By far, the worst-hit trusts this summer have been the oil and gas producers and the energy service trusts that do their drilling. One of the questions I’ve heard over and over from readers is why these trusts continue to “go nowhere,” even as oil prices make one new high after another.

The answer is that oil is only a part of the pricing equation. Outside of Canadian Oil Sands (COS.UN, COSWF), all trusts derive at least a portion of their cash flow from natural gas production. And although oil has risen from the USD50s to the USD70s per barrel range this year, gas prices have nearly fallen in half.

Proportionately, that represents a far greater drop and impact on cash flows than the oil price jump represents a gain, even for those more weighted to oil output. And oil price gains have been further offset by the fact that crude is priced in US dollars. The more than 8 percent drop in its value against the Canadian currency has cut whatever oil cash flows weren’t previously hedged by 8 percent.

 
The bottom line is, despite the headline jump in oil prices, overall energy producer cash flows are taking another hit this summer. And that’s especially true for trusts that are the most weighted to natural gas production.

Obviously, it’s going to take a recovery in natural gas prices—or at least no more dramatic drops—to ignite a recovery in Canadian oil and gas trust cash flows. As long as gas prices languish, the entire market will be in a defensive mode. And although I don’t expect the best of the biggest to cut distributions, more-leveraged plays remain at risk, as the Dividend Watch List in Tips on Trusts points out.

Takeover Turmoil

By and large, the Conservative Portfolio trusts have held up well since trust prices overall peaked in June. One reason is their cash flows aren’t tied to energy prices but rather to the basic health of their businesses. But although most are still well off their post-Halloween 2006 lows, they haven’t wholly escaped damage either.

Initially, these trusts—which have been chosen for their steadily growing businesses and ability to pay big distributions well past 2011—were hit by rising US interest rates. The uptick in the benchmark 10-year Treasury note yield to 5.3 percent in June sent investors scurrying, particularly out of trust sectors perceived to have the least credit risk–namely power and pipeline trusts and real estate investment trusts (REITs).

That mirrored similar selling of high-quality, income-generating fare in the US. And it was precisely the same pattern that accompanied the rate spikes of 2003, 2004, 2005 and 2006, which in turn were accompanied by a drop in rates and a return to buying high-quality income trusts. Investments with the least credit risk move most closely with interest-rate swings.

What happened then was a sharp divergence from the past four years. As before, evidence of a slowdown in segments of the US economy puts the breaks on rising interest rates. This time, however, the weakness has been in the highly leveraged US housing market, for years a key underpinning of the global economy.

Both lenders and borrowers have become increasingly aggressive in the US housing market in the past few years. People have made purchases well beyond what they could afford under a normal loan in a normal market. As a result, the slowdown has triggered a rising number of defaults in subprime loans, essentially mortgages taken out by people who wouldn’t qualify under normal standards.

Defaults, in turn, are causing credit standards to tighten, which are causing rising defaults among ordinary borrowers as well. Their defaults are driving down the prices of houses in many areas, which are making other borrowers effectively insolvent and forcing them to sell and drive down home prices further.

What does this have to do with Conservative trusts? Absolutely nothing, from a business standpoint. Even the trusts with substantial operations in the US are focused on things like power production and selling ice, which have no exposure to housing and are shielded against recession as well.

Trusts, however, do have exposure in one key area: takeovers. Since the Halloween announcement that trusts would be taxed as corporations beginning in 2011, we’ve seen 36 takeovers of trusts, most at high premiums. That trend could slow.

The subprime cycle has now spread to another very key area for the economy: high-yield bonds. Essentially, the “spread” between yields of lesser-grade and higher-grade securities is widening again after being at record lows for several years. That makes it a lot more expensive to issue debt rated below investment grade, which is the feedstock of the private capital-led acquisition wave of recent months.

At this point, none of the high-profile leveraged buyouts has been canceled because of widening high-yield spreads. In fact, the risk now is mainly with the money center banks, which are on the hook for hundreds of billions of dollars in “bridge” loans made to the likes of Kohlberg Kravis Roberts to finance the deals. Banks had intended to peddle these loans to investors as high-yield debt and now face the prospect of much-diminished demand.

It’s quite possible, however, that some of these deals could come apart if conditions worsen enough. And at the very least, rising high-yield debt costs are likely to slow the pace of new private capital acquisitions, including those of Canadian income trusts.

The good news is no trust takeover deals in progress are at risk, as virtually all of the 37 announced since Halloween 2006 have been completed and financing is apparently in place for the rest. Even the buyout of telecom giant BCE—not a trust—looks relatively secure, as participation by private capital is balanced by the participation of the cash-rich Ontario Teachers’ Pension Plan Board.

Future deals, however, are definitely at growing risk as long as this crisis deepens. As a result, we could see at least a lull in the pace of high-premium takeovers of trusts.

On the positive side, takeovers of trusts are still relatively small mouthfuls for would-be acquirers. And there are many other potential buyers, including other trusts, as I point out in the Feature Article. Also, the high premiums still being captured in deals are a pretty good indication that trusts aren’t pricing in buyouts before they happen.

That should limit any downside if private capital takeovers slow down in the coming months. But at least some of the selling we’ve seen in the safest names is no doubt due to a perceived reduced possibility of being acquired.

Still Buys

No one likes to see falling prices. But there’s a silver lining to the cloud that’s enveloped both Conservative and Aggressive Portfolio trusts in recent weeks. Mainly, the factors that stalled the trusts’ torrid rally are ephemeral. And once these factors give way, the trusts should return to the upside in earnest.

For one thing, what made Conservative Portfolio picks and other strong trusts attractive to private capital is as compelling as ever. They’re still growing businesses with secure market positions and strong balance sheets that generate rivers of cash flow.

Strong, nonenergy-related trusts have drawn takeover interest because acquirers can load them with debt, confident they’ll be able to cover it with a secured, rising stream of cash flow. That’s the same cash flow that makes these trusts’ lofty distributions possible. And as long as it’s flowing, these trusts will be attractive, both to would-be acquirers of all stripes and to individual investors on both sides of the border.

Moreover, it’s still a very long time to 2011. Even if the tax laws aren’t changed—still a very real possibility with the Liberals backing it and elections approaching in Canada—trusts still have plenty of time to adjust. And there’s also plenty of time for macro conditions to shift in favor of more mergers.

Strong, nonenergy trusts also remain among the cheapest income-generating investments out there, particularly relative to their operating risk. And price-to-book value ratios and price-to-sales ratios across the board are lower than equivalent corporations. You literally won’t find quality businesses selling cheaper anywhere. And with accounting standards better than ever, you can place a great deal of faith in trusts’ numbers for the very first time.

In other words, private capital takeovers or no, the Conservative Portfolio trusts are values that will grow wealth for investors, both up to 2011 and beyond. Moreover, the market is just starting to recognize their ability to escape the worst of corporate taxation, no matter how they’re organized. That, too, will push them higher in coming years, even as 2011 approaches.

If it all boils down to business quality with nonenergy trusts, energy prices and management’s ability to deal with their volatility are key to the Aggressive Portfolio’s oil and gas producers and energy service trusts. We’re not going to get anywhere as long as natural gas prices languish. But with the odds still favoring much-higher energy prices in the long haul, it’s only a matter of time before these trusts return to the upside, very likely in a big way.

As of now, only one of my recommended trusts—Vermilion Energy (VET.UN, VETMF)—is near its all-time high. That’s mainly because of its expanding global portfolio, which has made the trust virtually immune from the impact of 2011 taxation.

Vermilion Energy remains a buy up to USD36. I fully expect the rest, however, to recover all the ground they’ve lost in the past year and more.

Energy prices are as volatile here in mid-2007 as they’ve ever been, particularly natural gas, which is now literally pushed all over the map by daily weather forecasts. Despite this year’s ups and downs, the upward direction of the past eight years—since the bottom in oil under USD10 per barrel and gas under USD1 per million British thermal units in 1998—is still unbroken, even for natural gas. And from all indications, the bull market still has a very long way to run.

My view remains the same as it’s been the past few years: Before this bull market really ends, we’re going to have to see a lot more conservation, use of real alternatives, a major discovery of conventional oil and gas and very likely a demand-crushing recession. Those were the factors than ended the 1970s energy bull market, and they didn’t do it overnight–only after years of painful adjustment.

Oil markets are now clearly in the hands of producers, rather than the consuming nations, as was the case during the ’90s. Only permanent, major demand destruction coupled with new supplies can tilt the balance. Last time around, it was the opening of a fleet of nuclear plants that displaced oil in generating electricity.

A massive switch to smaller cars from the gas guzzlers of the ’60s further swung the balance, though it took a long time to change consumer habits. The opening of the North Sea increased global supply outside of the Organization of the Petroleum Exporting Countries (OPEC) nations for the first time in many years. And Paul Volcker’s recession wrecked scores of developing world economies and dried up demand there.

These were all painful steps that took years to play out. And although there are some signs of conservation today, it’s certainly nothing close to the magnitude of the changes felt in the ’70s. In fact, most market participants still seem to believe in the “magic bullet” theory—that demand on imported energy and oil and gas prices can be slashed painlessly by conservation and opening up a few wind-power plants. Some think you can even do it while shutting down coal plants to combat global warming and blocking new nuclear power plants.

As long as people are still thinking like this, there’s little risk we’ll see the kind of demand destruction and supply shifts needed to shift the balance back to the consumer and away from energy producers. That will keep energy prices heading higher in the next few years, particularly with developing China and India now competing with the US and Europe to import oil.

As for natural gas, even if you believe we’re going to have cool summers and mild winters from here to eternity, North America has become a net importer of natural gas via liquid natural gas. As a result, it’s going to be increasingly subject to the same price pressures oil is.
 
Every commodity price cycle ends, and so will this one for energy. This one, however, still has a ways to run, and as long as it does, prices of good energy trusts are going to head higher. That’s true no matter how they’re taxed in the future. Like the Conservative Portfolio trusts that just keep on growing, they remain powerful buys.

Keeping Up

As long as the financial markets are still roiling, there’s very likely more downside in store for trusts of all stripes. We’ll have plenty of good days. But on bad days, investors are only going to be interested in safe havens, and for most people, that means only US Treasury paper.

The main thing to remember during bad days is we’re buying quality trusts for long-term wealth building and high current income. These market factors can trigger some dramatic ups and downs in the shares of even the best trusts. But as long as their underlying businesses remain healthy, our picks will weather the storm and ultimately move onto new highs.

In the next few weeks, we’ll get a pretty good indication of how our picks’ businesses are faring as their second quarter earnings results are announced. We’ll be reporting them in our weekly issue of Maple Leaf Memo, which is e-mailed complimentary to Canadian Edge readers.

As of this writing, few trusts have reported. Precision Drilling (PD.UN, NYSE: PDS) released results that painted a grim picture for its industry, energy services. But it showed clearly that management has prepared the trust well because it was able to dramatically reduce debt in a quarter where cash flows fell nearly in half as rig utilization rates plummeted to their lowest levels in a generation.

Precision can’t thrive amid conditions like these. But management’s prescient moves ensure it will still be around when the macro situation does change, and it will. The shares’ volatility means they’re not for everyone. But Precision Drilling is doing what it’s supposed to in the Portfolio, and it still rates a buy up to USD30. See the Dividend Watch List in Tips on Trusts for more information.

That’s how I’ll be assessing the prospects of every trust as we review second quarter results. Again, as long as the trusts measure up on the business front, we’ll stick with them. Only if they falter on the fundamentals will we exit, no matter what the overall market holds in store.

One Canadian trust sector that’s been expensive but has become increasingly attractive in the past few weeks are Canadian REITs. Like US REITs, these have been clipped in recent weeks on fears about the US property market. But unlike US REITs, Canadian REITs’ core market remains very strong.

Both of the Canadian Edge Portfolio REITs—RioCan REIT (REI.UN, RIOCF) and Northern Property REIT (NPR.UN, NPRUF)—are back yielding close to 6 percent again, as are a number of other REITs. That’s despite continued sterling results. Both RioCan and Northern Property REITs are strong buys up to USD25. I plan to focus on the sector more fully in the September CE.