The Canadian Edge Aggressive Holdings feature seven oil and gas producers. All are former income trusts that have converted to corporations at some point over the past 12 months.

On average this group has returned 252 percent since the March 2009 bottom. That compares to a 65 percent total return by the S&P 500. And the seven have already tacked on another 10 percent-plus thus far in 2011.

Those are truly massive gains, and they’re particularly noteworthy in view of what these companies have gone through in recent years. All seven sold off hard when the 2011 tax on income trusts was first infamously announced on Halloween night 2006. And for more than four years after that they languished under misconceptions that Jan. 1, 2011, would be some kind of investor doomsday.

The early 2008 spike in oil and natural gas prices fueled a partial recovery from the late-2006 selloff. But the benefit was short lived, as all plunged sharply in the historic credit/economic/market meltdown later that year. All but one was forced to cut distributions at least once. The drop in the Canadian dollar’s exchange rate against the US dollar further magnified the 2008 losses for US investors.

Finally, the continued depression in North American natural gas prices has continued to be a drag on earnings for all of these companies. And with production and reserves still increasing from shale reserves, no operating facilities for exporting liquefied natural gas (LNG) and industrial and consumer demand still not recovered to pre-recession levels, hope of a near-term rebound seems remote.

The critical question now, however, isn’t where these stocks have been. Rather, we want to know whether they can continue to produce robust total returns in the aftermath of these gains. Valuations are certainly higher, to say the least.

A year ago, for example, these seven companies–along with most of their industry–sold at a discount to the value of their reserves in the ground. In other words, the net asset value of their holdings was greater than their market values.

That’s no longer the case, as the table “Room to Grow” demonstrates. In fact, the only producer trading at a significant discount to the value of its proven plus probable reserves is Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYTO), formerly known as Peyto Energy Trust.

Peyto sells at only about 60 cents per dollar of proven plus probable reserves it owns, though it once traded at a steep discount to the value of its proven reserves alone. Probable reserves are calibrated to have a 60 percent or better chance of being developed, while proven reserves have a better than 90 percent chance.

Yields are also much lower than a couple of years ago. Of the Portfolio picks, ARC Resources Ltd (TSX: ARX, OTC: AETUF), Enerplus Corp (TSX: ERF, NYSE: ERF), Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) and Vermilion Energy Inc (TSX: VET, OTC: VEMTF) managed to convert to corporations without cutting their payouts.

Only Vermilion, however, had maintained its distribution level throughout the 2008 meltdown–and despite the lower oil and gas prices in its aftermath. Perpetual, meanwhile, was forced to trim its monthly payout after converting in November 2010 to CAD0.03 from a prior CAD0.05, the result of sharply falling natural gas prices on the forward curve that prevented the rollover of hedges that were protecting cash flows.

As for the rest, the conversion-related dividend cuts came on top of payout reductions already made in 2009 to deal with lower oil and especially natural gas prices. And that’s only half the story, as rising share prices have further shrunk percentage yields.

The upshot: What were once double-digit yields have shrunk to single-digits, in some cases well under 5 percent. Even those yield levels are still more than competitive with what’s paid out by other energy producer stocks. Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE), for example, still pays a percentage point more than Super Oil Chevron (NYSE: CVX). That’s despite a gain of more than 18 percent since its Jan. 1 conversion and a cut of 40 percent in its payout last October in preparation for the move.

Single-digit yields alone, however, won’t drive these seven stocks–or, for that matter, any of the 31 energy producers under Canadian Edge How They Rate Oil and Gas coverage–to new highs. Even Penn West management wound up staying committed to a hybrid model for shareholder returns, combining a sizeable dividend with a large commitment to capital spending on growth. And while only oil-focused companies have been able to afford them to date, most management teams have indicated they won’t hesitate to lift payouts as corporations when circumstances warrant.

It’s going to take a catalyst or two to spur the kind of cash flow growth that will lift dividends. Likewise, it will take something more than what we’ve seen already to pique investor interest enough to push valuations higher.

The key is what’s capable of doing that–and whether the odds it will happen are great enough at this point to justify betting on companies that have admittedly already rallied quite strongly.

Keys to a Rally

To some extent, at least, a rally in these stocks was inevitable back in March 2009. They’d simply fallen too far, too fast. And though oil was scraping around USD40 a barrel and natural gas was less than USD4, companies were still selling at discount to the value of their reserves and capable of paying double-digit dividends.

The investor expectations embedded in those prices were so low the companies couldn’t help but beat them. And once oil prices started to rise, that became as easy as falling off a log for most.

The recovery of oil handed US investors another windfall in the form of a surging Canadian dollar. The loonie had fallen as low as USD0.78 in March 2009, largely because black gold’s price had crashed and burned. Oil’s recovery triggered and immediate surge back toward parity and eventually beyond, triggering a commensurate bonus gain in US dollar terms.

Finally, no one had forgotten that each of these seven companies would face taxes starting Jan. 1, 2011, either as a converted corporation or by remaining an income trust. Management had been making adjustments to meet this new burden for several years. But that did little to dispel investor fears that a trust doomsday was approaching that would make the declines of November 2006 and late 2008 look like a bull market.

That’s certainly not an impression anyone would have gotten reading Canadian Edge. In fact, we consistently maintained a view 180 degrees opposite the consensus: that Canadian trusts had been pricing in the absolute worst-case scenario for 2011 taxation since mid-November 2006 and that virtually all of them would convert to corporations, preserving as much of their dividends as possible.

In my view, what was really depressing the trusts was uncertainty about 2011. Once managements made clear their intentions regarding conversion and dividends, that uncertainty would disappear. Valuations would adjust upward, triggering what I called in the August 2009 Feature Article, The 2011 Windfall.

As it turned out, that’s exactly what happened. In fact, even companies that reduced dividends sharply at conversion have rallied sharply since stating their intentions. Some of the gains occurred immediately after the initial conversion/dividend announcements. A good deal more, however, didn’t show up until the actual conversions took place.

Today the 2011 windfall is largely played out. All of these companies have converted and set dividends and the market has adjusted to the news at last. As a result, this will no longer catalyze these companies’ share prices. And while valuations are still reasonable for these producers–particularly relative to others in the industry–it will take more than just showing up for work to beat the investor expectations now imbedded in share prices.

The upshot: It’s going to take something else to lift these stocks and their dividends higher in 2011. Happily, there are several good candidates to pick up the slack.

No. 1 is oil prices. To be sure, unrest in the Middle East is to blame for the recent spike in black gold north of USD100 a barrel. Leaders have fallen in Egypt and Tunisia. Libya has apparently sunk into civil war, taking an estimated one million barrels of oil a day off global markets. Meanwhile, tensions are running high in places as disparate as Shiite-dominated Iran and the Sunni-led Arabian Peninsula. Iran is the second biggest producer in the Organization of Petroleum Exporting Countries behind Saudi Arabia.

Certainly, turmoil could worsen in any of these countries in coming weeks, taking even more oil off the market. That would certainly have an impact on prices, which in turn would be a major plus for cash flow at Canadian producers.

Equally, however, markets have a tendency to immediately price in the worst-case scenario when it comes to geopolitical events, which in fact almost never happens. As a result, any sign that tensions are slackening and supply is returning to the market would have the opposite impact. And the higher prices go when tensions are rising, the faster they’ll fall when the situation cools.

There’s no way of knowing just exactly what will happen when the current situation in the Middle East shakes out. Turmoil could actually worsen in coming weeks. Most devastating would be some event that damages production in a country like Iran or Saudi Arabia.

That kind of price spike, however, is unlikely to induce any Canadian company’s management to hike their dividend. And unless you’re a very short-term investor, it’s nothing you want to bet on. In fact, if these seven stocks should spike on the basis of some political blow-up, I’ll be looking to take more profits, just as we did to a lesser extent in summer 2008.

There’s one implication from the Middle East situation that is of prime import to these companies’ long-term fate: It once again demonstrates the continuing tightening of global oil markets, as demand ratchets up in the developing world and recovers in the US–and producers are forced to go ever further and ever deeper to secure new supplies.

As we saw in 2008 and 2009, the going can be quite rocky. The world would arguably more easily absorb USD150 oil this time around than it did in mid-2008. But a rapid rise in energy costs will take money out of the pockets of consumers, businesses and governments that could have been spent elsewhere. That’s contractionary for growth. It also spurs all the things that eventually take a commodity’s price down: conservation, adoption of alternatives and new production that ultimately sow the seeds of lower prices.

Sooner or later that’s the fate that awaits the oil market, just as it has every commodity in a bull market in history. At this point, however, we’re a long way from that eventuality. In fact, every big contraction like 2008 arguably delays the ultimate day of reckoning by temporarily relieving the pressure and getting the economy more used to higher prices.

As a result, we likely still have a long way to go with this energy bull market. And that means big opportunities for light oil producers, as well as any company that drills for its primary substitutes in North America, namely oil sands and natural gas liquids (NGL). NGLs like ethane are increasingly used as substitutes for oil and therefore sell at oil-like prices.

Surging prices for light oil, heavy oil, bitumen (oil sands) and NGLs are already showing up as robust earnings for energy producers, including many of these seven companies. Odds are they’ll be even more profitable in coming months, particularly as shale reserves are developed using directional drilling technology. That means higher cash flows and dividends for producers and–almost certainly–share-price gains.

Higher oil prices will also continue to put upward pressure on the Canadian dollar-US dollar exchange rate. The loonie is already past parity with the greenback. That’s caused some consternation in the government, as a high exchange rate hurts Canadian exporters. But the Canadian central bank’s strategy seems to be to control the rise rather than reverse it.

That should produce further gains for US investors in these stocks, as the US dollar value of stock prices and dividends ratchets higher. Canadian investors won’t get that direct benefit. But they will win indirectly by owning companies that are moving in the US, such as Enerplus, whose investing funds will stretch further as the loonie moves higher.

Potential catalyst No. 3 for higher Canadian energy producers’ cash flows, dividends and share prices is the natural gas market. I’m no longer holding out a lot of hope for higher prices this year. That may in itself be a good sign. But at this point the higher-percentage bet is with companies that can benefit from rising output and reserves, even if the clean fuel’s price stays depressed.

That’s the point I made in the November 2010 Feature Article, Energy: Focus on Output. Since then we’ve seen some massive gains in both reserves and output for several companies releasing reserve data in recent weeks. For example, ARC Resources lifted its output 35.5 percent in 2010 in addition to increasing proven reserves by 25 percent and extending reserve life to 10.4 years based on proven reserves.

The key is directional drilling, which has opened up Canada’s immense shale reserves just as it has in the US. Unlike in many parts of the US, Canadian authorities are supportive of development efforts. And the opportunities are staggering.

Finally, as converted Canadian trusts get used to operating as corporations, management is going to get more comfortable lifting dividends. We’ve already seen some sizeable increases for oil-focused Baytex Energy Corp (TSX: BTE, NYSE: BTE), including a boost to a monthly rate of CAD0.20 per share from CAD0.18 in the first month it operated as a converted corporation.

It may take a while longer for others to follow suit. But a return to dividend growth will show once and for all that the specter of 2011 taxation is behind these companies. Managements by and large won’t raise payouts unless they’re convinced they can sustain them. But when capital projects are funded and debt is paid down, they’ll move quickly to push up dividends. After all, they’re major shareholders at all of these companies.

Best Bets

Taken together, these potential catalysts have the power to lift producers’ stocks much higher in 2011 and beyond. Some companies, however, are higher potential bets than others.

All of the companies in the table “Room to Grow” produce at least some light oil. And most are moving to pump even more of it in the coming year. Penn West Petroleum, for example, expects to spend 90 percent of its 2011 capital budget of CAD1.1 billion to CD1.3 billion on oil development, a strategy sure to increase the percentage of liquids in its base from an already high 70 percent. As I pointed out in a Feb. 23 Flash Alert, the company’s post-conversion dividend level affords it ample opportunity to invest in its business without borrowing or issuing large amounts of equity.

That will keep net asset value rising in coming years, even as the stock still only sells at about 1.22 times a very conservative valuation of those assets. Penn West has rallied sharply since clarifying its post-conversion dividend last year but still trades below its price when it converted to an income trust in 2006. I think the stock will hit that level and a lot more in coming years.

Buy Penn West Petroleum up to USD30 if you haven’t already.

Enerplus isn’t as heavily weighted to oil production as Penn West. But it has made lifting light crude production at its Bakken Shale properties its top priority for the coming year, with Bakken oil accounting for 60 percent of the CAD1.3 billion in properties it acquired last year. Much of the remainder comprises lands in the Marcellus Shale in the US that it’s been able to acquire cheaply with immense reserve potential. And the company also picked up 80,000 acres in the Deep Basin, which are rich in natural gas liquids.

These purchases were funded in large part by asset dispositions, limiting the need to issue new equity or debt. As a result, production has remained steady overall but is now more weighted toward liquids and low-cost gas. Operating costs accordingly dropped 6 percent during the year. The company also ramped up internal capital spending by 80 percent over 2009 levels.

Financial ratios are also solid despite the disruption of the transition. The payout ratio remained a low 55 percent, while 12-month debt-to-cash flow remained a low 1.0-to-1. Like many natural gas producers, Enerplus has been forced to write down the value of reserves as prices have fallen. This move to oil and liquids, however, has minimized the impact on the overall company, even as it preserves management’s ability to further lift output to meet new demand.

That’s a formula for further gains for Enerplus. The stock has shot up to the low 30s but is still barely half the all-time high it hit in September 2006. Moreover, a market price of 1.2 times net asset value and yield of nearly 7 percent still represent solid value. Enerplus Corp is still a buy up to USD33 for those who don’t already own it.

Vermilion, meanwhile, has lifted oil to 65 percent of its global production with a series of development projects, including ramping up its stake in the Cardium trend of Western Canada. The company has the added advantage of producing much of its natural gas for Asian and European markets, where prices are notably higher than in Canada. As a result, it turned in a realized price for gas of CAD5.74 per million British thermal units, some CAD2 more than its peers.

Vermilion’s overall numbers for 2010 were very strong. Fourth-quarter production rose to 35,302 barrels of oil equivalent per day, largely thanks to its efforts in the Cardium. The company boosted its holdings in this region to net ownership of 98,000 acres, drilling 28 wells last year including 15 operated wells. And it continues to boost efficiencies in the region, in part with scale advances.

The company replaced 137 percent of 2010 production globally, boosting reserves by 3.1 percent and extending its reserve life to 11 years on a proved-plus-probable basis. The payout ratio was roughly 50 percent of distributable cash flow, still management’s primary metric for paying dividends despite the conversion to a corporation in September.

And the company was taxed for the entire fourth quarter as a corporation, demonstrating it’s made the transition smoothly. Operating costs fell to CAD12.20 on a global basis, from CAD13.35.

Most important, fourth-quarter numbers confirm Vermilion is well on its way to fulfilling its five-year strategic plan targeting annual production growth of 10 percent. Key to this effort will be continued development of Cardium opportunities and the ongoing development of the Corrib gas project in Ireland. The latter especially has the potential to increase output, reserves and cash flows dramatically, with the initial boost still expected for 2012.

The key question I’ve had with Vermilion as the stock has risen recently is whether it’s worth paying for at these levels. The good news is these numbers–though not accompanied by a dividend increase–point the way to much higher value.

If you already own Vermilion, there’s no reason to do anything, other than possibly paring it back if the stock has grown to be too large a slice of your overall portfolio. If you don’t own Vermilion Energy, however, my new buy target is USD50, a level that represents a yield of only about 4.6 percent. But if the company succeeds in its development plans as oil prices stay strong, this is one stock that’s going a lot higher in coming years.

That’s also my feeling about Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF). The company won’t release earnings until Mar. 10. But it, too, has made oil its priority, lifting output last year by 12 percent to 66 percent of overall production. In contrast, it actually reduced output of natural gas by 3 percent. The numbers may eventually convince me to take more dramatic action. At this point, however, I’m keeping my buy target for Zargon Oil & Gas at USD22, which is about 10 percent below the current price.

Of this group, Penn West has the most exposure to the oil sands, through its Peace River project. Peace River is largely being funding by China Investment Corp (CIC), the sovereign wealth fund that’s made several major financial investments in Canada’s energy patch. The deal enabled Penn West to fund a development that it had placed on the back burner as too expensive. It represents a hefty potential source of production as it’s developed in coming years.

Outside of that, these companies are largely absent from the oil sands. In fact, Enerplus basically exited the field by selling its stake in the Kirby project to finance its recent purchases in the Bakken.

The reason is simply that oil sands production is a game of scale. Only large and deep-pocketed players can afford the immense capital expenditures and operating costs inherent in what’s basically a mining and chemical refining business. The real value is in the facilities needed to mine and process the tar sand to extract bitumen that can be refined into useable fuel. Having potential reserves is of little or no value without the money to build them.

That being said, CE Associate Editor David Dittman has some interesting comments in this issue’s Canadian Currents article on two oil sands plays we’re adding to How They Rate coverage. Note that oil sands producers are much more leveraged to oil prices than other energy players. That’s because production is so expensive. In fact, it’s not really economic if oil prices should slip much under USD40 per barrel. And unlike other types of energy production, rising output seems to push operating costs higher still. You can make big money, but stocks are going to be volatile.

That’s also true to a lesser extent of Baytex Energy, which specializes in heavy oil. This type of petroleum tends to trade at a discount to light oil, due to a lack of refining capacity and infrastructure to get it to market. That may change with the construction of new North American pipelines, assuming regulators eventually approve them. Until then, however, light oil will remain the safer bet.

Turning to upside catalysts for natural gas producers, I see three big ones. First, there’s NGL production from developing natural gas reserves that are rich in liquids. The Deep Basin of Canada has emerged as a major player in this area. Second, there’s simply increasing output, mainly by developing shale reserves that are ever-cheaper to exploit.

Finally, there’s the opportunity to beat what could hardly be lower investor expectations. Peyto Exploration & Development has risen sharply in recent month but still sells at just 60 cents per dollar of its proven plus probable reserves and a little below the value of its proven reserves alone. That’s only possible because investors view natural gas prices as permanently in a slump.

Admittedly, I’ve been dead wrong on natural gas prices before. But as we’ve seen time and again in the stock market, when expectations are low enough, almost anything short of total implosion will beat them. And when expectations are exceeded, stock prices rise.

All three of these factors should benefit Daylight Energy Ltd (TSX: DAY, OTC: DAYYF) going forward. First, the company boosted its proved plus probable reserves by 46 percent in 2010 with an aggressive drilling program, which also lifted its liquids percentage. Finding and development costs were the lowest in the company’s history. Proved plus probable reserve life was extended to 11.8 years, thanks to a 433 percent reserve replacement ratio and funds from operations hit a record for both the full year and the fourth quarter of 2010.

That pushed fund from operation per share up 38.7 percent for the fourth quarter to 43 cents–and pushed down the payout ratio down to just 33 percent. It also allowed the company to finance all of its capital spending and dividends with internally generated cash flow, eliminating the need to borrow or issue equity. Development included light oil plays in the Cardium region but also liquids rich gas in the Deep Basin.

Capital spending of CAD335 million in 2010–more than double 2009 outlays–ensures more gains in the year ahead. Meanwhile, production hit 41,161 barrels of oil equivalent per day on average in 2010, an increase of 53 percent.

Despite these big league gains, Daylight currently trades right at the net asset value of its reserves under very conservative assumptions. That suggests a lot more upside ahead, particularly as management looks to further ramp up liquids production at the most prolific of its properties. Buy Daylight Energy up to USD11 if you haven’t yet.

I’m also very bullish on Peyto Exploration, which reports earnings on Mar. 9, and ARC Resources, which I reviewed in the Feb. 23 Flash Alert. Both reported blockbuster growth in reserves. ARC has already reported a 10 percent lift in cash flow per share, thanks mainly to lifting production of natural gas and NGLs, increasing scale and driving down costs.

Throw in the fact that both companies have exceptionally sound finances and the potential to ramp up reserves and output even more in 2011 and you have a strongly bullish case, even with natural gas prices selling for less than USD4 per million British thermal units. And when gas prices finally do revive, those cash flow gains will double, triple and better. That’s plenty of reason to buy ARC Resources (below USD26) and Peyto Exploration & Development (below USD20).

Finally, gas market speculators will want to hang onto their shares of Perpetual Energy as well as pick up a few of Bellatrix Exploration Ltd (TSX: BXE, OTC: BLLXF). Neither is attractive for conservative investors now. The former pays a high dividend, which is increasingly at risk as energy prices. The latter pays no dividend.

We’ll know more about both when they report earnings, Bellatrix on Mar. 10 and Perpetual on Mar. 7.