The two other sector non-cutters are Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF)–which like Vermilion is virtually debt free–and Avenir Diversified Income Trust (TSX: AVF-U, OTC: AVNDF), which operates other businesses besides producing energy.

That we’re seeing these cuts is certainly no surprise. Oil prices are more than USD100 off the highs they set in mid-2008 and less than half where they were a year ago. Natural gas is trading at less than a third of its high and roughly a third cheaper than a year ago.

Producer trusts’ distributions depend on their cash flow, which in turn is set by three factors: how much they produce; what it costs to get it to market; and the price it fetches. The first two factors are largely within management’s control. Energy prices, however, are wholly beyond it.

The immediate impact of falling prices can be softened by “hedging,” or locking in a price months before the actual sale. But when prices drop as far and fast as they have the last six months, managements face a stark choice: Stake survival on a rebound and maintain current capital spending and dividend levels by borrowing, or else pull in their horns.

Since early 2006, producer trusts have weathered a series of stress tests, from volatile prices and the credit crunch to the fallout from prospective 2011 taxation. There are still a few weaklings left, such as dividend-less Enterra Energy Trust (TSX: ENT-U, NYSE: ENT). For the most part, however, the trusts surviving the past two years have become pretty hard to kill.

Not only is debt very low, but current reserves are long-lived and most trusts’ output would still be very economic even at much lower oil and gas prices. Moreover, every management decision the past two years has been made with one thing in mind: sustainability.

Today’s deep distribution cuts aren’t being made out of desperation. Rather, management is ratcheting down budgeted expectations for energy prices, and therefore cash flow. And they’re adjusting distributions to a level where 2009 cash flow will cover both planned capital spending and dividends. Some, like Penn West Energy Trust (TSX: PWT-U, NYSE: PWE), are also issuing equity to cut debt.

In short, management is pulling in their horns. The result is they’ve dramatically increased their odds of eventual recovery. And that will ultimately benefit investors much more than maintaining distributions at current levels, and risking total ruin.

Timing of recovery depends entirely on what happens to energy prices. Last summer, with oil around USD150 a barrel, I urged CE readers to take some profits on oil and gas producer trusts, based on downside targets of USD90 a barrel for oil and USD8 per million British thermal units for natural gas. Those levels were based on reserve replacement costs, i.e. what it costs producers to maintain current reserve levels.

The market’s plunge well below reserve replacement costs has already resulted in mass cancellations and postponements of new energy development. In fact, energy prices are actually well below production costs for non-conventional production. Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), for example, reported operating costs of nearly USD30 a barrel in the fourth quarter. Adding in crown royalties, interest expense and other costs, falling oil prices leave little for 2009 distributions, forcing the trust to cut its payout 80 percent last month.

Oil Sands is a certain survivor because it’s the trading stock for the Syncrude partnership, of which ExxonMobil’s (NYSE: XOM) Canadian unit is the lead player. Syncrude, in fact, plans to keep output steady this year, with the deep-pocketed partners eating losses in anticipation of huge profits to come. Smaller rivals, however, have no such backing, and have no choice but to cut back.

With the global economy on its back, the energy market is wholly focused on demand, rather than supply. But sooner or later, the economy will bottom, demand will return, supply will be strained again and energy prices will return to at least reserve replacement costs.

That, in effect, is what we’re playing for by holding onto our battered oil and gas producer trusts. As Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV) CEO Andy Mah indicated to me this month, this downturn may induce some trusts to convert to corporations to save cash. But whether that happens or not, a return to reserve replacement costs means big cash flow and dividend increases for producers.

It may take some months for this to unfold. But when it does, dividends are headed a lot higher, and so are share prices. And in the meantime, these trusts are hunkered down for survival. There may well be more distribution cuts if the global economy sinks further. But the underlying businesses will survive. And at today’s low valuations, further cuts aren’t likely to produce deep share price losses. In fact, most January dividend cutters have actually posted small gains since.

The other silver lining is our Conservative Holdings. We’re still waiting on fourth quarter numbers and will be updating them in Flash Alerts the next several weeks. But thus far, none have cut distributions, while several have issued strong guidance for 2009. Note that none have any direct exposure to energy production.

Several Conservative Holdings have rebounded strongly from their December lows, but all are cheap and ripe for bigger gains in the coming months. As with the energy trusts, the timing of full recovery depends on what happens to the global economy. But as long as their underlying businesses keep showing strength, the cash will keep coming.

And capturing big upside will be only a matter of being willing to wait.

Portfolio Action

I’m sticking with all of the current Canadian Edge Portfolio picks this month. I’m also adding another Natural Resource Trust to the Aggressive Holdings, Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF).

Over the next several weeks, I’ll be putting each of our holdings under the microscope as they report fourth quarter and full-year 2008 earnings, and issue guidance for 2009. As I pointed out in a January 23 Flash Alert, recent dividend action is likely to be a pretty solid forecaster of earnings numbers. But I remain committed to the strategy of only owning trusts and high-yielding corporations backed by healthy businesses.

My picks have survived nearly two years of stress tests already. But with more rough sledding ahead for the global economy–including Canada–there’s always the chance some will slip up, precluding their ability to pay dividends and recover last year’s share price losses.

High Yields of the Month

January’s High Yield Of The Month entries were both from the Conservative Portfolio. This month’s picks are both Aggressive Holdings.

New addition Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) was last highlighted in the December Feature Article.

Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) is the strongest of the energy producer trusts, with globally diversified operations and almost no debt.

How They Rate

How They Rate features the following trust groups:

• Oil and Gas–All producer trusts are included here.
• Electric Power–Power generators.
• Gas/Propane–A mixture of distributors, from propane to package ice.
• Business Trusts–A range of businesses involved principally with consumers.
• REITs–All qualified real estate investment trusts.
• Trust Mutual Funds–Closed-end funds holding portfolios of individual trusts.
• Natural Resources–Trusts and corporations that produce resources and raw materials other than oil and gas.
• Energy Services–Trusts and corporations whose main business is providing drilling, environmental or other services to energy producers.
• Energy Infrastructure–Trusts and corporations that own primarily pipelines, processing facilities and other fee-generating assets.
• Information Technology–Trusts and corporations that provide communications, newspaper, directory and other information services.
• Financial Services–Canada’s banks, investment houses and other trusts and corporations feeding that business.
• Food and Hospitality–Trusts and corporations that franchise restaurants, own and operate hotels and manufacture and distribute food and beverages.
• Health Care–Trusts and corporations involved in the medical care and/or supply business.
• Transports–Trusts and corporations that ship freight and move passengers by bus, truck, rail or air.

Here are advice changes. Note I’ve changed buy prices on a number of trusts this month to reflect the disaster hitting the credit markets and the likelihood of slower economic growth in North America.

See How They Rate as well for changes in buy targets. Price and yield information is updated every 15 minutes in both tables. Use this service as a reality check when errors occur with US quotes-based services.

Column four of the Table shows dividend frequency and the most likely way each trust will minimize 2011 taxation. “Foreign” indicates non-Canadian income, which is not taxed. “Pools” indicate tax pools used primarily by energy producers, which shield income dollar for dollar. “Depreciation” indicates businesses with large non-cash expenses that can be used to shelter cash flow. “None” indicates no visible method of avoiding 2011 taxes, though some trusts have stated their intention to simply outgrow their future liability and maintain distributions.

Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF)–Sell to Hold. The shares have fallen sharply, and the trust has reached a new omnibus agreement on costs and capacity purchases with parent Air Canada (TSX: AC.B, OTC: AIDIF). Both dramatically reduce the risk to owning this trust, though a distribution cut is still possible.

Progress Energy Resources (TSX: PRQ, OTC: PGXFF)–Buy @ 15 to Hold. Progress deleted its distribution, at least for the time being, when it merged with ProEx last month. It’s now organized as a corporation with rapidly growing output and nearly 700,000 acres of undeveloped land. The lack of a dividend may discourage some holders, but Progress is a very strong play on a recovery in energy prices as well as a potential takeover target.

Feature Article

Energy producers and trusts in related sectors like energy services led the broad-based S&P/Toronto Stock Exchange Income Trust Index down in 2008. Unfortunately, many of the closed-end mutual funds set up to hold trusts and high income vehicles fared far worse, due in large part to loading up on these laggards and by levering up with debt to boost yields.

CE Portfolio funds weren’t spared the carnage. But there are some reasons for hope for our favorites in 2009, not the least of which is their dedication to paying big distributions. Note that I still favor buying a basket of the best individual trusts to funds that hold the bad and ugly, as well as the good.

Canadian Currents

Tax time is fast approaching. The good news is the rules for trust taxation in the US haven’t changed. Neither has the ability for US investors to recover the 15 percent withholding of distributions in Canada by filing a Form 1116. The bad news is some brokerages are obtuse as ever about what constitutes a “qualified dividend,” which can create a great deal of confusion.

CE Associate Editor David Dittman has the scoop on how to make sure your trusts don’t add to your headaches at tax time. Note that the Income Trust Tax Guide has links to trusts’ Web sites that provide invaluable backup for filing their distributions as qualified.

Tips on Trusts

This section features short bits on a wide range of topics. For more evergreen and tutorial items, see the Subscribers Guide “Subscriber Tips” section.

Dividend Watch List–Once again, distribution cuts fell most frequently in the energy patch, with 12 different trusts wielding the axe in the name of sustaining their business in tough times. As noted above, I look for these to reverse with a vengeance when energy prices do eventually recover to reserve replacement costs.

More troublesome are the cuts outside the energy patch. SFK Pulp Fund (TSX: SFK-U, OTC: SFKUF) and Tree Island Wire Income Fund (TSX: TIL-U, OTC: TWIRF) have both eliminated payouts, due to the impact of economic weakness on their cash flow. Neither looks likely to go belly-up, and management is working hard to cope with the tough conditions.

But conservative investors are better off out of SFK Pulp Income Fund and Tree Island Wire Income Fund until the overall economic picture clears a bit. Speculators can hold onto both.

Somerset Entertainment Income Fund (TSX: SOM-U, OTC: SOEIF) remains a sell after cutting its payout by two-thirds. The trust has renewed its credit agreement, however, and should avoid Chapter 11.

Note Mullen Group Income Fund (TSX: MTL-U, OTC: MNTZF) has cut its payout in half as part of its decision to convert early to a corporation.

Still yielding over 8 percent and boasting a solid though challenged business, Mullen Group Income Fund is a buy up to USD12.

Bay Street Beat–How the Canadian analyst community views trusts, including our favorite trusts.

Iggy Pop–The new Liberal Party leader, Michael Ignatieff, indicated recently he’s as open to a fresh look at income trust taxation, specifically regarding energy trusts, as his predecessor.

More Information

The following is a regular repeat from prior issues.

Use our live quote feed in How They Rate for US dollar prices and yields of trusts and high yielding corporations intra-day. For other information, go directly to a trust’s website by clicking on its name in the table. Clicking on the Toronto symbol (suffix “.UN”) will take you to the Web site of our Canadian partner Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8), which has price charts and access to press trust releases.

For questions and comments, drop us a line at canadianedge@kci-com.com. Check out the Toronto Stock Exchange Web site for a range of information on income and royalty trusts. Sedar.com is an online library of documents filed by trusts with the Canadian equivalent of our Securities and Exchange Commission. The Toronto Globe & Mail features the “Globe Investor” section with all the latest news on trusts. Dominion Bond Rating Service is the pre-eminent credit rater for trusts.

The Bank of Canada Web site features a handy currency converter for Canadian dollars and US dollars into 50 other currencies around the world, and it’s a great source of free information on the Canadian economy.

To respond to the NAFTA challenge to the Government of Canada’s Tax Fairness Plan, go to http://www.naftatrustclaims.com/. Also, the Income Trust Tax Guide has backup to file distributions as qualified dividends.

Roger Conrad
Editor, Canadian Edge