It’s been a rough year for Canada’s energy patch. Despite a torrid recovery since winter, oil prices are still down more than 50 percent from last summer’s highs.

Natural gas has fared much worse, recently sliding to the neighborhood of USD2.50 per million British thermal units (MMBtu). That’s less than a fifth of its 2008 peak. And with a US government report showing inventories at record for this time of year, further declines are certainly possible, if not probable.

Whether they’re trusts or corporations, energy producers can only pay in dividends what they earn in cash flow. And that cash flow is determined by three factors: how much they produce; what it costs them to get it out of the ground; and the price that output fetches on the market.

In recent months we’ve seen some softening of drilling costs and even a decline in overall operating expenses at many trusts. Not surprisingly, however, that’s been more than offset by the massive drop in energy prices.

The bottom line: An average dividend cut of 36 percent over the last 12 months for the 29 Canadian oil and gas producer trusts and corporations tracked in How They Rate. That, in turn, has left share prices for the group down an average of 34 percent over the last 12 months.

It hasn’t all been downhill for the past year. In fact, since early March this group has staged a torrid recovery. Several among them have more than doubled off the lows, and we’ve even seen a handful of dividend increases.

The question now: Are these gains sustainable?

Why They Are

When I wrote my last energy-focused feature article in June, I was absolutely convinced there was a lot more to come for energy, well-run oil and gas producer trusts in particular. One reason was extremely low valuations, both for producer shares and the fuels as well, that reflected extremely low expectations for the sector.

Since that time, we’ve seen little that’s cheerful in the way of what are traditionally considered “industry fundamentals.” Namely, demand for natural gas remains extremely low in the face of mild weather–which depresses demand for peak generation of electricity–and significant idled industrial capacity.

That’s kept inventories at record levels even as summer has passed and “hump” season of traditionally low demand has begun. Moreover, the US Dept of Energy now projects industrial demand for gas will fall by 8.6 percent this year, the country’s overall consumption by 2.6 percent.

There’s considerable evidence that natural gas production in North America is falling rapidly. The number of drilling rigs in use has declined by more than 70 percent in Canada and by 50 percent in the US.

To date, however, the impact has been dwarfed by the drop in demand. And with hurricane season winding down, the possibility of storm-induced shut-ins is waning as well.

Sooner or later production declines will have an impact. We continue to see unprecedented supply destruction as gas wells are capped and new projects are delayed.

Even with advances in technology, the price of producing shale gas is still in the USD4-to-USD5 per MMBtu range.

The forward pricing curve for gas is high enough to make that economic enough to keep producers in business. But with the free-fall in spot prices, it’s not nearly enough to encourage massive new spending.

There’s also some anecdotal evidence that industrial demand for gas has stabilized and may actually begin to recover in the second half of 2009. Several US electric utilities serving heavily industrial areas have noted stabilized demand from their biggest customers between the first and second quarters of 2009 and are reporting plans from these same users to ramp up demand.

That remains the bull case. The bear case is natural gas prices are now in virtual free-fall. And given this week’s inventory numbers it’s hard to see an immediate catalyst for a reversal.

In fact, given the huge dollar volume of derivatives based on natural gas, we could see a whole lot more volatility, as players scramble around to shift positions and some struggle to stay solvent. That could well take spot and near-term futures down further still.

The bottom line is if you’re going to invest in natural gas now, you’d better be in positions that can weather a final bout of craziness. The more leveraged you are, the more at risk you are of getting flushed out before the inevitable market turn.

In a dollar-for-dollar sense, the massive decline in natural gas we’ve seen over the past 12 months is considerably greater than what happened from 2005-06, the year following hurricanes Katrina and Rita. Then, gas came down from a high in the mid-teens in late 2005 to a low of under USD5 per MMBtu as supplies burgeoned and demand faltered amid mild weather and massive industrial switching to oil.

Then again, the catalyst for the dramatic ups and downs in 2005-06 is pretty much the same as what’s been behind the ongoing decline. That’s simply a dramatic drop in demand, occurring at the same time new supply came on the market. Both were a response to high prices and the low prices that followed ultimately sowed the seeds of their reversal.

Some will argue the discovery of shale gas has changed the equation for natural gas prices in the North America forever. Shale gas, however, won’t be produced if today’s prices prevail–and in fact that‘s what we’re seeing now from producers scaling back. Moreover, conventional gas output is declining even faster, evidenced by the fact that the drop in rig count has been to date most severe in the Western Canadian Sedimentary Basin.

None of this going to show up in gas prices until demand has stabilized enough and output has fallen enough to bring inventories back into balance. Just as during the 2005-06 drop for gas–and in fact throughout 2007–the market is focused on inventories and is adjusting prices accordingly.

The aftermath of the 2005-06 slump–which extended into 2007–was ultimately the dramatic surge in natural gas prices of early 2008. After seeming too flush for months, inventories suddenly shrank in the face of surging demand and suddenly inadequate new supplies. The result was a dramatic revaluation of the energy market, and energy producers were off to the races.

Market history doesn’t ever exactly repeat itself. But seeing how little people have changed over the centuries, it’s likely the eventual recovery in gas prices from this swoon will follow a similar course. Just when most investors have given up, prices will surge dramatically across the board.

At that point it will be too late to get in, but energy will be all investors want to talk about. That was certainly the case in mid-2008 when I wrote The Case Against Oil and Gas, and I look forward to essentially writing that article again sometime in the next 12 to 18 months.

In the meantime, however, it’s important for investors to continue ignoring the energy bull that this time is somehow different, which seems to spew out of every media outlet.

The bottom line is natural gas and oil are commodities and are therefore subject to price cycles. Making money in these markets means being aware of that and planning accordingly.

Sticking to Our Guns

So what are the best plays on an energy recovery that won’t bankrupt you if prices stay depressed a while longer? My top recommendations remain the eight energy producer trusts in the CE Portfolio’s Aggressive Holdings.

The graph “Enerplus and Oil” is one I’ve run serially over the years for one reason: to make the point that energy producer trusts follow energy prices over time.

To be sure, Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF) has moved around that price over the years. And it’s also been impacted to a large extent by natural gas prices, particularly after acquisitions made the past couple of years have increased gas’ share of its overall output.

But over the years, Enerplus’ cash flows and therefore its distributions have tracked energy prices, and its share price has followed suit.

Put another way, there’s simply no way an enterprise set up to pay distributions out of cash flows drawn from energy prices can avoid having its payout–and therefore its share price–track those same energy prices over time.

Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) has pulled off the Herculean feat of holding its distribution over the past year, mainly because it’s able to sell oil and gas in Europe and Asia. That means it depends far less than its peers on the extremely depressed North American natural gas market.

Even Vermilion’s share price, however, has been affected by energy’s ups and downs. And the same goes for the other trusts to hold dividends over the past 12 months: newly converted corporation Crescent Point Energy (TSX: CPG, OTC: CSCTF) and Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF).

When it comes to business exposure to energy price swings, however, the 29 producing trusts and corporations tracked in How They Rate vary widely. All are ultimately affected by energy price swings, including the most aggressively hedged players. But their ability to weather depressed environments like this one is affected by myriad factors, including the use of debt leverage, the lifetime and cost of reserves, their dependence on natural gas as opposed to oil and gas liquids and of course how aggressively they pre-sell, or hedge, their output.

Oil & Gas Reserve Life highlights these factors for all of the 29 producers tracked in How They Rate.

The table “Cheap Energy” rates the producers on several other factors. Column one compares current price to the net asset value (NAV) of their oil and gas reserves. NAV is calculated once a year based on an independent assessment of reserves as well as various assumptions for the time value of money. The result is a rough estimation of the value of what each company has in the ground, hence its value to an investor or acquirer.

The NAV estimates used in the table are conservative, based solely on proven reserves (90 percent or better chance of being developed). The limitation of the number shown is that reserves are only calculated at the beginning of the year.

Companies making acquisitions since January 1 will be generally undervalued, as will those that rely on oil production. Conversely, those that have sold assets or that rely heavily on natural gas output would likely have a lower NAV now than they did at the beginning of the year.

The second column shows the percentage change in the distribution over the past 12 months. The third tracks the payout ratio of each company based on distributable cash flow, with lower numbers generally indicating safer dividends.

Note that the payout for Provident Energy Trust (TSX: PVE-U, NYSE: PVX) is safer than it appears because energy production only accounted for a third of second quarter cash flows, with the rest coming from more secure, fee-based midstream assets.

Column four may be the most important on the table. It shows the average price fetched after the impact of hedging for the oil (USD per barrel on left) and natural gas (USD per MMBtu on right) produced.

The most encouraging thing about these figures is that realized oil prices are in most cases considerably below the current spot price of around USD70. That suggests most trusts are going to realize higher earnings for their oil output in the second half of 2009 than they did in the first half.

The most discouraging is that realized gas prices are well above natural gas’ spot price and perilously close to the forward pricing curve, where output is presold. That suggests, unless a trust has been a particularly aggressive hedger like Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF), it’s going to be selling its gas output at a worst price in the second half of the year.

The most vulnerable to this are obviously trusts that rely the most heavily on natural gas production, which is highlighted in column five. We’ve already seen one trust capitulate to lower gas prices–Advantage Oil & Gas (TSX: AAV, NYSE: AAV)–and convert to a dividend-less corporation. Last month another one bit the dust, True Energy Trust (TSX: TUI-U, OTC: TUIJF).

Advantage Oil & Gas is a hold, True Energy Trust a sell.

Of course, True hadn’t paid a dividend since February and had rated a sell for some time. But its dramatic move is a clear sign of the dire straits small producers are in–whether organized as trusts or corporations–and particularly if they rely heavily on natural gas output and are debt-heavy.

Happily, of the How They Rate entries only Enterra Energy Trust (TSX: ENT-U, NYSE: ENT) and Trilogy Energy Trust (TSX: TET-U, OTC: TETFF) face anything close to the challenges of True.

Enterra Energy Trust is still a sell, but it took a giant step toward ensuring its future solvency by cutting net debt by 30 percent over the past year. This it’s been able to do with a combination of cost cutting and by not paying a dividend, making it somewhat less than attractive as a holding and it’s still quite small. But this is certainly a step in the right direction.

As for Trilogy, the second quarter payout ratio was high at 43 percent as realized gas prices (80 percent of output) plunged. Management expects a big rebound in the second half and first half cash flows did cover distributions by more than 2-to-1, indicating the shortfall likely relates to the impact of weather on output and costs.

But trading at a premium to NAV and offering only a modest yield, Trilogy Energy Trust still a hold, and a risky one at that because of its small size.

Unlike natural gas, oil is not a regional market but a global one. My belief is liquefied natural gas (LNG) will eventually be exported from North America, essentially diverting the current extreme supply glut to still supply-starved Asia and Europe.

This will require a huge expenditure, essentially to convert the current LNG import infrastructure to export capability. But several projects are already on the drawing board and the longer gas stays cheap here and expensive elsewhere, the greater the incentive to push them forward.

Until that happens, however, oil will be the only energy capable of being exported globally and therefore the only energy whose price will be set globally.

That, in turn, means trusts relying most heavily on oil production will be the best shielded from the current environment and, all else equal, will pay the safest dividends.

Oil reliance, for example, has kept Crescent Point’s dividend intact over the past 12 months, even allowing the company to convert to a corporation without touching the payout. Coupled with hedging, it’s also kept Zargon’s payout level.

Of course, reliance on conventional oil production is an entirely different matter from oil sands reliance. The main reason is extremely high production costs that essentially leverage margins for oil sands producers. Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), for example, had average production costs of more than CAD50 in the second quarter.

Distributable cash flow was actually negative, explaining the cut in the quarterly payout from CAD1.25 per share in August 2008 to just CAD0.15 by the February 2009 payment. Note that leverage does work both ways, as the trust was able to lift the payout to CAD0.25 with last month’s payment, thanks to recovering oil prices.

My inclination has been to build my core oil and gas producer holdings on the “diversified portfolio” principle. Put another way, I want trusts that own a balanced mix of oil and gas as the best way to keep cash flows balanced.

Current holdings ARC Energy Trust (TSX: AET-U, OTC: AETUF), Enerplus, Penn West Energy Trust (TSX: PWT-U, NYSE: PWE), Provident and Vermilion all feature a balanced production mix.

Except for Vermilion, all have had to cut dividends at least once during the last 12 months. The biggest surprise about their second quarter earnings numbers, however, is how well all are navigating the current environment. Simply, all are maintaining production and reserves, even while trimming debt.

ARC Energy saw its payout ratio tick up to 73 percent in the second quarter, the result of falling gas prices and its focus on boosting gas output from its Montney Shale find.

The trust did hold output and operating costs steady, indicating success in its long-run strategy despite clearly horrific conditions for its industry. Management also maintained capital spending guidance for full-year 2009 and is now in good shape to take advantage of lower drilling costs.

Realized energy prices for output in the second quarter are in line with the forward curve and spot prices, which should hold cash flows steady in the second half of the year. That’s even as ARC remains a relatively low-risk bet on a rebound in natural gas.

Enerplus Resources’ second quarter payout ratio came in at just 43 percent of distributable cash flow. Meanwhile, dividends and capital spending together came in at just 68 percent of output, allowing management plenty of room to cut debt and preserve capital for further acquisitions. Debt remains among the lowest in the industry at just 0.7 times annualized cash flow.

That’s about as conservative as you can get in this industry. And coupled with the low realized selling prices for gas and oil in the second quarter–which are likely to rise later this year–it means Enerplus investors face very few risks in the current environment. Even the 6 percent drop output is no cause for concern as it reflects a refocus on more profitable operations, including in the Bakken region.

Last week the trust made a major purchase of 116,000 net acres in the Marcellus Shale region, a 21.5 percent stake in a parcel of 540,000 acres. The move is Enerplus’ first major one into US shale gas carries costs of USD1.60 per thousand cubic feet. And just being able to meet the USD164 million price tag is yet another affirmation of this trust’s strength.

Penn West managed to both cut debt and beat guidance for its second quarter output. Credit goes to the trust’s continued progress integrating its steady stream of acquisitions over the past several years that have created a major producer with over 180,000 barrels of oil equivalent per day in output.

Cash flow, meanwhile, covered the distribution by more than a 2-to-1 margin, despite a steep drop in realized selling prices, particularly for natural gas.

Unfortunately, management still managed to stumble in its conference call, as critics twisted innocuous comments about 2011 taxation and future dividend policy into a distribution cut warning. That may happen as new taxes are absorbed and the trust attempts to continue growing output.

However, as management has explained to me, the key is energy prices far more than any new taxes. Meanwhile, these numbers definitely paint the picture of a strong enterprise worthy of holding for the long haul.

Provident Energy Trust is now more of a midstream company than a producer. Cash flows from these facilities do depend on throughput and commodity price spreads to some extent, so it’s not entirely independent of energy price swings.

On the other hand, at almost three quarters of second quarter 2009 income, these operations are delivering much-needed cash flow as the production arm continues to be hurt by low oil and gas prices. And management plans to expand assets will further extend the trust’s reliance on midstream, just as the sale of producing properties in Saskatchewan to cut debt will.

Provident’s payout ratio was high at 97 percent for the second quarter. Nonetheless, management affirmed its safety along as it announced the results of its “strategic review.” The company intends to remain a “cash distributing energy enterprise” past 2011, though details beyond that are sketchy.

Finally, Vermilion’s global output has not only diversified it against pricing problems in a single market. But it also means most of its income will escape the 2011 trust tax, giving it numerous options for dealing with the future and enabling management to affirm its dividend after 2011.

The trust is on the verge of completing two transforming transactions. One is the sale of its 42 percent stake in Verenex Energy (TSX: VNX, OTC: VRNXF) to either a Chinese company or to the government of Libya. This deal is currently on hold pending the actions of Libyan regulators but resolution is likely by the end of the year. When it closes, Vermilion will have enough cash to essentially pay off all of its already-low debt and then some.

The second is the purchase of a stake in a major producing property off the coast of Ireland that will immediately pump up cash flow and further diminish dependence on North America.

The only negative about these “core” trusts is, outside of Vermilion, they still haven’t given us a clear read on their 2011 plans.

All of them will benefit the rest of the year from a combination of higher oil prices and lower production costs, offset to some extent by the collapsing price of natural gas. But I don’t look for any of them to increase dividends until gas prices and in fact the entire economy stabilizes.

All of them have affirmed in one way or another that they intend to be dividend-paying entities once the new taxes kick in. What we don’t yet know is how greatly they’ll focus on growing reserves and output, which will take money away from paying distributions.

Vague statements about a possible dividend cut did hurt Penn West’s share price this earnings season despite strong numbers. So we can expect more ambiguity rather than less, at least until management is clearly ready to make a definitive move. And that may not be until 2011 or at least late 2010.

At this point, if I were a mind reader I would guess that dividend cuts to spur growth would be most likely at ARC, which has a truly promising find at Montney, and Penn West. Least likely to make big cuts would Enerplus and Vermilion, which is still saying “no cut.”

All of this, however, is pure conjecture. And it can’t be overemphasized that what will be paid will closely follow oil and gas prices. If oil goes to USD100 and gas can rebound and stay above even USD5, we’re going to see dividends increased, not cut, when 2011 taxes kick in.

On the other hand, if oil goes and stays under USD40 and gas heads below USD2, we’re going to see dividend cuts, even if the Liberal Party takes over Ottawa and extends trusts’ favorable status.

It’s that simple. This is all about energy prices. These core bets are still the safest way to garner high cash flows while betting on an oil and gas price recovery. But no one should hold them if they’re not willing to bet on energy.

If you are, buy below these prices: ARC Energy Trust (USD17), Enerplus Resources (USD25), Penn West Energy Trust (USD15), Provident Energy Trust (USD60) and Vermilion Energy Trust (USD30).

The other three oil and gas plays in the Aggressive Holdings are all natural gas-focused. The bet here is that gas will indeed recover and that these trusts are conservative enough to survive the downturn until they do.

That’s a more risky wager than the “core” trusts profiled above. But ultimately it’s likely to be the more lucrative.

Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF) is highlighted in High Yield of the Month and is the safest of the three, owing to a larger base and very conservative financial policy. Daylight Resources Trust is a buy up to USD11.

Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) is only less secure because of a higher payout ratio of 86 percent, based on second quarter distributable cash flow.

On the plus side, there was considerable progress cutting costs during the quarter, with interest expense per barrel of oil equivalent produced notably tumbling 30 percent from year-earlier levels.

The trust also realized some real efficiency gains, as field netback (revenue less production costs) hit 83 percent of revenue and reserve life remained 17 years based on proven reserves.

Peyto’s ace in the hole remains the lowest production costs in its industry; coupled with hedging and deep reserves, that’s kept the trust healthy despite crashing natural gas prices, which account of 84 percent of output.

You simply can’t rule out a payout cut at this time, which is why the trust’s yield is now over 15 percent. On the other hand, even if it does cut, this is still an exceptionally solid enterprise selling well under NAV. Again, don’t own Peyto if you don’t want to be on natural gas. But if you do, there are few higher percentage ways to play than to buy Peyto Energy Trust up to my target of USD12.

Last but not least is my most aggressive bet on gas, Paramount Energy Trust, which in fact produces only natural gas.

The trust has been able to hold its dividend steady since spring for only one reason: extremely aggressive hedging. That remains the case today. In fact, the next several months’ output is so locked up that cash flows will vary only by about 10 percent over the second half of the year, almost no matter what happens to gas prices. The second half 2009 payout ratio is projected at 67 to 71 percent, while net debt to funds flow will come in at 2.4 to 2.5.

Paramount’s current strategy is to take advantage of this conservative position to lock up new assets, and it’s now done so by acquiring Profound Energy. If natural gas prices do rebound by the first half of next year, that’s a plan that will pay off richly with higher output, cash flow and probably dividends.

On the other hand, if prices fail to rebound by then, there’s going to be another dividend cut.

Paramount is not for anyone’s safe money, regardless of management’s statement that it is the “most sustainable” trust due to hedging. This is a well-run but small outfit dependent on what’s become the most volatile-priced commodity in the world.