Some of the biggest oil companies in the world–BP Plc (NYSE: BP), Eni (NYSE: E), ExxonMobil (NYSE: XOM), Occidental Petroleum (NYSE: OXY)–are now working in Libya. And Muammar Qaddafi spoke at the United Nations this week, his 30 years as a pariah washed away by thoughts of Africa’s biggest oil reserves.

With fewer and fewer sizable oil patches left in the world, oil companies have incentives to acquire acreage wherever they can. For oil companies, doing business with a former pariah state is worth it.

Although the absolute size of the deal is unlikely to attract attention in an environment where the real players are accustomed to spending multiple billions of dollars, the recently announced “agreement” between the Libyan Investment Authority (LIA) and Verenex Energy (TSX: VNX, OTC: VRNXF) is bound to attract significant attention: LIA, a sovereign wealth fund (SWF), has become the instrument by which its sponsoring state authority has impeded market processes and damaged shareholders.

Rather than the CAD10 per share China National Petroleum Corp (CNPC) offered in February, Verenex shareholders–including 45 percent owner Vermilion Energy Trust (TSX: VET-U, OTC: VETMF)–are left with Libya’s CAD7.09 per share offer.

Within weeks of the CNPC offer, the Libyan government exercised a contractual right to block it. But, although the Libyans promised to meet the terms of the CNPC offer, Libyan parties made it clear verbally to Verenex that they wanted a lower price than the CNPC bid, Verenex CEO Jim McFarland said at the time.

Rather than wait out what was already an extended delay while Libyan authorities contemplated their next move, CNPC pulled its offer in early September.

LIA was established in August 2006 by decree of the General People’s Committee of Libya (GPCO) with estimated capital of USD40 billion; current estimates of its assets range from USD70 billion to USD80 billion. LIA oversees and manages government investments in various areas including agriculture, real estate, infrastructure, oil and gas and in shares and bonds.

Like most SWFs created during the 2004-to-2007 period, LIA was founded to manage and invest vast and mounting oil revenue surpluses. Ultimate authority rests with Qaddafi; operations overseen by an 11-member board of trustees; day-to-day management includes top officials in Libya’s banking industry. It is, at the end of the day, an instrument of the Libyan state.

The role of SWFs generally is the subject of a great deal of debate. For the most part, however, entities such as China Investment Corp (CIC), Abu Dhabi Investment Authority (ADIA), the Government of Singapore Investment Corporation (GIC) and the Kuwait Investment Authority (KIA) have acted responsibly and with great sensitivity to the concerns of recipients of investments. During the financial crisis these SWFs have stepped in with much-needed capital and have actually relented on key negotiating points–foregoing board positions that would reasonably be expected to accompany investments of the size they’ve made.

This exceptional move by the Libyan government undermines its reputation for honoring existing contracts with foreign companies, and LIA’s involvement is sure to draw more scrutiny to the behavior of sovereign wealth funds generally.

Whether the LIA’s offer becomes final may come down to Verenex’s main shareholder, Vermilion. Vermilion management hasn’t yet expressed its position on the LIA offer.

The point here, though, is that shareholders don’t have many options. Verenex could take the matter to international arbitration, a process that could take as much as three years. This may be a matter of cutting losses and taking what can be had.

Foreign investment has been flowing into Libya over the past few years following the lifting of United Nations and US sanctions against the North African country. Libya has been trying to communicate to the world that it’s open for business, but Verenex’s experience suggests problems can still occur. At least in the context of the last several years, the involvement of LIA is the exception for SWF behavior that proves recent rules.

No Election, This Time

Although the main opposition Liberal Party dramatically withdrew its support from the Conservatives, the New Democratic Party as well as the Bloc Quebecois, unexpectedly, stepped in to support the governing minority in a budget measure last week.

Parliament passed a ways and means motion that implements more of the Prime Minister Stephen Harper’s stimulus program and keeps him in power.

Liberal leader Michael Ignatieff claimed a sort of moral victory, saying it felt “right” for the “official opposition” to finally vote against the government.

“The question is,” suggested Ignatieff, “is this government good enough, yes or no?” Ignatieff will press on with his case that the answer is “no,” and will attempt to present Canada with a clear alternative. That task will only become more difficult as the roots of a nascent economic recovery, nurtured by the sitting government, take hold.

Although the NDP and the Bloc opposed Harper’s original CAD40 billion economic stimulus plan because “it didn’t go far enough,” the ways and means measure passed last week contained provisions that would benefit enough Canadians in need of help that the minor opposition parties realized the electoral calculus favored the status quo. In other words, whatever gains the Liberals would make in any fall 2009 election would come at their expense, not the Conservatives.

Recent polling suggests each party would likely return about the same number of members of Parliament as in the last two ballots, and Harper would remain at the head of a minority Conservative government.

Dear Prudence

During their fiscal third quarter (ended July 31) Canada’s Big Five once again demonstrated the value of conservative banking. The numbers announced in late August boosted Canadian banks’ reputation for prudent management during this severe economic downturn.

The Standard & Poor’s/TSX Composite Index gained 16 percent during the fiscal quarter ended July 31, bolstering trading fees and mutual fund sales for Canada’s banks. Provisions for loan losses were also significantly lighter than analysts’ forecasts. The bottom line: Bank of Montreal (TSX: BMO, NYSE: BMO), Bank of Nova Scotia (TSX: BNS, NYSE: BNS), Royal Bank of Canada (TSX: RY, NYSE: RY) and Toronto-Dominion Bank (TSX: TD, NYSE: TD) all exceeded expectations. Only Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) failed to meet forecasts.

Bank of Montreal led off by reporting a 6.9 percent increase in net earnings to CAD557 million (CAD0.97 per share), up from CAD521 million (CAD0.98 per share) a year earlier. Trading revenue surged on the equity market rally, interest income rose, and BMO set aside less money to cover bad loans. Two areas where BMO beat forecasts–net interest income and provisions for credit losses–bode well for future earnings.

Capital markets income grew 30 percent while net interest income rose 14 percent. As this month’s A Thousand Words feature details, Canadian banks’ foundation is traditional deposits, and BMO’s Canadian personal and commercial banking was solid again, with income up 13 percent. Net income from US operations fell 10.7 percent.

BMO set aside CAD417 million to cover bad loans, down from CAD484 million a year earlier, defying analysts’ expectations for an increase. Provisions for credit losses a year earlier included CAD247 million to cover two corporate accounts related to the US housing market. Management maintained the quarterly dividend at CAD0.70 a share.

Bank of Nova Scotia set a revenue record for the second consecutive quarter, as higher net interest income and strong trading boosted numbers. Domestic banking reported a record quarter–led by an increase in consumer deposits and asset-management fees–while net interest income was boosted by higher loan volumes and improved lending spreads. Increases in provisions for bad loans held back the results, though, and net income fell 7.8 percent to CAD931 million (CAD0.87 per share) from CAD1.01 billion (CAD0.98 a share) a year earlier.

Provisions for credit losses rose to CAD554 million from CAD159 million; though this figure more than tripled, it still came in below expectations.

Scotiabank said trading revenue more than doubled in the quarter to CAD514 million, a level management acknowledged was unsustainable.

Net income from Scotiabank’s international operation fell 6.9 percent to CAD312 million as the rise in the Canadian dollar ate away at the value of profits from abroad. The greatest deterioration in Scotiabank’s loan portfolio came from its international commercial lending, though results there still came in better-than-expected.

Bank of Nova Scotia left its dividend unchanged for the sixth straight quarter at CAD0.49 cents a share.

Royal Bank of Canada reported earnings surged 24 percent in the third quarter as a big jump in trading revenue offset higher loan-loss provisions. Net income was CAD1.56 billion (CAD1.05 a share), up from CAD1.26 billion (CAD0.92 a share) a year earlier.

Loan-loss provisions more than doubled to CAD770 million from CAD334 million a year ago but were down by CAD204 million quarter-over-quarter.

Royal Bank reported CAD1.6 billion in trading revenue in the quarter, more than 20 percent of total revenue of CAD7.8 billion. Earnings from its capital markets division were CAD562 million, more than doubling from year-earlier levels on stronger trading revenue.

Canadian banking division earnings fell 5.6 percent to CAD669 million, partly due to higher loan-loss provisions. Royal Bank’s international consumer banking, which includes Raleigh, North Carolina-based RBC Bank, lost CAD95 million, its fifth straight quarterly loss, on rising loan-loss provisions. Wealth-management earnings came in at CAD168 million, down 10 percent from a year earlier due to the market decline. Insurance earnings improved by 21 percent to CAD167 million as revenue from the segment soared 84 percent and premiums and deposits increased.

The dividend was unchanged at CAD0.50 a share.

Toronto-Dominion Bank reported fiscal third quarter net income of CAD912 million (CAD1.01 a share), down from CAD997 million (CAD1.21 a share) a year earlier but still well above analysts’ expectations.

Provisions for credit losses nearly doubled to CAD557 million, up from CAD288 million in the same quarter a year ago but down from the CAD656 million it set aside in the second quarter. Total quarterly revenue rose to CAD4.67 billion from CAD4.04 billion.

Canadian operations posted record profits of CAD677 million, up 5 percent from the year-earlier period. The boost came from strong volume growth in personal and commercial lending as well as cost-cutting. TD’s US operations earned CAD242 million, down 11 percent from a year earlier on higher loan losses. TD’s quarterly dividend will remain at CAD0.61 a share.

Canadian Imperial Bank of Commerce was alone among the Big Five in failing to meet expectations. The bank reported much higher loan losses and a fistful of writeoffs in the third quarter.

CIBC reported net income of CAD434 million (CAD1.02 a share), up from CAD71 million (CAD0.11 a share). Excluding all items, the bank earned CAD1.36 a share, but that was below consensus expectations of CAD1.39 a share.

CIBC said the largest one-time item this quarter was mark-to-market losses of CAD106 million (CAD0.27 a share) on credit derivatives in its corporate loan-loss hedging program. The bank said this had previously been a source of gains due to deteriorating credit conditions, but narrowing credit spreads have reduced those previous gains.

Loan-loss provisions rose to CAD547 million from CAD203 million a year earlier.

CIBC’s retail business posted revenue of CAD2.3 billion and net income of CAD416 million, while wholesale banking revenue and earnings came in at CAD572 million and CAD86 million, respectively.

Speaking Engagements

Roger Conrad is making the trip to the Great White North for The World MoneyShow Toronto, October 20-22 at the Metro Toronto Convention Centre.

Roger will, of course, discuss Canadian income trusts and high-yielding corporations as well as the utility universe. Click here to register and attend as his guest.

The Roundup

This week Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF) halved its distribution to a monthly rate of CAD0.054. The first payment at the reduced rate will be October 30 for shareholders of record September 30.

As I’ve reported previously in Canadian Edge, Consumers’ ability to maintain its prior distribution after Jan. 1, 2011 has depended for some time on the prospects for its Stratacon sub-metering business. These have been in doubt since March. That’s when the Ontario Energy Board (OEB) unexpectedly placed severe restrictions on sub-metering in the province, triggering losses and driving Consumers’ overall dividend payout ratio well over 100 percent.

On August 13 the OEB amended its initial decision, allowing Consumers’ to resume activity. There were new caveats, however. In the Ontario apartment market segment–half of Stratacon’s business–Stratacon is now required to gain tenants’ written permission to install and operate sub-meters. This requirement is retroactive, meaning Consumers’ must secure permission to keep existing customers, as well as to secure new business.

The upshot is the sub-metering business is still potentially very profitable. But it’s not going to generate anything close to the cash needed to cover a post-2011 dividend.

Moreover, Consumers’ is now paying higher interest costs as the result of purchasing Stratacon. It’s going to require substantially more upfront capital to grow that business. And Consumers’ core waterheater rental business has seen higher attrition rates, mandating more capital investment there as well.

The distribution cut will provide an additional CAD31.8 million annually, which should be more than enough to cover these cash needs. In fact, management stated in this week’s conference call that the new rate is “sustainable” after the new taxes kick in Jan. 1, 2011. And if it’s successful on the business side, future dividend increases are likely going forward, possibly as soon as 2011.

Consumers’ share price has ticked down a bit since the cut was announced this week. But its yield has been well over 20 percent for some time. That’s a pretty clear sign that the potential for a cut has been well baked into the share price.

The lower rate should hold going forward and the saved cash will protect Consumers’ from any future problems in the sub-metering business. On the other hand, given the drastic nature of this move, I want to see some positive numbers before giving the all clear and upgrading Consumers’ to a buy again.

The next benchmark will be third quarter earnings, which should be announced at the beginning of November. Until that time, those who own Consumers’ Waterheater Income Fund should continue to hold on and collect the still substantial dividend. Would-be buyers of this still steady business should await further developments.

The other key development in the CE Portfolio this week concerns Series S-1 Income Fund (TSX: SRC-U, OTC: SRIUF). The closed-end fund’s proposed merger with other Citadel group funds is still slated for a vote on September 30. Most investors and their brokers by now have been mailed proxies soliciting their vote.

My advice for the past several months has been to vote for the deal, which will create a larger closed-end fund with better economies of scale, and therefore presumably lower expenses per share.

Investors should also have been notified of a rival proposal from Blue Ribbon Fund Management, which has charged the Citadel merger will result in a fund with much higher expenses and potential conflicts of interest. And it has gained some support in the Canadian investment community.

The chief point of contention here, however, seems to be who will run the combined fund once the mergers are completed. In the final analysis, that matters a lot less to us than how the Canadian markets do.

And in any case, when you buy a fund, you’re relying on the management. Series S-1 Income’s current management has done a good job over the years. But if the post-merger management doesn’t, we’ll be swapping out for another fund.

That’s very different from buying individual trusts, which boils down to assessing the risk of a particular business. And it’s the main reason I prefer investors own individual trusts and high-yielding stocks rather than mutual funds in general.

But for those who prefer a fund, I intend to hold the new Series through the merger, as well as EnerVest Diversified Income Fund (TSX: EIT-U, OTC: ENDTF).