Natural gas prices have softened up again, just weeks after their recovery looked set. The primary culprit is the mild start to the summer cooling season, coupled with better timing on the part of power utilities for keeping their cheaper, baseload coal and nuclear plants on line during months of peak demand. That’s limited the need for gas this summer to generate electricity, the only growth market for the fuel in recent years. Industrial demand, for example, has fallen by double-digits over the past year.

The bullish factors for gas I’ve cited in recent months are still very much in place. Canadian production, for example, has plummeted, with drilling levels down more than 60 percent over the past year.

US output has hung up but now shows signs of tapering off. And North America is becoming increasingly dependent on liquid natural gas imports (3 percent of current supply), which is cheap for the moment in Europe but extremely volatile historically.

In short, the pieces are still very much in place for an upward spike in natural gas prices, possibly even later this summer, should supplies be interrupted by a hurricane or a temperature increase. However, they’re also likely to go even lower should current conditions persist. And with weather setting the tone, there’s absolutely no way to reasonably forecast which way things will go.

With oil prices at lofty levels, producer trusts weighted toward crude or oil sands output are at little risk to dividend cuts. The major trusts that balance output between oil, gas, gas liquids and other fuels are slightly more at risk. However, these trusts proved their resilience by weathering the 2006 drop in gas prices and should be able to come through this as well. They’d really only be at risk if oil falls or gas drops to some highly unlikely level, say USD2 per million British thermal units.

In contrast, gas production weighted trusts—and the trusts that provide drilling services to them—are indeed at greater risk. To date, only one has announced a distribution cut, Paramount Energy (PMT.UN, PMGYF).

I had the opportunity to speak with Paramount’s management last month on this and other key subjects, particularly its recent acquisition of assets from US utility Dominion Resources. The most-recent cut takes the monthly payout down to 10 cents Canadian from a prior level of 14 cents Canadian, and 20 cents Canadian at the beginning of 2007. And management didn’t rule out another reduction, stating the board reviews the payout every month, taking into account the forward pricing curve for natural gas, production costs, ongoing hedging and expected levels of output.

As is the case with all oil and gas producer trusts, Paramount can pull one of three levers when its cash flow drops, which always happens when gas prices fall. It can cut back on its drilling program, thereby sacrificing future output in the cause of conserving cash, it can borrow more to cover the shortfall, or it can cut the distribution.

In management’s view, the first two courses of action are destructive to the trust’s long-term sustainability and financial health. Consequently, although it will try to minimize dividend volatility, it won’t hesitate to act when cash flows fall to preserve sustainability.

On the plus side, management also stated it wouldn’t hesitate to increase distributions if gas prices rose sufficiently. And it’s increased its cash generating capabilities substantially this year, both with hedging and the Dominion property acquisition.

The latter increased the trust’s output and reserve base by adding complementary properties and increased tax pools as well, which the trust will try to maximize between now and 2011. It will also keep reserve decline rates at their current low level of around 18 percent, which are competitive with those of other trusts despite Paramount’s relatively low proved reserve life index of around five years.

As I pointed out in the July 19 Flash Alert—which commented on both the meeting with management and the distribution cut—I own Paramount precisely for its extreme leverage to natural gas prices. Obviously, I didn’t expect the recent dip in prices.

But in my view, management has the trust pointed exactly where it should be as a leveraged gas play. This one is going lower if gas prices continue to get hit. But it will rebound with a vengeance if and when the market turns. And management’s focus on sustainability means it’s not going out of business either.

Paramount Energy is still a buy for speculators up to USD13. I’m also sticking with the Portfolio’s other extremely leveraged gas play, Precision Drilling (PD.UN, NYSE: PDS), as a buy up to USD30.

Like Paramount, the trust’s share price has fallen along with its distribution this year. And second quarter earnings were a genuine horror show, with revenue falling 45 percent from year-earlier levels, led by a 50 percent drop in contract drilling sales. Cash provided from operations slid by a third.

The reasons for this crackup aren’t rocket science: a 54 percent drop in the trust’s drilling operating days in Canada and a drilling rig operating utilization rate of just 14 percent, the lowest level in many years. The completion and production services segment saw a decline in its service rig utilization rate to just 24 percent, also the lowest in a generation. And the impact of lower Canadian drilling dwarfed the trust’s rapid expansion in the US market, which reached 17 percent of income in the quarter.

The Canadian drilling market may not sink a whole lot from these levels. But until gas prices rebound, it’s not likely to get a whole lot better either.

The only good news is Precision’s management has largely anticipated the industrywide slowdown, to the point where operating cash flow was roughly double distributions plus capital spending. That allowed it to reduce debt by CD96 million to barely 4 percent of equity.

As a result, the trust is in great shape to weather the worst of the drilling market and even expand at the expense of weaker competitors in the coming months. No one, however, should own it unless they’re willing to shoulder the risk and volatility.

Outside the gas-producing sector, investors should keep a sharp eye on Connors Brothers Income Fund (CBF.UN, CBICF), which now faces a product recall because of botulism. Also, Priszm Income Fund (QSR.UN, PSZMF) has apparently been hurt in the near term by problems with its aggressive marketing promotion for its trans fat-free fast-food lines. Sales throughout Canada in the second quarter were down 4.1 percent and particularly weak in the key Ontario market (6.2 percent drop in same-store sales).

In addition, the cost of restaurant sales rose to 60.6 percent of revenue from 57.8 percent a year ago, as food and labor costs ticked up. The result was a ballooning of the second quarter payout ratio to 107 percent, nearly double levels of a year ago.

Year-to-date, the payout ratio stands at 223 percent, a tally that’s clearly unsustainable. Management is working hard on recovery. But until the numbers show it, conservative investors should avoid Priszm Income Fund.

Here’s the rest of the Watch List. I expect Countryside Power Income (COU.UN, COUUF) and Sound Energy (SND.UN, SNDFF) to come off the list next month or two, as they’re taken over this month.

Canetic Resources (CNE.UN, NYSE: CNE)
Clearwater Seafoods (CLR.UN, CWFOF)
Connors Brothers Income Fund (CBF.UN, CBICF)
Countryside Power Income (COU.UN, COUUF)
Daylight Energy (DAY.UN, DAYFF)
Enterra Energy Trust (ENT.UN, NYSE: ENT)
Essential Energy Services (ESN.UN, EEYUF)
Fording Coal (FDG.UN, NYSE: FDG)
Freehold Royalty (FRU.UN, FRHLF)
Harvest Energy (HTE.UN, NYSE: HTE)
Newport Partners Income Fund (NPF.UN, NWPIF)
Noranda Income Fund (NIF.UN, NNDIF)
Paramount Energy (PMT.UN, PMGYF)
Peak Energy Services (PES.UN, PKGFF)
Precision Drilling (PD.UN, NYSE: PDS)
Priszm Income Fund (QSR.UN, PSZMF)
Sound Energy (SND.UN, SNDFF)
Sun Gro Horticulture (GRO.UN, SGHRF)
Tree Island Wire (TIL.UN, TWIRF)
Trilogy Energy (TET.UN, TETFF)
True Energy (TUI.UN, TUIJF)
Vault Energy (VNG.UN, VNGFF)
Wellco Energy Services (WLL.UN, WLLUF)
Westshore Terminals (WTE.UN, WTSHF)

Bay Street Beat

Cineplex Galaxy Income Fund (CGX.UN, CPXGF) extended its reign atop Bloomberg’s average analyst ratings this week, scoring another perfect 5.0.

Aggressive Portfolio recommendation Trinidad Energy Services Trust (TDG.UN, TDGNF) also notched a 5.0 average rating. July 2007 Conservative Portfolio addition Energy Savings Income Fund (SIF.UN, ESIUF) similarly impressed the pros on Canada’s version of Wall Street, earning a 4.778 average.

Conservative Portfolio holding Yellow Pages Income Fund (YLO.UN, YLWPF) was just behind the top scorers with its 4.75 average. Aggressive Portfolio members Vermilion Energy Trust (VET.UN, VETMF) and ARC Energy Trust (AET.UN, AETUF) continued to earn solid reviews, posting 4.615 and 4.333, respectively.

Aggressive Portfolio holding Advantage Energy Income Fund (AVN.UN, NYSE: AAV) was among the lowest-scoring companies with a 1.571 average. Advantage is highly leveraged to natural gas prices, though it’s repositioned itself with recent mergers and will rise and fall with the price of the commodity. Cash flow will be hurt by the recent slide in natural gas, but it’s a well-managed company and will rise again once the natural gas market rebounds.  

Aggressive Portfolio recommendation Provident Energy Trust (PVE.UN, NYSE: PVX) generates a significant amount of income outside Canada, which shields some of its payout from the new tax on distributable cash. Provident has already spun assets off into US-based partnership BreitBurn Energy, a move that could foreshadow similar future deals.

Bay Street’s low esteem is mirrored on Wall Street, but that makes the units cheap. More important, the trust is boosting 2007 capital spending and production, and operating costs in Canada are projected to come down by an estimated 5 percent. Provident is still a sound business.

Tax Pools Made Dry

The ability to provide a tax-deferred return of capital distribution is driven by the accumulation and drawdown of tax pools; it’s not an actual return of capital to investors. Tax pools provide a shelter, enabling a trust to return distributions to unitholders in two ways: as a return of capital and as a return on capital or investment income.

The tax-pool sheltered portion is deemed a return of capital and is taxed as a capital gain when a unitholder sells his or her units. Capital distributions have two advantages: The tax payment is deferred until the units are sold, and a capital gains tax applies.

Non-sheltered distributions are deemed a return of investment income. The capital/income ratio of cash distributions is determined by the size and availability of the given trust’s tax pools.

Tax pools are of value because they reside primarily at the corporate level where income is generated. Significant balances are available for high rates of annual claim, such as Canadian exploration expense (100 percent), noncapital losses (100 percent), Canadian Development Expense (30 percent) and undepreciated capital cost (25 percent).

A Canadian Development Expense (CDE) consists of expenses incurred in drilling, converting and completing an oil well in Canada. Or it consists of sinking or excavating a mineshaft, main haulage way or similar underground work for a mine in a mineral resource in Canada built or excavated after the mine came into production. The cost of any Canadian mineral property or of any right to or interest in any such property also qualifies as a CDE.

CDEs are accumulated in a pool called Cumulative Canadian Development Expenses (CCDE). The taxpayer/business can deduct up to 30 percent of the unclaimed balance in that pool at the end of each year. Unclaimed balances may be carried forward indefinitely.
 
In the case where an entity doesn’t have taxable income against which to claim CDE, the CDE can be used to create a noncapital loss. This noncapital loss can then be carried backward or forward to taxation years where the entity can use the deduction to reduce its taxable income.

A Canadian Oil and Gas Property Expense (COGPE) is the cost of acquiring an oil or gas well; an interest or right to explore, drill or extract petroleum or natural gas; or a qualifying interest or right in oil or gas production (excluding Crown royalties).

The Canadian tax system allows an optional deduction of this cost up to 10 percent per year on a declining balance basis. The COGPE account is credited when any disposition takes place, but an entity’s negative COGPE account may be offset by the CDE account. Any negative COGPE account still remaining is treated as resource income.

Tax pools are basically built on the exploration, development and production of oil and natural gas; the advantage from the perspective of a Canadian trust is that the pools can help reduce future federal income taxes.

Tax pools do make dividends safer beyond the imposition of Finance Minister Jim Flaherty’s levy. Trusts with a lot can shelter cash flow based on fiscal incentives accumulated through their development efforts. They represent a significant advantage for those trusts that have significant pools for the foreseeable future.

Though a comfortable and cozy refuge under the heat of the now-passed Tax Fairness Plan, a tax pool is basically just another asset a particular trust controls. The more you have, the better you are–at least on the basis of supporting a high payout to investors.

The Canadian government has recognized that certain development activities deserved special treatment, exploitation of natural resources among them. Tax pools essentially complement other assets of the underlying business. 

Action Update

In the April 2007 Canadian Currents article, “A Piece of the Action,” we recommended five dividend paying, non-income trust Canadian companies.

Were we updating in last month’s Canadian Edge, this report would be all wine and roses; alas, the group gave back gains along with the broader market in the late-July selloff.

Those of you who invested in the companies we profiled in the spring have benefited from a sharply appreciating Canadian dollar. The loonie has surged toward parity with the US dollar, and your positions in Canada-based dividend payers have served the dual purpose of equity investments and de facto long positions in the Canadian dollar.

The Bank of Nova Scotia (NYSE: BNS), alone among the group, has posted a negative return since April 5, down 0.6 percent in US dollar terms. ScotiaBank traded above USD50 and as high as USD49.24 before coming back with the rest of the financial sector at the end of July.

It’s still posting solid quarterly results and expanding its geographic footprint, though, and pays a healthy dividend. Cheap relative to its peers, The Bank of Nova Scotia rates a buy up to USD49. 

Manitoba Telecom Services (TSX: MBT, OTC: MOBAF) has posted a 9.6 percent return since recommendation; some analysts anticipate better-than-expected second quarter earnings. (MTS announced earnings Aug. 2; we’ll have a report in the September CE.) The company is still a rumoured takeover target, though talk has cooled because of plans to expand its wireless service to a national platform and the associated capital costs. Continue to buy Manitoba Telecom Services, which yields in excess of 5 percent, up to USD46.

Russel Metals (TSX: RUS, OTC: RUSMF) is the big winner among the five: it’s returned 15.4 percent in US dollar terms since April 5. Russel reported earnings of CD29.3 million (USD27.4 million), or 47 cents Canadian per share, for the second quarter–down from CD46.2 million, or 74 cents Canadian per share, a year ago. Sales were CD653 million, down from CD686 million.

Russel attributed the decline to an overabundance of energy-sector tubular product and a slowdown in drilling activity, which pressured margins. Management anticipates a rebound in drilling activity during the second half of 2007. Corporate expenses increased by CD2.3 million over the year-earlier period because of stock options issued in the quarter.

Russel’s board also approved a quarterly dividend of 45 cents Canadian per share, payable Sept. 15. Yielding 6 percent, Russel Metals is a buy up to USD31.   

Norbord (TSX: NBD, OTC: NBDFF) reported a second quarter loss of USD15 million (11 cents per share)–mostly because of lower prices for its key construction product–down from USD33 million (23 cents per share) a year ago. The company also reported continued strong results from its European operations and modest North American price increases for oriented strand board (OSB), a substitute for plywood, at the end of the quarter.

Changes in interest and depreciation expenses and a lower tax recovery rate offset those positive developments. Still a decent way to play an eventual real estate recovery and yielding 4.9 percent, Norbord is a buy up to USD8.50.

Canadian Hydro Developers (TSX: KHD) is a pure play on green energy; its long-term prospects are tied to government support for alternative energy through grants and tax credits. Essentially a small cap technology company, Canadian Hydro will move in fits and starts.

Canadian Hydro owns 12 hydroelectric-generating stations, five wind farms and a biomass plant and has a number of new projects set to come on line in the near future. It will benefit from the shifting political and economic winds in favor of wind energy, biomass and hydroelectric power. Buy Canadian Hydro Developers up to USD5.95.