What a difference a couple years have made in the energy industry. Two years ago, before the crash of 2008, energy prices were at record levels and rising steeply. Producers were wildly profitable, and everyone wanted a piece of their action.

Energy services companies wanted to jack up fees for use of their drilling rigs and other equipment. Environmentalists on both sides of the border wanted steep new controls on development, particularly in the oil sands. Meanwhile, the government of Alberta proposed its “Our Fair Share” royalty scheme, designed to dramatically increase the province’s take of energy profits.

Today, production costs are falling steeply, as the cost of drilling equipment and services has plunged amid a massive supply glut. Calls to shut down the oil sands have been drowned out by cries to drill new previously untapped areas for oil and gas and fears that clamping down would drive the Alberta economy into ruin.

The threat of a cap-and-trade system to reduce carbon dioxide emissions has foundered on the rocks of economic reality, as politicians are increasingly unwilling to pass on anything that smacks of higher taxes with unemployment still lofty.

That same economic reality has shelved attempts to restrict the use of hydraulic fractionating, or “fracking,” to develop shale reserves. That’s the clear implication of the easy regulatory review given Exxon Mobil’s (NYSE: XOM) proposed blockbuster merger with shale gas producer XTO Energy (NYSE: XTO).

As for the Alberta royalty regime, regulators have moved into full retreat. Back in 2007, Premier Ed Stelmach was a driving force pushing for higher royalty payments from producers. The result was a mass exodus of development capital to other provinces, particularly British Columbia and Saskatchewan.

Now the same Stelmach is trying to get some of that development money back with a considerably more favorable royalty scheme, this one titled “Energizing Investment: A Framework to Improve Alberta’s Natural Gas and Conventional Oil Competitiveness.” Whether that will lure back investment dollars is another matter. But it will make life easier for producers already operating in the province to make a reasonable return.

As we noted in the March 16 Maple Leaf Memo, the new Stelmach plan basically rolls back his old one. As of Jan. 1, 2011, the top royalty rate on conventional oil wells goes back to 40 percent from 50, while the top rate on natural gas wells goes back to 36 percent from 50 percent.

The minimum royalty rate for conventional oil and natural gas wells will remain at 5 percent, while the current 5 percent first-year rate for new conventional oil and natural gas wells becomes permanent, rather than expiring Mar. 31, 2011. The government will announce new royalty curves by May 31 that promise to take the average company’s taxes lower still.

Other provisions include holding the sliding scale for oil sands royalties unchanged at its current preferential rate. These hold down royalty payments until the price of oil crosses certain set thresholds, with the highest rate not reached unless oil prices hit USD120 per barrel or higher.

With two-thirds of its production portfolio in Alberta, Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) greeted the proposed changes with a pledge to double capital spending in the province. More important to smaller players is likely to be how the province follows through on an oft-stated pledge to reduce over all regulatory burdens, particularly when it comes to approving the use of new technologies to unlock shale reserves and hitherto uneconomic reserves in older wells.

Producers and drillers in the Cardium light oil formation of the Pembina field are one area likely to benefit from that particular push. And we happily have several on our recommended list.

These are all encouraging developments for oil and gas production in Canada. Yet the major players continue to sell cheaply, particularly those involved mainly in producing natural gas. Low gas prices are one big reason. Another is lingering, misguided fears about approaching 2011 trust taxation.

Many investors remain mistakenly convinced that it represents some kind of doomsday. That’s despite the fact that, of the nine dividend-paying energy producer trusts that have announced conversions thus far, six haven’t cut dividends at all, a better ratio than the trust universe at large.

Cut-less converters include Baytex Energy Trust (TSX: BTE-U, NYSE: BTE)–which actually increased its distribution 50 percent following its conversion announcement–already converted Bonterra Oil & Gas (TSX: BNE, OTC: BNEFF) and Crescent Point Energy (TSX: CPG, OTC: CSCTF), Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF), Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) and Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF).

A seventh, Trilogy Energy Corp (TSX: TET, OTC: TETFF) cut its payout as little as it could afford, given its small size and exposure to weak natural gas prices. Only Advantage Oil & Gas (TSX: AAV, NYSE: AAV) and Bellatrix Exploration (TSX: BXE, OTC: BLLXF) actually eliminated their payouts, and they did so arguably by necessity, as plunging natural gas prices threatened their solvency.

To be sure, oil and gas producer trusts did slash distributions mightily in late 2008 and early 2009 in the face of falling natural gas and oil prices. That left them with extremely conservative payout ratios that have fallen further for many as oil prices have risen and production costs have tumbled.

But it’s increasingly clear that at least most trusts see themselves as retaining a separate identity as they convert to corporations. That is as dividend-paying entities with reliable cash flows, thanks to reliance on proven reserves with well-known geology.

Ultimately, these companies’ profits and the distributions they can pay are still largely determined by what happens to energy prices. But paying what they can is the only way income trusts have been able to compete for capital over the years with giants like EnCana Corp (TSX: ECA, NYSE: ECA) and the Super Oils. And it’s the only way they’ll be able to keep doing it as tax-paying corporations, either before or after Jan. 1, 2011.

In the near term, beating expectations for post-conversion dividends remains easy work. In fact, all that’s really been required is for trusts to provide guidance on what their post-conversion dividends will be. That guidance alone blows away years of uncertainly regarding 2011, and the result continues to be windfall gains for converting companies.

Picks and Pans

Even after rallying for a year, the picture for the Canadian energy producers in our How They Rate universe remains bullish. In fact, most of the companies and trusts continue to rate buys, or would at slightly lower prices. Nonetheless, there are considerable differences between the individual producers. One of the biggest is the degree of focus on producing natural gas versus liquids like oil and natural gas liquids.

Until the last couple years, it was assumed that natural gas was the fuel of the future, clean burning and plentiful in North America. In contrast, oil was considered the fuel of the past, with a growing percentage either imported from hostile nations or produced from non-conventional and environmentally hazardous methods such as oil sands.

Then came the explosion of production from shale gas reserves in the US, made economic by the development of horizontal drilling technology and the refinement of techniques like hydraulic fractionating. The result was a flood of new supply on the market that has still not been absorbed by demand. Instead, natural gas prices have plunged to multi-year lows and stayed there, despite massive shut-ins by producers from conventional sources. Particularly hard hit has been the activity in the Western Canada Sedimentary Basin.

As a result, trusts and other producers focused on natural gas output have had a very rough go. And, with prices still lagging this spring, the tough times may not be over yet.

In stark contrast, it’s the salad days again for oil producers. Not only has black gold continued to surge, pushing well into the USD80s per barrel in early April 2010 and increasing revenue. But with drillers experiencing record low capacity utilization, they’ve been able to ramp up output at relatively little cost.

The result has been surging cash flows for trusts-turned-corporations like Bonterra and Crescent Point. Bonterra lifted its dividend again last month by a generous 16.7 percent. It also announced that it had lifted its proven reserves per share by 8.7 percent over year-earlier levels. Other dividend-paying oil producers are likely to follow suit over the next several months, pushing their unit prices still higher.

A report this month by the US Dept of Energy (DoE) sent shockwaves through Wall Street by casting doubt on how DoE has been calculating natural gas supplies in recent years, with the implication that it had been over-estimating output. That provides a ray of hope that perhaps North America’s supply and demand for natural gas may not be quite as out of whack as it now appears.

Meanwhile, improving numbers in manufacturing have boosted expectations that industrial demand for gas as well as electricity produced from gas may be reviving as well. The latter especially will be critical to restoring gas demand to pre-2008 crash levels, which, in turn, is the key to any real resurgence in natural gas prices.

All these are possible bullish signs for the natural gas market and, by extension, for producers. It’s hard to argue, however, that the situation for gas is anywhere close to being as bullish as it is for oil. That’s because oil is a real global market with the fastest-growing markets for it in Asia. That’s a stark contrast to natural gas, which is still a regional market and is therefore still almost completely dependent on a recovery of demand in the US.

Sooner or later, that’s exactly what will happen. And natural gas focused producers will be the main beneficiaries. Until then, however, the easier road to gains by far will be with oil.

The need to be conservative has brought payout ratios and debt down sharply over the past year for producers of all stripes. Nonetheless, there are still sizeable differences between the individual companies and trusts.

How They Rate features one measure of debt, mainly as a percentage of total capital. Lower ratios generally indicate better capitalized companies. The ratio of net debt-to-annualized cash flow is a more conservative measurement. Again, lower ratios mean less encumbered companies.

Tax-advantaged trusts, by their nature, minimize earnings per share, as distributions paid to unitholders actually reduce taxable income. That’s why distributable cash flow–which adds back in non-cash expenses like depreciation and takes out non-cash gains such as increases in the value of price hedges–has always been the best measure of trusts’ profits. And it’s why distributable cash flow is the best denominator for payout ratios, rather than earnings per share, which are basically meaningless.

Tax accounting for converted corporations will be quite different in the details. However, the most important measure of these companies’ profitability and ability to pay dividends will still be distributable cash flow rather than earnings per share. Mainly, energy producers that are organized as corporations still have numerous ways to shelter income.

These include non-cash expenditures common to companies of all stripes, such as depreciation and amortization of goodwill. But there are also numerous non-cash deductions, many of which reduce prospective taxes dollar-for-dollar. Because these tax pools are always being replenished by development activity, the result is an effective tax rate far below the statutory level, which itself is slated to fall to 15 percent over the next several years.

Producers vary also vary widely on costs and the quality of reserves. Some, like Peyto, have exceptionally long reserve life and very low development and operating costs. That’s the result of an extensive inventory of lands and development opportunities, as well as expertise in the getting the most from properties. Other companies, in contrast, have relatively short reserve lives and higher costs. The former are steadier in all environments, the latter more leveraged to rising prices.

Canadian producers calculate reserve data on an annual basis using independent auditors to make assessments per government regulations. Peyto’s evaluation, for example, was conducted by Paddock Lindstrom and Associates, in compliance with National Instrument 51-101 and in accordance with the COGE (Canadian Oil and Gas Evaluation) Handbook.

A typical reserve report contains a wealth of information on the producing company, starting with information about the nature, quality and quantity of oil and gas reserves. Reserves are rated from Proved Producing, or “most likely to be brought to market,” to Probable, which have a projected chance of development of 60 percent or better.

The assessment is made on the projected economics, including costs and the market price of the finished product. As a result, a change in market price of has an impact on both the amount and value of reserves. Falling natural gas prices, for example, have made more expensive sources of the fuel less economic to development as well as less valuable. As a result, several gas-weighted producers saw the value of their reserves decline, despite making advances in actual development and drilling.

On the plus side, technological advances can trigger reclassifications of reserves from less to more likely to be developed. Peyto, for example, was able to apply horizontal drilling technology at 108 locations to add 245 billion cubic feet of Proved Plus Probable Additional Undeveloped Reserves. Approximately 75 percent of these are in the liquid rich Cardium formation, which stands to gain from the change in the Alberta royalty rules.

After an assessment is made of actual reserves, the tallies are then discounted at various scenarios to find their true worth, or net present value. Most assessments use at least three different discounting scenarios, 0, 5 and 10 percent. The higher the discount rate, the lower the net present value (NPV) and the lower the net asset value of the reserves.

Net asset value (NAV) is also affected by costs–Peyto replaced 79 percent of produced reserves in 2009 using less than a third of its operating income, the lowest cost in its industry–as well as the level of debt. Net asset value per share, in turn, is heavily influenced by how much equity a company has issued over the past year, though that’s not been a significant factor for income trusts due to restrictions on issuing share capital under the 2007 “Tax Fairness Act.”

Rating Producers

The Oil and Gas Reserve Life table is our comprehensive data bank for how How They Rate producers stack up on these counts, as well as dividend history and size, based on average daily production for the most recent reporting period.

With all tracked companies now reporting their reserve data for 2009 as well as full-year and fourth-quarter earnings, we have a pretty good assessment of where each stands as a business in this volatile environment.

“Cheap Energy” shows how each company stacks up in terms of net asset value, mainly as it relates to stock prices. I’ve run this table periodically to demonstrate how cheap many producers–particularly those focused on natural gas and/or are still organized as trusts–still are relative to their assets in the ground. And this time is absolutely no different.

Despite a strong rally since March 2009, Canadian producers are still selling on the cheap. The only real question is which companies are best suited for what type of investors. Some may be tempted to simply shop for the highest yields on the list.

That’s not a strategy I would necessarily advise. True, you’ll get a higher yield, at least initially. But companies out-yield their peers for a reason–mainly risk that could lead to share price-punishing dividend cuts.

Given what we’ve been through the past couple years and the fact that most producers really are hunkered down, I don’t see too much dividend risk, even in the energy producers yielding the most now. But consider this: Better times also mean that lower-yielding fare is more likely to grow distributions, which will also boost unit prices. That means buying higher-yielding, weaker companies may entail an opportunity cost.

Moreover, yields now are almost surely at low ebb. Not only have producers’ prices rallied strongly, but companies have been playing things close to the vest in light of weak gas prices and upcoming corporate conversions. Only oil producers have been pumping out robust increases. But that, too, will eventually change for the better.

As a result, yields alone are not a good gauge of value. Rather, the best measure is just to look at how companies are valued relative to the net asset value of their assets in the ground. The lower the price-to-NAV ratio is the cheaper are the producer’s shares.

There are plenty of reasons why one producer may be cheaper than another. Advantage Oil & Gas sells at less than half its NAV largely because it pays no dividend, still carries a high level of debt and is steeply leveraged to its Glacier natural gas play. Paramount is also cheap because of leverage to natural gas and hefty debt.

Meanwhile, it should come as no great surprise that Vermilion trades roughly 27 percent above the value of its NAV. The trust never cut its distribution during the 2008-09 meltdown, and it won’t when it converts to a corporation later this year. That’s the kind of value that tends to command a premium valuation, though I would argue the company is actually deeply undervalued as reserve assessments don’t take into account the company’s unique access to more profitable markets.

By and large, natural gas producers are still selling more cheaply relative to assets than oil-focused producers. That should come as no surprise, given the rally in oil and slump in gas. But investors should also keep in mind that oil-weighted NAVs are likely slightly undervalued, given the rise in oil since the beginning of year. Spot natural gas, meanwhile, has fallen from USD5.572 per million British thermal units (MMBtu) since the end of 2009 to just USD4.138. As a result, NAVs on gas-weighted producers may actually be overstated, based on current prices at least.

Many investors have asked me over the years if I favor oil over natural gas producers as long-term investments. But despite the obvious outperformance of oil-weighted fare over the past several years, I continue to prefer companies that maintain a balance of production between oil and gas.

That’s mainly because over time the advantages of one over the other will even out. There couldn’t be a clearer sign that the world’s greatest oil company, ExxonMobil, agrees with me than its bid for XTO Energy. Demand from China and India will keep oil in demand for years to come.

But at barely USD4 per MMBtu there’s a great deal more upside for gas. Nor is there a safer way to play the fuel switch than a company that also produces oil.

Here are the rest of my preferences for Canadian oil producer picks:

• Payout ratio of 60 percent or less and preferably down-trending;
• Debt maturities for the next two years no more than 10 percent of market capitalization; Debt to annualized cash flow of no more than 1.5-to-1 and debt to capital of 30 percent or less;
• Overall production of 50,000 barrels of oil equivalent per day or more, which indicates sufficient size and scale;
• Operating and FDA (finding, development and acquisition) costs below the industry average and down-trending;
• Reserve life of at least nine years based on proven reserves;
• Price-to-NAV no more than 1.3-to-1, preferably with a reason to believe NAV is understated.

Which companies come closest to matching these criteria? It’s still the seven that comprise the core producer group in the Aggressive Holdings: ARC Energy Trust (TSX: AET-U, OTC: AETUF), Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF), Enerplus Resources Fund (NYSE: ERF), 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).

I’ve added Daylight to the group to reflect its newfound production and reserve balance. The company’s acquisition of West Energy Ltd is a bold move made possible by the powerful rally in the trust’s shares over the past year to the point where they trade above NAV. Valued at CAD570 million, it will increase Daylight’s percentage of oil to 45 percent of overall output by adding key properties in the Cardium light oil region in the Pembina region of central Alberta.

The new properties, in management’s words, are “highly complementary” to existing assets and present abundant opportunities for new development as well. And they should further reduce Daylight’s exposure to volatile swings in natural gas prices. I’ve also added back Provident to the core group to reflect the company’s progress restructuring as a more conservative income-generating investment.

The only leveraged play on natural gas in the Portfolio is still High Yield of the Month Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF). That’s actually more a bet on management’s ability to continue innovating, however, as well as trust’s still very low price and elimination of 2011 corporate conversion risk.

Of my core group, Enerplus and Vermilion have also confirmed they’ll convert to corporations at the end of the year with no change to their current distributions. Peyto management, meanwhile, has indicated the same, barring a collapse in energy prices. As a result, there’s no longer any 2011 risk for unitholders.

ARC, Daylight and Penn West have stated they intend to convert, with Daylight making a move potentially as soon as next month. All have indicated they’ll pay dividends after conversion but haven’t confirmed what their payouts will be. Provident has only stated it’s undergoing a “strategic review” on what course it may take for 2011 and will inform unitholders when it reaches a course of action.

As I wrote last month, the history of converting trusts is an extremely bullish one. That’s even been true of cases when distributions are cut, as eliminating uncertainty about 2011 taxation has triggered relief and brought back the buyers. Moreover, with no-cut conversions outnumbering conversions with cuts by 9-to-1 last month, the tide is clearly running in the direction of higher dividends, which means more trusts will beat expectations and score market gains.

Despite the record of nearly 60 converting trusts, however, investors remain skeptical. That means trusts yet to announce concrete post-conversion policies still trade more cheaply than they would if investors were sure about what they’re going to do.

The bad news is that’s not going to change for these favorites until they do make their moves. The good news is the news is almost certain to beat what are very low expectations, which means we can look forward to some nice gains later in the year–and possibly as soon as May, when these companies will report first-quarter earnings.

In the meantime, it’s still a good time to buy them, despite the recovery gains they’ve run up over the past 12 months.

My best advice now is not to get too caught up in the speculation about corporate conversions and post-conversion dividends. Rather, focus on the underlying company and its ability to produce steady cash flows over the long haul with low-cost and balanced oil and gas output and conservative financial policies.

Sure, Penn West may indeed elect to cut its distribution when it converts, as so many have speculated. But even if it does, shareholders will still own a company that’s trading at just 80 percent of the value of its well-balanced reserves and with myriad opportunities for growth. And as we’ve seen with the nearly 60 conversions so far, buyers eventually come back, even to companies that cut their distributions deeply.

The best approach is to buy a basket of these trusts now and plan to hold past conversion. Should there be any dividend reductions, you’ll almost surely have the opportunity to sell at a higher price should you so desire. And you’ll be able to lock in shares of those that don’t cut at prices that are likely to be well below post-conversion trading ranges.

Here are buy targets for my Portfolio picks. For advice on other oil and gas trusts see How They Rate. Note that fourth-quarter and full-year earnings for ARC, Daylight, Enerplus, Penn West and Vermilion were highlighted in the March Portfolio Update. Paramount, Peyto and Provident have the floor this month.

Buy ARC Energy Trust (up to USD22), Daylight Resources Trust (USD11), Enerplus Resources Fund (USD25), Paramount Energy Trust (USD6), Penn West Energy Trust (USD22), Peyto Energy Trust (USD15), Provident Energy Trust (USD8) and Vermilion Energy Trust (USD33).

You may be tempted to pay above the buy target for some of these when they trade at higher prices. Don’t. Though I like all eight of these companies’ prospects, they do get bid up by the undiscriminating at times. Be patient and wait for your price. As the old saying goes, there’s always another train leaving the station.