Exactly one year ago, I penned an article urging readers to buy oil and gas producer trusts. My rationale was two-fold.

First, the late 2008 nosedive in oil and gas prices was overdone and was due to reverse. Second, producers–particularly those in the Aggressive Holdings–were dirt cheap, pricing in not just the then-current oil price of USD40 per barrel but something more like USD20.

Moreover, despite falling energy prices’ negative impact on cash flow, our picks were still rock-solid as businesses. Recovery was only a matter of time.As it turned out, the nine companies featured all had very good years, posting an average total return of 61.5 percent. Business conditions, however, were far from ideal for their operations.

Oil prices roughly doubled in 2009. Realized selling prices for oil in the first three quarters, however, were well below year-earlier levels. As a result, earnings comparisons for even oil-weighted producers were horrific. The good news for black gold is spot prices in the fourth quarter of 2009 averaged well above those of 2008.

That should translate into higher realized selling prices for producers and, coupled with a decline in costs, higher profits per barrel produced for oil-focused companies like Baytex Energy Trust (TSX: BTE-U, NYSE: BTE), Bonterra Energy Trust (TSX: BNE, OTC: BNEFF), Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), Crescent Point Energy (TSX: CPG, OTC: CSCTF) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF).

Baytex, Bonterra and Canadian Oil Sands, in fact, have already raised distributions at least once this year. Even 2011 taxation isn’t a real threat. Bonterra and Crescent Point converted to corporations without trimming distributions. Last month, Baytex announced it would convert at the end of 2010 and simultaneously raised its distribution by 50 percent, a level it expected would maintain a 50 percent payout ratio in 2010.

Vermilion continues to assure investors it expects a cut-less conversion later this year. And Canadian Oil Sands states its post-conversion dividends will be “similar to the distributions we have paid as a trust, reflecting changes in crude oil prices and economic conditions, and Syncrude operating performance and capital commitments.”

As I’ve written many times, energy prices–not the new taxes that begin in 2011–are the primary driver of oil and gas producers’ cash flows, and therefore what they can pay in distributions. And as a glance at “Enerplus and Oil” shows, producers’ share prices generally track energy prices over time as well.

Given the choice, management would obviously rather not pay the additional taxes imposed by Messrs Flaherty and Harper.

But compared to a USD10 per barrel swing in the price of oil or a USD1 change in natural gas prices, having to pay corporate taxes is merely a drop in the bucket.

That’s especially true when you consider the many non-cash expenses producing companies can book to avoid the new levies.

Unfortunately, natural gas prices didn’t perform nearly as well as oil in 2009. Thanks to a mighty rally of more than 140 percent since early September, gas prices finished the year roughly where they started it, a little less than USD6 per million British thermal units (MMBtu).

Along the way, however, they actually averaged around USD4. That meant realized selling prices were lower in every quarter versus year-earlier tallies; they’re set to lag again in the fourth quarter as well.

The result: steep declines in distributable cash flow for gas-focused trusts, resulting in dividend cuts across the board. Thus far, four gas-focused trusts have either completed or announced conversions to corporations: Advantage Oil & Gas (TSX: AAV, NYSE: AAV), Bellatrix Exploration (TSX: BXE, OTC: BLLXF), Progress Energy Resources (TSX: PRQ, OTC: PRQNF) and Trilogy Energy Trust (TSX: TET-U, OTC: TETFF).

In stark contrast to the generally cut-less oil-weighted converters, Advantage and Bellatrix (formerly True Energy Trust) completely eliminated their payouts. Progress cut its dividend by two thirds, from CAD0.10 per month to CAD0.10 per quarter. Damage was least at Trilogy, which cut its payout by 30 percent last month when it announced a conversion to take place following a scheduled February 4 vote.

Advantage, Bellatrix and Progress cited “growth” as their primary reason for sacking their payouts. And even Trilogy stated it would be able “to reinvest more cash flow into its business in order to capitalize on future growth opportunities.”

The reality, however, is that natural gas prices have sunk so low that cash flow has dried up, leaving these small producers with a stark and uncomfortable choice.

They could keep paying dividends and be forced to either cut back on operating activities or borrow to make up the difference until energy prices recover. Or, they could slash dividends, maintaining operations and keeping their balance sheets relatively healthy until energy prices recover.

In end, the only reasonable decision management could make was to cut or eliminate distributions. Early conversion to corporate form provided a ready-made rationale. But in truth, the cuts would have come even if there were no 2011 trust taxes. Crashing natural gas prices required it.

Interestingly, Trilogy’s conversion announcement also conveyed a desire “to provide long-term stability of distributions.” The company still plans to pay a monthly dividend and the new rate of 3.5 cents Canadian will provide the same after-tax yield to its core shareholder base, i.e. taxable accounts held by Canadian residents.

That suggests Trilogy is listening to the market, which has rewarded converting trusts that have beaten expectations on dividends with a lower cost of capital. Crescent Point, for example, is up 53 percent since just prior to its May 7, 2009, conversion announcement. That’s effectively cut its cost of equity capital in US dollar terms by nearly a third.

The result is a successful acquisition spree that’s seen Crescent’s annual output rise from a pre-conversion rate of less than 40,000 barrels of oil equivalent per day (boe/d) to an anticipated 56,500 boe/d in 2010.

That’s excluding the impact of future and highly likely acquisitions. And it’s far, far better than Crescent could have done by slashing its payout and relying on the savings to finance growth.

Clearly, Trilogy’s management made the decision that it wanted to be a lot more like Crescent than Advantage or Bellatrix. And other trusts that are yet to convert are more likely than ever to do the same.

What they’ll be capable of doing, however, depends squarely on what happens to energy prices in the coming months. And with gas and oil prices where they are now, the task of holding dividends steady after conversions will be far easier for trusts focused on oil than natural gas.

Gas or Oil?

So, does this mean we should set our sights only on the oil rich? My view is definitely not.

For one thing, the most durable dividend-payers in the producer universe are the larger fare that balance output between oil and gas, such as ARC Energy Trust (TSX: AET-U, OTC: AETUF) and Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF). Both have been hurt by lower natural gas prices, but recovering oil has kept their growth plans on track.

Enerplus, for example, plans to boost 2010 capital spending by 35 percent over 2009 levels to fund a major push in the Bakken and Marcellus shale regions. ARC, meanwhile, last month completed the acquisition of oil and gas assets at Ante Creek, Alberta. The deal, the trust’s largest in many months, lifted output by 2,000 boe/d and undeveloped land holdings by 20 percent. The CAD180 million cost was financed by CAD252 million equity offering completed at ARC’s highest unit price in more than a year, and which far exceeded the original projection of raising CAD200 million.

These are exceptional trusts that have shown immense fortitude under difficult conditions. Both trusts have pledged to remain big distribution payers after they convert to corporations, with amounts depending mainly on energy prices. And their use of low-cost capital today to lock down long-term production ensures they’ll be around for many more years.

ARC Energy Trust (up to USD20) and Enerplus Resources Fund Fund (up to USD25) are buys for those who haven’t already bought and locked them away.

Equally important, believe it or not, and despite its weak condition today, the future of natural gas in North America is actually much brighter than oil. That’s the obvious implication from the energy industry’s biggest blockbuster merger in recent years–ExxonMobil’s (NYSE: XOM) proposed USD41 billion purchase of XTO Energy (NYSE: XTO)–as well as the smaller USD2.25 billion investment by Total (NYSE: TOT) in Chesapeake Energy Corp (NYSE: CHK).

The greatest of the world’s Super Oils, ExxonMobil doesn’t make big moves very often. In fact, its last major one was buying Mobil over a decade ago.

The fact that it would spend its well-documented treasure hoard on a major producer of natural gas from non-conventional sources like shale–and pay a 25 percent premium to the pre-deal price–is an extraordinary admission that gas–not oil–is the future.

The deal has already attracted regulatory scrutiny and is likely to come with conditions as well. Moreover, it’s also set to focus attention on hydraulic fracturing, or “fracking,” the primary method of extracting natural gas from shale deposits. Fracking injects a mixture of water, chemicals and sand into the ground at extremely high pressure to fracture rocks, through which gas is extracted.

In 2005, fracking was exempted from the Safe Drinking Water Act by the Bush administration. As a result, there have been no real limitations on chemicals that can be used, and most drillers have refused to divulge what they use.

Fracking is used in 90 percent of US wells, so an outright ban is highly unlikely. What we’ll almost certainly see, however, is tighter regulation of the chemicals used in the process, which could drive up costs for some. ExxonMobil actually has an out in its merger agreement that can be triggered should federal environmental regulators force changes to XTO’s fracking process.

Natural gas used to generate electricity, heat homes or power vehicles, however, emits less than half the carbon dioxide (CO₂) of its chief rivals, coal and oil. That means rising demand in coming years, even if liquefied natural gas facilities aren’t revamped to enable exports as well as imports of LNG.

Dozens of electric utilities in North America, for example, have shelved plans to build coal facilities in favor of gas-fired plants, setting off a “dash for gas.” Some of these are being built to back up less reliable wind and solar energy, construction of which is turn is being required under mandates set by three dozen states. And if the federal government–either Congress or the Environmental Protection Agency–imposes new limits on CO₂, the action will only get crazier.

Whereas oil is a truly global market, natural gas is still mainly regional, with the vast majority used where it’s produced rather than exported as LNG. As long as that’s the case, the price of gas in North America will depend heavily on the weather, as well as the strength of demand from industry.

An expectedly cold winter in much of the country is the major reason why gas prices have recovered so ferociously since September. Nonetheless, natural gas inventories remain at high levels, exceeding the five-year average by 11.3 percent, according to a report issued January 7 by the US Dept of Energy (DoE).

That’s down from 14 percent the week earlier, but it still reflects the impact of a record 3.837 trillion cubic feet (tcf) of natural gas stockpiles at the end of November. In addition, current inventories stand at 3.123 tcf and will have to come down to 1.5 tcf by April to reach the historical average. That’s an awful lot of cold weather and is one reason prices remain constrained.

Growth of North American natural gas output has, of course, sharply contracted from mid-2008, when producers were fighting for rigs to get their output to market. Rig utilization in both the US and Canada is near record lows. Nonetheless, overall output is still rising as shale gas reserves become increasingly accessible.

What’s missing from the equation is industrial demand, which represents 29 percent of total US consumption in a typical year. Encouragingly, utilities have reported stabilizing demand for energy from their industrial customers over the past several months, and even sequential improvement from the first half of 2009. The most recent DoE report, however, pegged consumption by factories, steel mills and chemical plants as off by 9.8 percent from year-earlier levels.

Only a reversal of the negative trend in industrial demand will spark demand enough to soak up the supply glut and send prices higher. And that’s going to take an acceleration of economic growth from what we have now. Those interested in a more in-depth discussion of energy supply and demand factors should check out my colleague Elliott Gue’s sector advisory The Energy Strategist.

For our purposes as income investors, however, there are several implications from this big picture for natural gas.

One, gas demand is going to rise in coming years for reasons that are both cyclical (faster economic growth) and secular (greater adoption as a fuel). Two, the availability of natural gas in North America has never been greater, and there are still immense areas to explore, even if fracking must clean up its act. Three, supply is going to exceed demand until the economy stages a real recovery. In effect, natural gas prices will track the economy’s revival.

As far as natural gas producers are concerned, investors should not expect a return this year to the record realized selling prices that prevailed in mid-2008. That means cash flow and distributions are also unlikely to return to those levels over the next 12 months, possibly even longer.

On the other hand, to make money in natural gas producers our picks only have to beat expectations. And, despite a solid rally from some in recent weeks, there are still plenty of opportunities to do so, particularly when it comes to setting post-conversion dividends. Even Trilogy managed to rally following its distribution cut/conversion announcement, because a 30 percent haircut was better than most projected.

For all their troubles, natural gas-focused producers were the top performing trusts in 2009. Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), for example, surged 92 percent. That was more than twice the surge in Canadian Oil Sands Trust, despite the fact that Oil Sands increased its distribution twice while Peyto cut once.

The difference maker was Peyto’s results beat expectations by a wider margin. And that’s a trend still more likely to play out favorably for gas than oil-focused producers in 2010, even if a full recovery in gas prices takes longer than expected.

Targeting Success

A brief scan of the Oil and Gas section of How They Rate reveals pretty quickly that I’m bullish on Canadian energy producers for 2010. In fact, for the first time in the history of CE, I’m not currently recommending a “sell” for any companies I cover in this sector.

One reason is my generally positive outlook for crude and natural gas prices, coupled with generally low investor expectations for either operations or post-2010 distributions.

That’s a fact clearly demonstrated in the table “Cheap Gas” by the low price-to-book values and the fact that most sell at steep discounts to the value of their assets in the ground.

Low expectations combined with an improving macro environment are the best possible prescription for profits. And they’re why I’m currently rating even small, indebted weaklings like Enterra Energy Trust (TSX: ENT-U, NYSE: ENT) as holds, despite the fact that they don’t pay dividends.

All of the oil and gas producer trusts I track in How They Rate have one thing in common: They’ve survived some of the toughest conditions ever faced by any industry–from volatile costs and selling prices to regulation that virtually shut them off from capital markets–and have come out the other side in working condition.

That’s true even of the weakest fare. And it gives me tremendous confidence to recommend them, particularly my favorites, despite the fact that conditions in early 2010 are far from ideal.

On the other hand, you’re going to do a lot better by picking your spots in this sector. As the past few years have proven, some are much better able to take a punch than others. Although higher-quality operators don’t always score the biggest returns from quarter to quarter, they’re unmatched at building wealth.

ARC Energy, for example, has returned more than 128 percent over the past five years. That’s nearly three times the returns on the broad-based Toronto Stock Exchange. And it contrasts sharply with the 84 percent loss sustained by Enterra, the 51 percent nosedive by Bellatrix Exploration or, despite its 62 percent gain in 2009, Advantage Oil & Gas’ 23 percent setback.

Assessing the health of underlying businesses is how I pick the wheat from the chaff in any sector. The highlights of my research in the oil and gas producer sector are shown in the Oil and Gas Reserve Life table.

Item one is the payout ratio, which is the current distribution rate as a percentage of the last quarter’s distributable cash flow (DCF). DCF is basically the trust’s cash flow from selling its energy, less the cost of getting that energy to market. That’s to be distinguished from earnings per share, which include a range on non-cash expenses that shelter income from taxes but say nothing about a producer’s ability to fund its distribution.

Lower payout ratios are better than higher ones because they indicate more cash for capital spending and to absorb falling prices. The best news about third-quarter 2009 payout ratios shown in the table is they’re unlikely to go any higher, as they represent cash flow at low ebb for energy prices. Natural gas spot prices, for example, averaged well under USD4 per MMBtu during the summer months. Oil, meanwhile, spent most of the time under USD70 per barrel.

The trust’s dividend history has three data points. The left-hand number in the column shows the number of months since the last dividend action. The middle item shows whether the dividend was increased (up) or cut (down), or if it hasn’t been changed since the trust’s inception (none). The right-hand number shows the number of months since the last dividend cut.

I like to see a lot of months between dividend cuts, as it indicates management has done a good job of navigating tough markets. But again, the extremely volatile price action of 2008-09 have forced far more than the normal number of dividend cuts. Rather, the way to look at this is that dividend cuts are the norm. And companies that have avoided them–Crescent, Vermilion and Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF)–are all-stars.

The total debt-to-annual cash flow ratio measures of balance sheet strength. Debt has historically not been a big part of trust finance, mainly because before Halloween 2006 they could issue as much equity as they wanted and after that debt markets were already tightening up. Also, Canadian managers tend to be debt-averse.

Nonetheless, low energy prices have pushed down cash flows and therefore pushed up this ratio, with the third quarter again likely representing a high. Being able to earn more cash than total debt (ratio less than 1.0) in such an environment is an astounding feat and the true mark of a very strong balance sheet. Anything under 2.0 in this environment, however, is commendable and indicates a company able to take a very hard body blow and come out swinging.

The fourth column from the left shows the balance of output natural gas and liquids, mainly oil but also natural gas liquids whose price follows that or oil. I prefer balanced production portfolios, though gas-weighted plays likely have more upside potential in 2010.

Costs were an afterthought when oil and gas prices were surging. But they’ve taken on new importance after energy’s crash. The table presents two measures of costs: operating costs per barrel of oil equivalent (boe) and Finding, Development and Acquisition costs (FD&A) per boe.

The simple rule is the lower these costs, the better. Operating costs measure the cost per boe to get a company’s energy out of the ground. FD&A gauges what it cost a trust to replenish reserves per boe over the past year.

Unfortunately, these numbers are only updated once a year, and the last data we have are for 2008. That also goes for reserve life index (RLI), which basically divides a company’s proven reserves (90 percent or better chance of production) by its last 12 months’ production rate in boe. Unlike RLI, production rates are constantly updated to reflect output decisions, acquisitions and even weather conditions.

A higher RLI is generally better than a low one. But just because a company has an RLI of five years, for example, doesn’t mean it’s going to liquidate in five years. It just means it will have to work harder to find new sources to replenish reserves. In contrast to proven reserves, many companies quote their RLI in terms of “probable” reserves, which have only a 60 percent chance. But I prefer to take the more conservative approach.

It should also be pointed out that trusts and trusts that have converted to corporations have one huge advantage over the typical intermediate or junior exploration and production (E&P) company when it comes to generating reliable cash flows, and therefore paying dividends.

That’s the fact that they specialize in mature properties where geology is well-known. That gives them the ability to drill holes with 99 or even 100 percent assurance of what they’ll find. That means far more controllable costs and predictable output, which can in turn be hedged and the cash flows secured. The typical trust or ex-trust’s property is also centered on deep, long-life pools, again prolonging the sustainability of cash flow.

It’s this distinction that will enable trusts to pay large distributions even after they start paying taxes in 2011. The tradeoff is trust reserves generally don’t have the big strike potential that the typical E&P shoots for, including Super Oils. But again the predictability for output and costs is what assures cash flow to pay big and steady distributions.

In general, I like to see a reserve life of at least eight years for the trusts I recommend. Peyto Energy Trust, for example, has a 17-year reserve life, greater than ExxonMobil’s. It can literally continue to operate without doing any exploratory drilling for 16 years, a very valuable cushion in a volatile price environment.

Again, FD&A costs, reserves and reserve life are only calculated once a year, unless there’s a major acquisition. The figures in our table won’t reflect 2009 results probably until late February or early March, when the companies release the results of the independent auditors contracted to review what they have. I expect to see some erosion of RLI at most companies, reflecting lower capital spending, offset by generally lower costs, reflecting the lower energy price environment.

Perhaps the most important column now for these companies as we await fourth quarter numbers is the sixth from the left, or fourth from the right. That’s realized selling prices for oil and gas in the most recent quarter, in this case the third of 2009. As I’ve noted above, this is pretty much as bad as it gets. The extent to which each producer is able to beat these numbers in the fourth quarter will determine how much its distributable cash flow bounces back.

The figure for oil is on the left; that for gas is on the right. These prices are net of all hedging–i.e. measures taken to lock in selling prices ahead of time–and are priced in US dollars, which sets the global price for fossil fuels as well as most major commodities.

Some companies recorded substantially higher realized prices than the spot thanks to very conservative hedging strategies.

It’s important to remember that hedging is done on the forward curve, where prices are usually higher than the spot. As a result, a company can consistently sell above spot if management is willing to keep locking in. The tradeoff is if prices spike up, the loss on the hedges will offset at least some of the gain in commodity prices. But the result is smoother cash flows, which ultimately means more reliable dividends.

What to Buy

Over the past 18 months, producers’ realized selling prices for their energy have trended lower, particularly for natural gas. That’s forced management to save cash by sacrificing dividends in order to maintain production and avoid over-loading on debt.

The good news is this vicious cycle is mutating into a virtuous one where higher prices allow more capital spending, leading to higher cash flows and increased ability to pay distributions and cut debt. And the higher energy prices go over the next year, the more positive the outcome.

Oil- and even natural gas-producing companies aren’t as cheap as they were a year ago, or even last summer.

But they’re also still well below levels held very recently, and that means there’s still considerable upside for those who buy in now.

I’m reasonably positive on almost every oil and gas producer trust at this point. I remain most bullish, however, on those counted among the CE Portfolio Aggressive Holdings.

That group includes ARC Energy Trust (TSX: AET-U, OTC: AETUF), Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF), Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF), Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF), Penn West Energy Trust (TSX: PWT-U, NYSE: PWE), Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), Provident Energy Trust (TSX: PVE-U, NYSE: PVX) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF). All remain solid buys up to my recommended targets.

If any should happen to move above those levels, stick to the other picks. Information on the latest numbers from all of these companies can be found in the archive via the “Search” function on the website, or by simply scanning the Portfolio articles for the November and December issues where third-quarter earnings are analyzed.

Should we see a strong recovery in natural gas prices this year, Daylight, Paramount and Peyto would be the biggest beneficiaries. Paramount is the most aggressive, relying on gas for 100 percent of its output and still saddled with a large amount of debt. It’s also a potential takeover target for parent Paramount Resources (TSX: POU, OTC: PRMRF), owing to the connections of the Riddell family.

No one who isn’t willing to bet aggressively on natural gas–and accept the consequences if prices slump another couple of years–should buy in. But for those who can live with the risk, Paramount Energy Trust is a buy up to USD5.

Of the companies in the table “Cheap Gas,” ARC and Enerplus are the highest-percentage bets, thanks to scale, production balance, conservative finances, low costs and deep reserves. Daylight comes next, as conservative financial practices offset a much heavier reliance on gas. Peyto’s long reserve life and low costs back up management’s statement that it should be able to maintain its current distribution level after 2011, even in this price environment.

Advantage is a good way to buy into gas very cheaply, if you don’t mind the lack of a dividend. Progress Energy Resources’ (TSX: PRQ, OTC: PRQNF) gutting of its distribution last year makes it less attractive as well. But it does have a very promising portfolio of natural gas properties where output is growing rapidly.

Last but not least is EnCana Corp (TSX: ECA, NYSE: ECA), which has dramatically altered its profile by spinning off its oil production business. I highlight its prospects in this month’s Dividend Watch List.

Two other trusts worthy of comment–mainly because of the volume of reader questions I get on them–are Penn West and Provident. Both are large and stable companies that should do well as corporations.

Provident is shedding oil and gas production assets and adding to its collection of fee-generating midstream assets. As a result, its cash flows are becoming progressively more stable. Penn West has one of the richest collections of oil and gas reserves in North America and continues to trade well below their value.

Both trusts’ unit prices continue to suffer from investor skepticism, with the result that both are cheaper than their peers. That’s in large part because of intense uncertainty about how much in dividends they’ll pay as converted corporations. Penn West has repeatedly dropped hints, for example, that it will cut its distribution dramatically to devote operating cash flow for growth.

That’s a dubious strategy, at best, in light of the favorable treatment cut-less conversions like Crescent Point’s are receiving from investors. The good news is they’ve pushed expectations for post-conversion dividends so low that it won’t be difficult to beat them. Meanwhile, Penn West trades at a steep discount to the last estimate of what its reserves are worth.

That ensures a higher share price eventually, probably when the company clears up uncertainty about 2011. But I’m not a mind-reader, either, and there could still be a dividend cut here, which would require waiting out the selling for future gains. I rate Penn West Energy Trust a buy up to USD20 for those willing to live with that possibility.

As for Provident, the focus on midstream will ultimately make this a much safer dividend play. But with energy prices still on the low side and the company still in transition, another dividend cut is possible here as well. With that caveat, Provident Energy Trust is a buy up to USD7.

Whatever oil and gas companies you buy, make sure energy isn’t the only sector you’re invested in. Also, by all means diversify among several rather than bet the ranch on one. This is a group that’s cheap and has great promise for capital gains and dividend growth if energy prices rise half as much as I expect. But energy prices are volatile, and there’s still a lot of 2011 uncertainty out there.