Three Canadian trusts cut distributions last month. Unlike last month’s cutters, however, their moves did have a hugely negative impact on share prices, as they indicated much greater business weakness than investors had expected.

Lanesborough REIT (TSX: LRT-U, OTC: LRTEF) scrapped its distribution entirely last month. It had already trimmed its payout by 57 percent in late March, from a monthly rate of CAD0.04667 to a quarterly rate of CAD0.06.

At the time of the March cut, management indicated that it was prepared to hold the new rate for the rest of 2009, despite the weakness in the energy patch and particularly in Fort McMurray, center of the oil sands boom and the REIT’s biggest market.

The REIT cited a near doubling of fourth quarter interest expense from year-earlier levels due to its rapid expansion, coupled with less than a commensurate increase in net operating income due to weakening market conditions. Management further stated that unitholders had “upside potential” when “there is a turnaround in rental market conditions in Fort McMurray,” and it announced a divestiture program to raise cash and limit borrowing needs.

When first quarter results came out in late May, however, it was clear that underlying market conditions and Lanesborough’s portfolio were still deteriorating. But the REIT appeared to have prepared itself for the worst. Occupancy had fallen to 91 percent of the portfolio from 94 percent a year earlier. But distributable income was higher, thanks to cost controls and higher sales from a larger property portfolio. And even interest expense was markedly lower, down 12.1 percent sequentially from fourth quarter 2008 levels.

The only real negative was management’s admission in its MD&A report that “there is uncertainty surrounding the ability of LREIT to continue as a going concern,” due to the possibility it could wind up in “violation in the debt service covenant.” The elimination of the distribution this month is a clear sign that little or nothing has been resolved on this front, and that weak market conditions are still a threat to bring down the REIT.

Eventually, I look for the oil sands region to bounce back and for Fort McMurray real estate to become more profitable than ever. The key, of course, is oil prices, which makes the timing uncertain. But ultimately, any player that can survive this market is sitting pretty.

That applies to two CE Portfolio REITs with exposure in the area: Artis REIT (TSX: AX-U, OTC: ARESF) and Northern Property REIT (TSX: NPR-U, OTC: NPRUF). Unlike Lanesborough, however, these REITs were set up conservatively and are well-diversified in other markets. As a result, they’re far better plays on an oil patch recovery than Lanesborough, which appears so leveraged its very existence is threatened and now pays no dividend. Sell Lanesborough REIT if you still own it.

Primary Energy Recycling (TSX: PRI-U, OTC: PYGYF) has also elected to eliminate its distribution, effective with the July payment. That’s despite the fact that the company’s shares are actually “enhanced income securities” (EIS), combining a high-yield bond with equity to generate a higher dividend. Before the elimination, the EIS paid CAD0.04219 per month in equity dividend and CAD0.02448 of interest on the company’s 11.75 percent notes. As a result, the elimination of the distribution is technically a default.

The power trust’s troubles actually began back in early 2007 when it was forced to cut its payout by roughly 30 percent and later that year to suspend it following problems at one of its four projects. These are essentially facilities attached to steel manufacturing plants that convert waste energy to electrical and thermal energy.

The trouble at the Harbor Coal facility chiefly related to the terms of a contract with the plant’s operator and was later resolved at less favorable terms for Primary, resulting in a permanent reduction in the distribution to a monthly rate of CAD0.06667.

Ironically, the latest round of troubles has little to do with the company’s own operations, which have run relatively smoothly for nearly two years. Rather, they’re part and parcel of the continued deterioration of its core market of steel producers, which has prevented management from bidding out Primary’s assets to the highest bidder even as tight credit conditions have squeezed finances.

The dividend elimination is part of a comprehensive “recapitalization” of Primary, including the mandatory conversion to common units of all of the outstanding 11.75 percent notes attached to the EIS. The company will also seek a new senior debt facility that will amortize over the life of its assets, the restructuring of its management agreement to increase its control over projects and a continued alliance with energy giant Epcor Power LP (TSX: EP-U, OTC: EPCPF).

Dominion Bond Rating Service (DBRS) responded to the move by cutting Primary’s stability rating from a moderate STA-5 (high) to an extremely risky STA-7 (middle). The rating service noted that Primary had failed to obtain adequate bids for its assets and noted uncertainty regarding its CAD135 million term bank loan that expires Aug. 24, 2009. DBRS also cited the risk that EIS holders would not approve the recapitalization, and that it could also be rejected by the Supreme Court of British Columbia where Primary is domiciled.

In my view, other power trusts have been far more attractive than Primary for a long time. Even the EIS’ exemption from 2011 taxes has not tempted me since the May 2007 distribution cut, and I’ve never regretted staying away as the shares have continued to trend lower.

Primary may indeed succeed in a restructuring that once and for all eliminates its weakness. But with no dividend and grave threats to survival, there are far better alternatives in the power sector. Sell Primary Energy Recycling.

Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF) has been a fairly consistent sell since Canadian Edge’s inception. That’s mainly because I’ve never believed its business plan of branding decaffeinated coffee to be particularly conducive to consistently paying big distributions over time.

The trust’s initial monthly distribution of CAD0.14 per share was quickly dropped to CAD0.1085 a month later in October 2002. It then held at that level until January 2006, when competition and rising costs forced a reduction to CAD0.708. That level was raised to CAD0.075 in early 2007, a point it held until the most recent cut to the current rate of CAD0.03.

Management attributes last month’s 60 percent reduction to a need to shore up cash flow in the wake of cost pressures on coffee supplies, as well less than expected revenue due to an inability to hold prices and move product in the current weak global economy.

CFO Sherry Tryssenaar is quoted in the dividend cut earnings release as stating “the reduced distribution level is sustainable for 2009, given the current environment and the level of capacity utilization that we can confidently expect.” She also asserted “the new distribution level will enable the fund to maintain a conservative capital structure and the financial flexibility to manage the business effectively.”

Unfortunately, Swiss Water has one additional factor working against it going forward: the Canadian dollar. Basically, 75 percent of revenue is generated in US dollars. A rising loonie decreases the value of those sales in Canadian dollars and simultaneously pushes up Swiss’ costs relative to those of US and other foreign competitors.

That makes the trust’s cash flow, distributions and share price literally a counter play to oil and natural resources, but one which gets virtually no credit in the market for that because it’s both priced in and pays distributions in Canadian dollars. Then there’s the fundamental question of whether such a business can really support a flow through model, where cash isn’t bankrolled but rather constantly paid out.

Swiss Water is priced at just 51 percent of book value and 64 percent of sales. Debt is extremely low at just 6.5 percent of equity, marketing is solid, and the business appears to have achieved at least some decent scale. The new distribution level should indeed hold for the rest of the year.

The real question is how suitable this trust is for income investors, given these uncertainties. My advice: Sell Swiss Water Decaf Coffee Fund. There are plenty of better alternatives with far more upside and less risk.

Ironically, there were no dividend cuts in the oil and gas producer group last month. The near double in oil prices since early 2009 has certainly boosted cash flow of trusts weighted toward liquids production. In fact, Bonterra Oil & Gas (TSX: BNE, OTC: BNEFF) actually increased its payout last month by 16.7 percent to a monthly rate of CAD0.14.

The price of natural gas, however, remains distinctly in the doldrums. Even while oil was rallying hard in the spring, gas prices didn’t reach their nadir of barely USD3 per million British thermal units until late April. They’ve since huffed and puffed a bit higher, but have been largely unable to break decisively above USD4, as inventories have remained high and investors spooked about the US economy.

Unlike oil, natural gas is a regional commodity. And until there’s significant liquid natural gas exporting capability here, all that’s going to matter for Canadian and US producers is North American supply and demand.

Many producers have been successful locking in at least a large portion of their projected 2009 output at prices much higher than current spot levels. And most have locked in at least a portion of sales at good prices for 2010 as well, in particular Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF).

Even a cursory read of realized first quarter selling prices for natural gas, however, makes it clear that realized selling prices for the second quarter are going to be lower still. That means more pressure on cash flows of trusts that rely most heavily on natural gas sales.

We’ve already seen one all out capitulation of a gas-weighted producer, Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV). The trust completely eliminated its payout in March and announced its conversion to a non-dividend paying corporation. Enterra Energy Trust (TSX: ENT-U, NYSE: ENT) and True Energy Trust (TSX: TUI-U, TUIJF) have also eliminated dividends, due to a combination of falling revenue due to lower gas prices and heavy debt. Advantage Energy Income Fund, Enterra Energy Trust and True Energy Trust are sells.

The good news is other gas dependent trusts like Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF) are far better protected against weak gas prices than the above trio. But if you’re unwilling to ride out another distribution cut, don’t invest in any producer trust.

My view is a year from now we’ll be looking at much higher prices for both oil and natural gas. For one thing, gas is coming off the market at an unprecedented rate, as even major producers like EnCana (TSX: ECA, NYSE: ECA) shut in huge amounts of capacity. And industrial demand appears to have bottomed out as well. But with inventories still high, it’s likely to be some time before we see a full-on recovery for gas. And that’s what it’s going to take to fully restore fortunes of gas-laden trusts.

Neither should anyone be overly comfortable about oil prices at these levels. Certainly, there’s every sign they’ll be going a lot higher as the global economy continues to recover, and I’m confident we’ll see new highs well above those of last summer. But the timing depends on what happens to the global economy and, more important than that, investor perceptions which are extremely changeable. Be patient.

Here’s the rest of the dividend watch list. See How They Rate for buy/hold/sell advice. Note I don’t include energy producer trusts. Again, investors should consider these as high cash flow bets on energy prices that ebb and flow with what happens to oil and gas.

• Big Rock Brewery Income Fund (TSX: BR-U, OTC: BRBMF)
• Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF)
• Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)
• Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF)
• Essential Energy Services (TSX: ESN-U, OTC: EEYUF)
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)
• InnVest REIT (TSX: INN-U, OTC: IVRVF)
• Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF)
• Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF)
• Noranda Income Fund (TSX: NIF-U, OTC: NNDIF)
• Primaris REIT (TSX: PMZ-U, OTC: PMZFF)
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)
• Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)

Bay Street Beat

China’s growing influence will have a significant impact on the global as well as the Canadian economy. Many observers continue to look with wonder at oil’s rise during the last several months, perplexed by falling demand and rising inventories in the US. They’re not looking in the right direction.

In its June Commodity Price Index report, Scotia Capital, the investment banking and research arm of Bank of Nova Scotia (TSX: BNS, NYSE: BNS), concludes that China is leading the global recovery in oil and base metal demand and that the Asia-led super-cycle is gaining new momentum.

China’s dependence on foreign oil has now surpassed that of the United States: According to Scotia Capital, China relied on imports for 57 percent of its petroleum production in May, while the US imported 55 percent of its needs. China’s import dependency was less than 40 percent in 2003 and averaged 50 percent in 2008.

China is spending billions to acquire foreign oil producers and construct vast storage facilities to safeguard future needs.

Much of China’s demand has come from new car owners. In May, the government said sales increased by 54.7 percent year-over-year to 812,178 vehicles. In 2008, China sold more cars last year than the US and is forecast to see another 10 percent rise this year.

Scotia’s Commodity Price Index rose 2.2 percent in May, paced by advances in the oil and gas index, which was up 4.4 percent month-over-month. The metals and mineral index surged 4.2 percent month-over-month in May, with gains in base metals, gold, silver and uranium.

China’s imports of refined copper and iron ore were at record levels in the first four months of 2009; China’s industrial activity has re-accelerated in the past three months on the government’s aggressive infrastructure spending program. A recovery in the domestic housing market has also pushed up demand for metal-intensive appliances.

Exports of commodities and resource-based manufactured products accounted for 44.3 percent of Canada’s merchandise exports from 2003 to 2007 and 50.9 percent in 2008, of which almost a quarter was energy. China’s drive to build its strategic oil stockpile in the next several years will have profound implications for the global economy, overwhelmingly positive ones for Canada.

Spirit of Cooperation

Under a draft proposal distributed by Canada’s Competition Bureau, an independent agency, firms would no longer face criminal conspiracy charges for cooperating on the construction of new megaprojects.

This means Canada’s energy giants could be allowed to consult each other on new oil sands projects, a key change that would give them greater purchasing power to help prevent cost overruns and speed construction timelines. Only collusion on price-fixing, market selection and output volumes will be considered immediate criminal offences under new regulations that are set to come into effect next March.

Under current law, competitors can be held criminally liable for conspiring on purchases that “unduly” restrain competition. Under the new rules, such collaboration would fall under a less onerous civil law that provides an important new defense: Companies will now be able to argue that their actions are not anti-competitive if they create substantial industrial efficiencies.

The new rules are especially pertinent to the oil sands, where some operators have taken the unusual step in recent months of calling for a more coordinated effort to build the massive energy projects planned for the Fort McMurray area.

Between 2000 and 2008, the price of building an oil sands project tripled, in great part because demand for labor produced huge price spikes. Under the new competition law companies can get together to, among other things, plan construction schedules, provided the Competition Bureau doesn’t find that such collaboration slows the pace of development and therefore influences output or price.

The hope among oil sands producers and stakeholders is that a more logical, coordinated effort at building new projects might mitigate the drastic feast-or-famine cycle that’s played out over the last several years, where producers try to build their projects all at once when things are good, then pull back all at the same time when things are bad.

Convention Changes

On Dec. 15, 2008, the Fifth Protocol to the 1980 US-Canada Income Tax Convention, originally signed Sept. 21, 2007, entered into force.

The Fifth Protocol introduced a rule that will deny treaty benefits to persons who receive amounts of income, profit or gain, including interest, dividends and distributions, from certain hybrid entities if the tax treatment of such amounts in the jurisdiction of the recipient is not the same as if the hybrid entity hadn’t been used. This rule will apply, for example, to distributions to US residents by unlimited liability companies (ULC) formed under certain provincial corporate statutes, where the ULC has “checked the box” so as to be a disregarded entity for US tax purposes.

An amount of income, profit or gain, including interest, dividends, or distributions, paid by a ULC to a US resident will no longer qualify for a reduced rate of withholding tax under the Treaty. Rather, the statutory withholding rate of 25 percent will apply to such amounts. These rules won’t come into effect until Jan. 1, 2010.

It’s important to note that the withholding tax rate won’t increase for unitholders of a Canadian trust treated as a corporation for US federal income tax purposes, which applies to the vast majority of trusts in the How They Rate coverage universe and all of the CE Portfolio holdings.

In response to the Fifth Protocol, Pengrowth Energy Trust (TSX: PGF-U, NYSE: PGH) announced that it will amend its US tax entity classification to be reclassified as a corporation for US federal income tax purposes.

US-based Pengrowth unitholders would have become subject to the 10 percentage point increase in withholding tax on their monthly distributions had Pengrowth remained a partnership. US unitholders will now receive a form 1099; a schedule K-1 will be issued for 2009, covering the period up to June 30, 2009.

The effect of Pengrowth’s election to be treated as a corporation for US federal income tax purposes for US unitholders will be as though such unitholders had disposed of their Pengrowth trust units for shares of Pengrowth.

The deemed disposition amount will be equivalent to the closing price of Pengrowth trust units listed on the New York Stock Exchange on the close of business on June 30, 2009. According to its statement announcing the election, it is Pengrowth’s understanding that US unitholders may recognize a gain but not a loss on their US tax returns as a result of the reclassification.

Pengrowth won’t issue a form 1099 or K-1 in respect of the deemed disposition; if you own Pengrowth, you must calculate and report the transaction on your 2009 US federal income tax return. Consult your tax advisor for a full and complete discussion of the tax implications of this transaction.

Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF) is also a partnership for US federal tax purposes, but the company is no longer paying a distribution. Those who own units won’t be affected because 15 percent or 25 percent of zero is still zero.