Natural gas prices are still languishing near their lowest levels since 2002. Nonetheless, there’s still plenty of money to be made on volume these days, if management has the right properties and execution.

That’s the clear lesson from ARC Energy Trust’s (TSX: AET-U, OTC: AETUF) robust third-quarter earnings, as the company rode a 43 percent boost in natural gas output to a 17 percent increase in cash flow per share. Those results were so favorable management announced both a cut-less conversion to a corporation on Jan. 1, as well a CAD625 million capital budget to spur another 24 percent jump in production by the end of 2011.

Daylight Energy (TSX: DAY, OTC: DAYYF) posted a 79 percent increase in its third-quarter output of oil and gas. That spurred a 35 percent jump in funds from operations for the company, which converted to a corporation earlier this year. Management’s chief target: production of light oil and natural gas liquids, which soared 162 percent from year earlier levels.

More than a few yield-focused investors abandoned Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) when the company cut its distribution in advance of a Jan. 1 conversion to a corporation.

Anyone interested in growth, however, will find little to dislike in its CAD1 billion to CAD1.2 billion capital spending plans for 2011, which is strongly focused on the company’s extensive reserves of increasingly valuable light oil.

At a time when most rivals are struggling just to stay in business, driller Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF) nearly quadrupled its distributable cash flow on a 121 percent jump in revenue. Its secret: exclusive focus on horizontal drilling employed in drilling shale oil and gas, which is where all energy patch activity is now.

Finally, Newalta Corp (TSX: NAL, OTC: NWLTF) came in with a 19 percent jump in revenue, a 21 percent increase in net margin and a 12 percent boost in cash flow. Again, the reason is management’s strategy of focusing environmental cleanup and recycling operations where the action is, both in the energy patch and elsewhere in industrial Canada. And CAD56 million in “growth capital expenditures” assures it will be there in 2011 as well.

The key for all of these companies’ success: output. At a time when even oil prices are still 40 percent off their pre-2008 crash highs–and gas is less than a third its high–these energy producers, drillers and even infrastructure companies have returned to growth by focusing on production.

For producers, higher volume means improved economies of scale, which, in turn, drives down costs. And with shale reserves opening up across North America thanks to technological advance, conventional production areas that once seemed dead are coming back to life–providing unprecedented opportunities to boost output further still.

For service companies like Phoenix Technology, these are ideal times to showcase their prowess getting at those reserves as never before. Rig rates are still well below where they were just a few years ago. But, as with the producers, they’re enjoying record volume. Energy prices are still depressed, but business is good.

As in the US, the lowest-risk plays on energy’s quantum shift to shale are the owners and operators of infrastructure, such as pipelines, storage facilities, gathering facilities and processing centers.

These assets earn fees as producers use them, some on capacity basis, ensuring revenue even if they’re not used. And just as in the US, they’re in critical shortage in Canada’s shale rich areas, meaning infrastructure companies can literally lock in all the customers they need before they turn a shovelful of earth.

Portfolio Update highlights third-quarter results of several of my energy infrastructure favorites, including AltaGas Ltd (TSX: ALA, OTCL ATGFF), Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF) and Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF). All turned in solid numbers and, more important, reported strong progress with asset additions–both through acquisitions and by construction–that will lift future cash flows.

AltaGas and Pembina Pipeline have already converted to corporations and are paying taxes, while Keyera plans its own cut-less conversion for Jan. 1. That means no 2011 risk and considerable potential for dividend growth the next few years as the new assets start generating cash flows. All three are buys up to prices listed in the Portfolio table.

Below I highlight the best higher-octane plays on the trend–i.e. producers, drillers and service companies–that are wired into the rising output bonanza. I also take a look at what’s going on with Perpetual Energy (TSX: PMT, OTC: PMGYF), by far my most aggressive bet on energy.

Pumping Profits at Low Prices

Rock-bottom natural gas prices, juxtaposed with recovering oil and suddenly compelling natural gas liquids: That’s the state of affairs in the North American energy industry now.

Oil prices have benefitted the past couple years from the continued growth of developing world demand, which has offset weakness in North America. In contrast, the market for natural gas is still largely a local one, and that market remains severely depressed.

The US does have considerable capacity to import liquefied natural gas (LNG), thanks to a wave of investment that resulted from spiking gas prices in the mid-’00s. Then along came the shale gas revolution, which drove up domestic supply and took down prices below where LNG was economic. As a result, LNG import capacity mostly lies fallow, while regulatory and financial hurdles inhibit the huge investment needed to make facilities two-way–capable of exporting America’s shale gas riches.

LNG is, of course, a fabulous business elsewhere in the world. Massive projects to ramp up exports from Australia to China are well underway. And LNG remains a key alternative source for Europeans who are now heavily dependent on Russian supplies. Until the US can start exporting, however, shale gas will only be sold here, and the market will remain profoundly local.

That’s not a bad thing in normal times, when industry is humming. And there’s plenty of reason to expect robust demand growth for natural gas in coming years, from electric utilities’ need to build non-coal baseload power generating capacity to potential for a trucking fleet conversion to natural gas.

These major transitions are going to take time. And while industrial demand has been reviving in recent quarters, it’s still well below pre-2008 crash levels. That means all the bulls can really hope for is periodic price spikes due to weather-related demand for the fuel that temporarily depletes reserves.

Happily, as third-quarter numbers are demonstrating, companies with rising production don’t need a spike in prices to stay healthy or pay dividends. They’ll do better when gas does recover.

But in the meantime, they’re cheap and solid–the very definition of a good investment. And despite converting to corporations and taking on additional taxes, they still boast some of the best yields in energy.

Last month Canadian giant EnCana Corp (TSX: ECA, NYSE: ECA) made headlines by announcing it would trim capital spending in response to low gas prices. Less noticed, however, was how its numbers affirmed the merits of an output-led strategy for gas, even in the current pricing environment.

For one thing, the much ballyhooed reduction in capital spending was CAD200 million–a big deal for a smaller company but a drop in the bucket for EnCana, which still has a budget of CAD4.8 billion. Similarly, the company’s production cutback was from 3.365 billion cubic feet a day (Bcf/d) to 3.315 Bcf/d. That’s a big cutback for a smaller company, but hardly a catastrophe for EnCana. Even the reduction in expected 2010 cash flow was only a lowering of the upward limit of the range–i.e. from CAD5.95 to CAD6.50 to CAD5.95 to CAD6.20.

The move did send EnCana shares down hard initially. That’s to be expected in a market that’s still so overwrought. The stock, however, has since made up virtually all of that ground. More important, the company still expects production growth of 12 percent this year and continues to spend to develop reserves.

I’m still bullish on EnCana as a long-run bet on natural gas. The real value, however, lies in smaller companies that have adopted similar strategies, particularly income trusts that have either already converted to corporations or will do so by Jan. 1.

One of these is ARC Energy Trust. The company has big plans for production and, as third-quarter earnings demonstrate clearly, it’s systematically executing them.

That increased scale is slowly and surely bringing the company’s costs lower, and management expects a much bigger impact as fast-growing shale gas becomes a larger percentage of output.

Current numbers don’t look bad, either, with the third-quarter payout ratio falling to just 48 percent. Remarkably, ARC achieved that while selling its natural gas (60 percent of output) at an average realized price of just USD3.79 per thousand cubic foot. One reason: Much of its gas is rich in liquids.

ARC boosted its third quarter natural gas liquids (NGL) output by 26 percent in the quarter, while simultaneously realizing a 26 boost in realized selling prices. NGLs are substitutes for oil in many processes and products. Consequently, they tend to follow oil prices, though at a discount. As a result companies like ARC can actually in a pinch produce ordinary gas at a loss if it’s rich enough in liquids.

That’s not the case with ARC. But it is another arrow in the company’s considerable quiver. And it’s another good reason to buy ARC Energy Trust anytime it trades below my buy target of USD22.

Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) won’t announce its third-quarter earnings until Nov. 11. But when it does the numbers are certain to show the benefits of a similar output-led strategy.

Unlike ARC, Peyto has elected to cut its distribution by half when it converts to a corporation in January. Investors, however, have focused squarely on simultaneously announced plans to ramp up capital spending to CAD250 million to CAD275 million next year, with the bulk to go towards production of a wealth of shale gas reserves discovered over the past couple years.

Peyto has historically been a rapid grower, boosting reserves and production at compound annual rates of 54 and 43 percent per unit, respectively, since summer 2003. Production rose another 30 percent per unit over the past 12 months, even as the company was able to cut new production costs a whopping 50 percent. That’s the kind of scale that ensures success, even in an environment of very low gas prices.

With more than 80 percent of output coming from gas, Peyto Energy Trust is a buy up to USD16.

Daylight Energy is also squarely focused on boosting output and reserves, boosting the latter by 40 percent in the first nine months of 2010.

But its strategy differs from ARC’s and Peyto’s in one major way: It’s focused on increasing light oil and gas liquids production, rather than gas itself.

That strategy has proven no less profitable in the near term. And it provides a nice cushion as well in case gas should remain at depressed levels longer than anticipated.

The company’s strategy in its early years was to take stakes in properties that majors were developing, in order to capitalize on the acquired geologic knowledge and experience without forking out capital as well. Now it’s squarely in the second stage of its development: focusing on a few choice areas and ramping up output.

Going forward, that should continue to lift reserves, output and cash flow, which covered the distribution by better than 2-to-1 in the third quarter. And assuming it succeeds, management should begin to lift distributions as well sometime next year, provided oil prices remain steady to up-trending.

Daylight has fallen back since its conversion, presumably because investors were unhappy with the dividend. That’s placed it squarely on the bargain counter. Daylight Energy is a buy up to USD11 for those who don’t already own it.

Penn West Energy Trust has also chosen a liquids-based strategy for ramping up output in coming years, specifically for its light oil properties. Third-quarter results were steady, with production coming in at 164,087 barrels of oil equivalent per day and costs generally on target. The real benefit, however, will start to show up next year as the fruits of this year’s CAD1 billion in capital spending unfold.

Remarkably, the company is ramping up output of light oil at the same time it’s reducing debt, slashing CAD787 million in the first nine months of 2010. That’s a benefit of the now very conservative payout policy, under which distributable cash flow covers the CAD0.09 per month payout rate by better than 2-to-1.

The lower yield will deter some from owning Penn West. So will the fact that the shares have now moved up well above my buy target of USD22 to a new 52-week high.

The company, however, still trades at a steep discount to the likely value of its reserves in the ground.

That, in my view, means there’s still a lot of gas in the tank, even if the stock may be temporarily ahead of itself. I’m sticking with Penn West Energy Trust, a buy up to USD22 for those who don’t own it.

Finally, Vermilion Energy (TSX: VET, OTC: VEMTF) also remains on track for big production gains in coming years, though its increased output will be largely from outside North America. The company successfully completed its conversion to a corporation without cutting its distribution on Sept. 1. As a result, it spent part of the quarter as a trust and part organized as a corporation.

That made little impact on profitability, however, thanks to nearly 80 percent of earnings coming from outside Canada, where the tax did not apply. Funds from operations per share were again solid at CAD1.07, covering the CAD0.19 monthly distribution by a strong 1.9-to-1 margin. That strength of coverage strongly suggests a return to dividend growth once new projects come on stream and capital spending winds down. These include a major light oil project from its Cardium land position in Canada, a completed project to rev up output at the Wandoo field in Australia, the LIAS shale oil play in France and, above all, the Corrib project off the Irish coast.

Overall, Vermilion expects to exit 2011 with production volumes exceeding 37,500 barrels of oil equivalent per day, up from 31,298 in the third quarter of 2010. That supports an overall plan for 5 to 10 percent average annual growth from existing projects. In 2012 we should start to see the fruits of the company’s 9 percent stake in Corrib, which management has said could boost output as much as 20 to 30 percent.

One of Vermilion’s key strengths over the years has been management’s clear aversion to taking on debt. That remains the case, with annualized cash flow covering total obligations by nearly a 2-to-1 margin. That means unmatched flexibility to pursue a wide range of wealth building prospects, as well as supporting a strong dividend. Buy Vermilion Energy on dips to USD38 if you haven’t yet.

As for my other two Canadian Edge Portfolio oil and gas producers–Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF) and Perpetual–we won’t see third-quarter numbers until next week or later. The pair, however, has become a study in contrasts, which should be well reflected in their results.

Enerplus units have surged back to the upper 20s in the wake of the company’s announcement that it will hold its distribution level in 2011, when it converts to a corporation. That’s a level it hasn’t seen since mid-2008, and it continues to attract buyers.

Perpetual’s shares, however, have largely languished since it actually converted without cutting its payout, taking a steep plunge in late October for no apparent reason. And despite a partial recovery the past week or so, the company is by far the biggest loser in the CE Portfolio.

There are, of course, many business differences between the two. To begin with, Enerplus is much larger with a market cap of more than USD5 billion, as opposed to Perpetual’s USD600 million. Enerplus’ debt level is fraction of Perpetual’s as well, and its distribution coverage is consistently greater.

The biggest difference, however, is production profile. Enerplus has invested heavily in boosting output for coming years, taking huge positions in the Bakken and Marcellus shales as well as developing light oil reserves. Perpetual, meanwhile, has big plans to develop Cardium reserves, as outlined in a press release on “Game Changers.” But it’s continued to be hampered by less than optimal access to cash.

The root of Perpetual’s problem is, of course, near 100 percent reliance on natural gas production to generate revenue. And that problem has become acute now in the face of rock-bottom gas prices, now that hedge positions are starting to roll off. Only about half of remaining 2010 production, for example, has a locked-in price, while only about a third of next year’s does. Worse, opportunities to lock in higher prices on the futures market–which have kept cash flows high this year–are non-existent, with prices there also less than USD4.

We’ll get a pretty good idea of how this is playing out when Perpetual announces its third-quarter earnings on Nov. 9. And in the meantime investors can take heart in that the 13 percent-plus yield won’t be affected by 2011 (the company has already converted), and that it prices in a lot of business risk in any case.

Perpetual Energy remains a buy up to USD6. Conservative investors, however, are much better off in one of the other selections and not shooting for the additional yield. Enerplus Resources Fund is still a buy on dips to USD28.

For my advice on other Canadian oil and gas producers, see How They Rate. Note that many of the most attractive plays–including oil-focused companies–currently trade above my buy targets. I may raise these levels at some point.

For now, however, maintain discipline. Energy is a volatile market where prices you thought you never would see again can reappear in the blink of an eye. Don’t chase.

Service Stars

Life has gotten a little better for energy service companies in one respect in recent months. That’s the increased demand for rigs, particularly those capable of exploiting shale oil and gas. That positive has been offset by falling rates for rigs, as producers have taken advantage of an abundance of supply (and providers) to demand lower prices.

For some companies that’s led to disappointing results despite the improved conditions. The biggest Canadian services company, Precision Drilling (TSX; PD, NYSE: PDS), enjoyed strong revenue growth of 42 percent but also lower net earnings, as higher activity levels were offset by lower average drilling revenues per day.

I still expect Precision to be a big winner in coming years, as the industry consolidates and overall conditions improve. Ditto Trinidad Drilling (TSX: TDG, OTC: TDGCF), which releases earnings on Nov. 9.

At this point, however, the best Canadian drilling play by far is Phoenix Technology Income Fund. Unlike Precision or Trinidad, the company is a specialist in the unconventional drilling that’s unlocked the secret to North American shale gas.

As a result, it has none of the baggage of servicing conventional production and in fact has been able to take its expertise profitably to foreign shores as well.

Third-quarter earnings were a study in outperformance. The company enjoyed the highest quarterly revenue in its history, surpassing even the crazy days of mid-2008, when oil and gas prices were at much higher levels. Management was able to take advantage of record activity levels in all of its operating areas, posting a 113 percent jump in consolidated operating days.

Distributable cash flow more than tripled, driving the quarterly payout ratio to just 28 percent. And the company ramped up capital spending to a record CAD47.2 million to manage an anticipated 36 percent rise in concurrent job capacity. Growth in Russia and Columbia continues apace as well.

Importantly, growth is coming without sacrificing margins. In fact, cash flow as a percentage of revenue rose to 21.1 percent in the third quarter versus 17 percent a year ago.

That pretty much says it all about the company’s competitive advantage, and it’s why I continue to rate Phoenix Technology Income Fund a buy up to my target of USD10.

Finally, I also remain very positive on Newalta Corp, the CE Portfolio pick that specializes in clean-up of energy production and industrial sites, and recycling of waste. Third-quarter results were a continuation of the positive developments in previous periods, as revenue rose 21 percent and spurred a 12 percent jump in cash flow and a 77 percent surge in net earnings.

Oil production is a filthy business that produces a lot of waste, particularly when it’s mined from tar sands. Newalta has positioned itself neatly to take advantage of the need for cleanup and disposal. The Onsite Division’s revenue surged 16 percent, while net margin rose 24 percent demonstrating management’s ability to translate sales into profits.

As its long-suffering investors know, things haven’t exactly been easy for Newalta the past few years, as its major customers pulled in their horns. Throughout, however, management kept at its plan of disciplined expansion through asset acquisitions and construction. Now that’s starting to pay off in higher profits, with much more to come.

The stock is now more than four times its Mar. 27, 2009, low, where it was left for dead after converting to a corporation in the heat of the bear market. But it’s still less than a third its levels of late 2006, before it had to prove its durability and was arguably a far less valuable company as well.