Canadian oil sands player MEG Energy Corp (TSX: MEG) debuted on the Toronto Stock Exchange (TSX) in late July, the second initial public offering (IPO) of 2010 connected to the vast bitumen deposits located in remote regions of Alberta.

As we’ve often noted in this space, the oil sands generally represent an incredible opportunity for Canada as a whole and for investors, and there are many particular ways for individuals to allocate their capital these days. The Canadian dollar, because of the strong fundamentals supporting it, is an attractive currency for American investors. You can partake of the loonie’s upward flight against the buck–and you can lock in sustainable and high yields at the same time.

There is no way to mitigate away all risk, but you can establish a continuum, at least, that distinguishes between “bets” and “investments.” At one end of the Canadian oil sands story at the moment are MEG Energy and Athabasca Oil Sands (TSX: ATH, OTC: ATHOF). At the other are heavyweights such as Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), the biggest pure play, and Suncor Energy (TSX: SU, NYSE: SU).

Of the latecomers to the public market, MEG is a better proposition than, Athabasca Oil Sands, which listed on the TSX back in April. We like Suncor and Canadian Oil Sands, though Suncor is a bit beyond value range right now. The best bet remains longtime Canadian Edge Portfolio Holding Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF).

The MEG story includes many of the elements that make the broader case for Canada particularly compelling: a major piece of a key asset, the Canadian oil sands, and the 170.4 billion barrels of recoverable crude that distinguish Canada from the rest of the developed world; heavy participation by serious North American institutional players; and China.

The first investment by a Chinese government sponsored entity in a Canadian company was made by CNOOC Ltd (NYSE: CEO), one of China’s fleet of state-backed companies that’s staking claims, particularly on resource assets, all over the globe. The Middle Kingdom’s thirst for oil first led CNOOC to pay CAD150 million for 16.7 percent of then-private MEG Energy. CNOOC now owns 15.8 percent, as more capital has flowed into MEG over the last half-decade and diluted its stake.

When finally priced the IPO came in well below MEG’s original target of more than CAD1 billion. We’re not in the long-distance mind-reading game, but it’s safe to say the Athabasca Oil Sands experience colored investors’ view of this latest offering. Athabasca came to market in a much-ballyhooed deal but fell more than 33 percent during the 30 days following its IPO, the second-worst first month of any stock to debut on the Toronto Stock Exchange over the last five years. (Athabasca is in white in the graph below, Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF) is orange, the S&P/Toronto Stock Exchange Energy Index is yellow and the front-month crude oil futures contract is green.)

Source: Bloomberg

“Too many people with a 10-minute time horizon bought a 10-year story, and when it didn’t jump out of the gate for them to make their profits, they turned around and started selling. And selling begets more selling,” explained Kevin Sullivan, CEO of GMP Capital (TSX: GMP, OTC: GMPXF), which co-sponsored the offering along with Morgan Stanley. One could argue, however, that going public with no track record of production is a little shortsighted, too. Whatever, Athabasca’s shortcomings right now, another Chinese entity, PetroChina (NYSE: PTR), dumped CAD1.9 billion into a joint venture with the company before the IPO.

At midway through its 10th trading day MEG had shed 7 percent from its CAD35 per share public open. What separates MEG from Athabasca Oil Sands is its track record; as in, MEG has one. It reported average production of 26,000 bbl/d for the second quarter, achieving that rate one year after commencing operations at its two commercial facilities.

MEG Energy owns 100 percent working interests in more than 800 sections of oil sands leases; as of Dec. 31, 2009, according to evaluations of certain of these assets by independent oil and gas engineering firm GLJ Petroleum Consultants Ltd, MEG’s lands hold 1.7 billion barrels of proved plus probable bitumen reserves and as much as 3.7 billion barrels of contingent bitumen resources. The company is currently running two commercial steam assisted gravity drainage (SAGD) extraction operations, one at Christina Lake, the other at Surmont. GLJ’s analysis suggests these two projects “will support 260,000 bbl/d of sustained bitumen production for over 30 years.”

For reference sake, Suncor reported year-to-date average oil sands output of 260,000 bbl/d through July. (The monthly rate for July, 322,000 bbl/d, indicates Suncor could approximate its 280,000 bbl/d target for 2010.) The Syncrude consortium, which includes Suncor and features Canadian Oil Sands Trust, reported second-quarter average production of 324,000 bbl/d, with an ultimate goal of achieving design capacity of 350,000 bbl/d.

MEG Energy is a better proposition simply because in the high-cost environment that is oil sands production a track record of any length certainly beats no output. Heavy Chinese interest is further indication that the Middle Kingdom–and Asia generally–will drive oil consumption during the next decade. Demand from these new economic powers mitigated the declines in consumption in the developed world from 2007 to 2009 and set the table for a new era of permanently high, relative to old norms, crude prices.

And from an income investing perspective, a dividend of any kind beats no payout. Getting paid on a regular basis, even a little bit, builds a cushion for investors. Dividends smooth market volatility and contribute mightily to total return over the long term, and the regimen of cutting checks to investors establishes a discipline for management that prevents misguided expenditures. Canadian Oil Sands’ quarterly distribution validates the company’s business proposition by putting something in your brokerage account every quarter, even if all it does is offset some of a capital loss. Every little bit counts.

A side note about dividends, with a segue into another on measuring safety: Only those Canada-based companies traded on a major exchange such as the New York Stock Exchange (NYSE) or the Nasdaq allow permitted by US securities laws to allow reinvestment participation for American investors. You can’t automatically put these dividends back to work, but you can sweep the cash into your account and enforce your own “discipline-plus:” Use limit orders to put that money back to work at a level of your choosing, preferably set according the value-based buy targets listed in the Canadian Edge Portfolio and How They Rate tables.

In those tables you’ll also find a CE Safety Rating for each company, an index based on seven criteria directly impacting dividend sustainability; a high Safety Rating doesn’t always mean “buy,” nor does a low Rating imply “sell.”

The relative risk reflected in a company’s Safety Rating may or may not be priced into its stock. A perfect “7” (seven-for-seven on the Safety Rating criteria) may be overpriced. Likewise, though rarely, a company hitting two or even just one benchmark can still merit a “buy” in the advice column. Some things are cheap for good reasons, others because they suffer for short-term or easily correctible flaws. You can lock in a compelling yield when the market overreacts to perceived risk, and you can overpay and crimp your long-term wealth-building, too. We like to lock in safety at value-based buy targets.

Pembina Pipeline Income Fund, about as secure and sound a dividend-payer as there is, according to the CE Safety Rating System, holds an exclusive contract to transport production from the Syncrude consortium to terminals in Edmonton, Alberta. Pembina Pipeline’s cash flow is based on throughput; its fee-for-service revenue is not directly tied to the price of crude oil.

In the graph below, Pembina Pipeline is represented by the white line, Canadian Oil Sands by the orange, the S&P/Toronto Stock Exchange Energy Index by the yellow and the front-month crude oil futures contract the green. As you can plainly see, Pembina Pipeline has far outperformed over the trailing year.

Source: Bloomberg

It’s important to consider as well the distinction between the US and Canadian recessions and what it means for American investors looking to maximize returns over the next decade. The US is digging itself out of a balance-sheet recession; there’s no easy way to get rid of debt except to pay it back, and that requires more savings and less spending. Recovering from this mess will be a long, slow grind. (Imagine: Fifteen years ago John Fund, writing in The Wall Street Journal, described Canada as an honorary member of the Third World because of its exorbitant public debt. Perhaps the path of austerity championed by so many will have such an outcome as that in the Great White North.)

Canada’s recession was caused by a sudden deterioration in its terms of trade caused by a collapse in commodity prices. When commodity prices rebounded so did Canada’s terms of trade and so did its economy. New demand from emerging markets has replaced demand destroyed in the US (and other major developed economies) during the downturn. This trend toward new engines of global economic growth actually evidenced itself before 2007; the collapse of 2008-09 only accelerated the process. Canada has already narrowed its output gap–the difference between potential GDP and actual GDP–by half in its recovery phase.

The Bank of Canada (BoC) has lifted interest rates twice and is on track to push its target rate above 1 percent by mid-2011, when the Canadian federal government’s stimulus measures will have wound up. Should soft employment numbers and slackening trade terms threaten overall growth during the latter half of 2011 the BoC will have room to trim its target overnight interest rate.

These are all consequences of Canada’s relative discipline during the Roaring 2000s. Canada didn’t underpin home ownership growth with dodgy subprime loans. Public debt–after more than a decade of spending cuts at the federal and provincial levels–came down from near 70 percent of GDP in 1995 to below 30 percent before the global crisis forced officials to compensate for lost private demand in the short term.  

Once again, the relative ease of Canada’s path is set in stark contrast to what stands before US policymakers. Canada’s federal government will let its fiscal stimulus package expire on schedule in the first quarter of 2011. The BoC and monetary policy will then be left to provide any counter-cyclical propping of the economy. In other words, Canada will handle what was for it a better-than-ordinary recession with ordinary responses. Still, Canada’s debt-to-GDP ratio is projected to peak below 40 percent before resuming its long-term downward trend.

This, along with the hard asset that is the Canadian oil sands, is bullish for the Canadian dollar. For the latest and best word on how to play the Canadian oil sands and gain exposure to the best economic story on the planet, consult Canadian Edge.

The Roundup

Conservative Holdings Atlantic Power Corp (TSX: ATP, OTC: ATLIF), Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF), Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF) and Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF) and Aggressive Holding Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) released second-quarter results after Friday’s release of the August issue of Canadian Edge.

The numbers–all solid, all supportive of long-term, wealth-building dividends–are reviewed in Tuesday’s Flash Alert. We’ll have another Flash Alert on Friday covering the rest of the Portfolio.

Following are more second-quarter highlights–on top of the look we gave in the August Canadian Currents–from the How They Rate coverage universe. We’ll have a last look at results in next week’s MLM.

Oil and Gas

Cenovus Energy (TSX: CVE, NYSE: CVE) CEO Brian Ferguson was satisfied with his company’s operational performance during the second quarter and was optimistic about the progress made on achieving long-term goals such as producing 300,000 barrels  a day (bbl/d) of oil sands production by 2019, a five-fold increase from current levels. He was up front as well as with his concern about a decline in reported cash flow from CAD945 million to CAD537 million, or about CAD0.71 per share.

About of the decline is traceable to a 38 percent drop in realized natural gas prices, while the other half is the impact of volatile crude prices on Cenovus’ downstream operating cash flow and the first in, first out accounting required by Canadian Generally Accepted Accounting Principles (GAAP). “The things we control,” said Ferguson during a conference call to discuss the second quarter, “such as production, operating and capital costs are doing very well.”

Cenovus reported second-quarter net income of CAD172 million (CAD0.23 per share), up from CAD160 million (CAD0.21 per share) a year ago, as revenue rose to CAD3.32 billion from CAD2.87 billion. Operating earnings dropped to CAD142 million from CAD512 million a year ago, reflecting the falloff in cash flow.

Second-quarter production from the Foster Creek and Christina Lake oil sands projects, which employ the in situ steam-assisted gravity drainage (SAGD) extraction method, increased 42 percent to about 59,000 bbl/d. Total output is ahead of forecast, and year-to-date operating and capital expenditures are below estimate. Cenovus Energy, with solid growth prospects and a 2.8 percent yield, is a buy up to USD30.

Talisman Energy (TSX: TLM, NYSE: TLM) reported better-than-expected second-quarter 2010 results, helped by higher commodity prices. Earnings per share (EPS) from continuing operations was CAD0.13 per share, beating consensus estimates but roughly in line with the year-ago figure. Revenue was CAD1.6 billion, up 5 percent from the second quarter of 2009. Cash flow from continuing operations was CAD771 million.

Total production was down approximately 3.1 percent to 411,000 barrels of oil equivalent per day (boe/d) on planned maintenance shutdowns in the North Sea. Oil and liquids production was down 14.3 percent to 181,907 bbl/d; this segment accounted for 44 percent of total production. Second-quarter natural gas volume was up 8.3 percent to 1.4 billion cubic feet per day (bcf/d).  Realized prices were up 10.3 percent from the year-ago quarter to CAD52.81 per barrel of oil equivalent (boe), reflecting rebounding oil prices.

Talisman has been selling assets in an effort to rationalize its asset base around opportunities in North America, the North Sea and Southeast Asia, a program that’s generated CAD1.5 billion in 2010. The goal for the remainder of the year is to reach CAD1.9 billion; this cash, in addition to helping shape up the balance sheet, will be used to fund organic growth.

Management projected overall capital spending of CAD4.6 billion for 2010 and maintained production guidance of 400,000 boe/d. Talisman Energy is a buy up to USD20.

Electric Power

TransAlta Corp (TSX: TA, NYSE: TAC) reported comparable EPS of CAD0.10, reversing a CAD0.03 per share loss during the second quarter of 2009. Higher production coupled and lower costs paved the way for a turnaround. Generation gross margins also benefited from improving market conditions. Energy trading gross margins and an extended unplanned outage at a key plant held results down. Revenue declined to CAD582 million from CAD585 million.

Cash flow from operations for the quarter was CAD98 million, up from CAD57 million a year ago. Management expects to see CAD800 million to CAD900 million in cash flow for the full year. Funds from operations (FFO) was CAD184 million, up from CAD94 million a year earlier. Fleet availability for the second quarter declined to 81.9 percent compared to 82.8 percent in the second quarter of 2009 due to higher planned and unplanned outages. For the year, TransAlta expects total fleet availability to be in the range of 89 to 90 percent compared to 85.1 percent in 2009. TransAlta Corp is a buy up to USD22.

Real Estate Trusts

Calloway REIT’s (TSX: CWT-U, OTC: CWYUF) portfolio occupancy rose to 99.1 percent from 98.6 percent a year ago, and it renewed 90 percent of expiring leases at an average rent increase of 8 percent. FFO was CAD43 million, up from CAD40.4 million in the second quarter of 2009. FFO per unit was CAD0.421 compared to CAD0.424 a year ago. A quarterly distribution of CAD0.387 per unit translated to a payout ratio based on FFO of 91.9 percent, up from 91.3 percent in 2009.

As things stand, Calloway doesn’t qualify for the REIT exemption to the specified investment flow-through (SIFT) tax brought to life by the Tax Fairness Plan and will be subject to it as of 2011. According to its second-quarter Management Discussion & Analysis (MD&A), “It is Calloway’s current intention to restructure its business affairs and/or discontinue certain of its activities, if necessary, by January 1, 2011, in order to qualify for the REIT Exemption.” We will be monitoring Calloway’s negotiations on these matters closely. In the meantime, Calloway REIT is a buy up to USD20.

Canadian REIT (TSX: REF-U, OTC: CRXIF) second-quarter FFO rose to CAD39.7 million (CAD0.60 per unit) from CAD37.7 million (CAD0.57 per unit) a year ago. The payout ratio came down from 60 percent to 58 percent.

The REIT continued its active growth-by-acquisition campaign during the quarter and plans to follow up with more high-quality asset additions in the third quarter. A strong balance sheet, significant liquidity and ample cash flow from operations suggest Canadian REIT will continue to execute.

Total portfolio occupancy–covering the REIT’s industrial, retail and office properties–declined to 94.6 percent from 96.4 percent year over year.

Canadian REIT is reorganizing its structure and some operations to make sure it qualifies for the REIT exemption from SIFT taxation; it’s awaiting a ruling from the Canada Revenue Agency in this regard. Management plans to make the necessary changes before Jan. 1, 2011. Canadian REIT is a buy up to USD25.

Dundee REIT (TSX: D-U, OTC: DRETF) reported a 46 percent rise in FFO on higher portfolio occupancy and the impact of acquisitions.

Second-quarter FFO was CAD25.1 million (CAD0.69 per unit), compared with CAD17.1 million (CAD0.82 per unit) a year ago. Units outstanding has climbed in the intervening 12 months from 20.8 million to 39.7 million, as Dundee raised equity capital to complete CAD528 million of acquisitions in 2010 alone. The payout ratio for the period was 79.7 percent, up from 67 percent a year ago. Portfolio occupancy was 96.6 percent as at June 30, up from 94.2 percent a year ago.

Dundee REIT, on track to qualify for the REIT exemption to the SIFT tax, is a buy up to USD23.

Primaris Retail REIT (TSX: PMZ-U, OTC: PMZFF) generated second-quarter FFO of CAD23.2 million (CAD0.351 per unit), up from CAD21.1 million (CAD0.337 per unit) from a year ago. Acquisitions made in 2009 and organic improvement contributed to the gain. The payout ratio for the period was 86.9 percent, down from 90.3 percent a year ago.

Net operating income (NOI) was CAD44.4 million, up CAD6.7 million from CAD37.7 million in the second quarter of 2009. Same-property NOI was up 1.5 percent.

Primaris renewed or leased 312,512 square feet of space during the second quarter at a weighted average rent increase of 5.9 percent. Portfolio occupancy of 96.6 percent on June 30 was basically consistent with the 96.7 percent on March 31 and 96.4 percent at the end of the second quarter of 2009. Primaris Retail REIT is a hold.

Natural Resources

Barrick Gold (TSX: ABX, NYSE: ABX) reported a 59 percent jump in second-quarter net income to CAD783 million (CAD0.79 per share from CAD492 million (CAD0.56 per share) a year ago. Revenue was CAD2.64 billion, up from CAD1.96 billion in the second quarter of 2009.

Management also announced a 20 percent dividend increase. Barrick Gold is a buy up to USD45.

First Quantum Minerals (TSX: FM, OTC: FQVLF) reported a decline in second-quarter copper production because legal problems in the Democratic Republic of Congo (DRC) have forced the company to limit investment at its Frontier mine in the country, which only exacerbates similar difficulties stemming from the Kolwezi project. First Quantum is still mining at Frontier because authorities haven’t yet shut down the mine, however management has cut spending because of the uncertainty.

Copper production in the quarter fell 7.7 percent to 85,400 tonnes, while first half output declined to 170,464 tonnes from 181,926 tonnes a year ago. Gold output rose to 96,113 ounces from 87,252. Management lowered its 2010 copper production forecast by 6.5 percent to 360,000 tonnes. The company recorded a net loss of CAD442 million for the six months ended June 30; a year ago First Quantum posted net income of CAD112.4 million. The second-quarter net loss total CAD588.2 million, compared with net earnings of CAD101.5 million a year ago, a consequence of the trouble in the DRC.

Management expects arbitration with the DRC government over the rights to the Kolwezi could take years to resolve. During a conference call to discuss second-quarter results CEO Clive Newall said that there would be a hearing in September as to how the arbitration would proceed, but that investors shouldn’t expect a “a nice, clear-cut outcome in the next few months.”
The DRC government revoked First Quantum’s license for the Kolwezi mine in August last year, and this month put the operation under liquidation. First Quantum Minerals remains a hold.

Potash Corp of Saskatchewan (TSX: POT, NYSE: POT) recorded second-quarter EPS of CAD1.55, up from CAD0.61 a year ago. Excluding one-time items earnings were CAD1.38 per share. Revenue surged 70 percent to CAD1.44 billion, as a four-fold rise in sales volumes offset lower prices for the crop nutrient.

Potash Corp expects third-quarter EPS of CAD0.80 to CAD1.20 per share, and management forecast a 10 percent rise in global potash demand to 55 million tonnes for 2011.

The company sold 1.9 million tonnes of potash in the quarter, up from about 400,000 tonnes a year earlier. Increased demand boosted operating rates and helped reduce its cost per tonne of production.

Although the company raised its 2010 earnings forecast, it tightened its potash sales volumes outlook and lowered its potash gross margin forecast for the year. Despite its caution, Potash Corp expects a strong fertilizer application season this fall, with an anticipated early harvest in many parts of the US. Potash Corp of Saskatchewan, riding the ever-present and rising demand for improved food production, is a buy up to USD100.