX) is my most aggressive play on oil, since its natural gas liquids are most profitable when oil sells for more than gas. Last month’s dividend cut should bring the payout to a level that’s sustainable. And risk is low with the stock pricing in another dividend cut.

Outside the Portfolio, the sector is also pricing in far lower oil and gas prices than we’re likely to see. As a result, virtually everything is a buy.

It’s useful to note again that these trusts have been stress-tested for more than two years by a set of extraordinary circumstances. These started in mid-2006, with the dramatic drop in natural gas prices from post-Hurricane Katrina highs. The Halloween 2006 announcement of the Tax Fairness Plan basically cut them off from capital markets. Then the credit crunch limited their access to debt, as the global slowdown hit revenue hard.

Basically, trusts have had to fund operations, dividends, debt and development solely with cash from operations in a period of unprecedented energy price volatility. Every decision on financing, production, exploration and hedging has been potentially critical.

There have been plenty of ups and downs along the way, and we’re definitely in a trough now. But through it all, these producer trusts have survived. That’s the best possible indication they’ll survive until energy prices recover–and will throw off monster returns when they do.

I never recommend overloading on a particular stock or even a sector. But that’s a great risk/reward combination, even in these uncertain times. If you haven’t yet bought in, now’s the time.