The age of Canadian oil and gas income and royalty trusts–popularly dubbed “Canroys”–is over. The era of dividend-paying Canadian energy stocks, however, is just beginning.

Plunging natural gas prices and the cost of converting from trusts to corporations wreaked havoc with sector dividends from late 2008 to early 2011. And yields fell further as rising energy prices pulled their stock prices higher.

Even after all that, however, several of the strongest former trusts still pay out 7 percent-plus. And after the market turmoil of the past month or so, weaker fare are pushing 10 percent.

Better, more than a few have again begun to increase dividends. As they’ve gotten used to operating as corporations, they’ve used surprisingly abundant cash flow to pay down debt and build strong production profiles.

Investors are not only seeing higher cash flow. But share prices are starting to head higher as well. And as reliable energy supplies globally become increasingly scarce that trend increasingly has legs.

To date Canadian producer dividend growth has been almost entirely from those most heavily weighted to oil. It’s not hard to see why. The dramatic drop in natural gas prices since late 2005 is still an underappreciated drag on profitability for those weighted to gas. Despite a decided shift in Canadian producers’ capital spending to liquids production in recent years, gas still accounts for half or more of the production of many companies included in the Oil and Gas Reserve Life table.

In late 2005 natural gas prices in North America peaked in the high teens, as the combined destruction of hurricanes Katrina and Rita triggered outright shortages. Conventional wisdom was the rise in gas prices was here to stay and that the US especially would rapidly become a major importer.

Companies like Cheniere Energy Inc (NYSE: LNG) made multi-billion dollar bets building capacity to import liquefied natural gas (LNG). Meanwhile, activity boomed in Canada’s Western Sedimentary Basin and the country’s national champion Encana Corp (NYSE: ECA) invested heavily in exploiting “non-conventional” gas resources across the continent.

Then came arguably the most revolutionary development in the energy industry since the modern drill bit: Producers at last cracked the code to unlocking oil and gas reserves theretofore trapped in shale rock.

The process–known as hydraulic fracturing, or “fracking”–is still controversial in some places. And some state and local governments in the US are starting to regulate the chemicals that are essentially mixed with water to pulverize rock and liberate the energy. But the result is that producers can now access these reserves at costs that are in many cases below the expense of developing North America’s remaining and dwindling “conventional” energy reserves.

That’s effectively set what appears to be a new baseline price for natural gas of somewhere around USD4 per million British thermal units. Prices still rise in winter and the peak summer cooling season, and they drop in off-peak spring and fall when air conditioners and heaters run less. But every push above or below the range seems to be met with resistance and support, respectively. And investors continue to react to the latest inventory numbers as evidence the market is becoming either more or less oversupplied.

Meanwhile, market sentiment for natural gas the commodity and natural gas producers could hardly be worse. One reason is almost total inability of North American producers to export via liquefied natural gas. That’s in large part the legacy of so much import capacity being built.

There are some projects underway to remedy that. One is the Kitimat project off the British Columbia coast, which is supported by a number of producers, including EOG Resources (NYSE: EOG). None of them, however, are close to fruition. Until they are the North American natural gas market will remain a local one, following its own supply and demand fundamentals.

That’s been a decided negative for gas producers in recent years, as shale production has surged and the market has appeared to slide into a semi-permanent state of oversupply. The glut could expand even further in coming months, should North American industrial sales (28 percent of total US gas consumption) begin to contract. Meanwhile, cooling demand continues to lag this summer despite extreme heat in some areas. Power plants use about 30 percent of US energy supplies, according to the US Dept of Energy.

Use of gas to generate electricity is on the rise throughout North America. Even without definitive regulation on carbon dioxide (CO₂) emissions from power plants in the US, North American gas is increasingly cheaper than coal, for which overseas demand is extremely robust. And burning gas also emits far fewer pollutants that are currently regulated, namely sulphur oxide, nitrogen oxide and mercury.

Coal currently accounts for roughly half of US power generation and an even higher share of lower-cost baseload plants that run most or all of the time. But nearly 35 percent of plants were built more than 40 years ago. Every year they get older and less efficient to run–and closer to being shut permanently.

The US Nuclear Regulatory Commission (NRC) under President Obama has been a reliable champion for nuclear energy, approving license extensions for most of the currently operating plants. And it’s strived to keep construction of a new generation of plants on track, even as the Fukushima-Daiichi accident in Japan has revved up opposition to all things nuclear. It now appears the NRC will require even fewer modifications to plants as a result of its post-Fukushima study than it did following the Sept 11, 2001, terror attacks.

Even with all of that, however, nuclear power’s share of US electricity production is unlikely to rise much above its current range of 20 to 22 percent. Neither is renewable energy likely to make much of a dent, given the small size of projects. The largest wind farm in the US, for example, is Idaho Wind, partially owned by Conservative Holding Atlantic Power Corp (TSX: ATP, NYSE: AT). It’s quite profitable for its owners but capacity is less than 200 megawatts and it runs 25 to 30 percent of the time. Contrast that with 1000 megawatts-plus for a modest-sized coal plant.

That leaves natural gas-fired power to fill the breach as well as projected demand growth of at least 10 percent by 2020. Coupled with potential use of gas for fleet vehicles–a process slowly but surely taking shape across North America–it adds up to a lot more demand for natural gas in coming years, even as industrial demand recovers.

The problem is markets are notoriously impatient, and this is going to take time. Fortunately, there is one type of natural gas that’s already in a bull market: Natural gas liquids (NGL).

Enter NGLs

NGLs are naturally occurring elements found in natural gas, including propane, butane and ethane. By separating–or “fractionating”–these elements, producers can sell them separately. Because some are substitutes for oil, they fetch a much higher price than “dry” gas.

Ethane, for example, is used as a building block for polymers such as polyethene; polymers are key elements in the manufacturing of plastics. Availability of that NGL has made it very cheap to produce plastics in North America. It’s also created something of an export boom for it, particularly to Europe as Asia demands more of Saudi Arabia’s output.

Propane has long been used for home heating, particularly in rural areas not served by conventional natural gas pipelines. The NGL, however, is increasingly viewed for a much broader range of uses, including transportation and other industrial processes.

Butane’s uses for heating are also well known, particularly for campers and backpackers. But it also has a range of uses, including as a refrigerant, a feedstock for production of base petrochemicals in steam cracking, and as a propellant for sprays such as deodorants.

For much of their history NGLs have been an afterthought for producers, who were far more focused on oil and conventional natural gas. “NGLs on the Up and Up” shows why that’s no longer the case and explains why gas producers across the board are now focusing intently their output of NGLs.

At the same time natural gas prices have fallen sharply to flatten this year, NGLs have headed higher along with oil. And unlike dry gas, NGLs are ready for export once they’re separated. As a result they’re priced for the still-robust global oil market, rather than the landlocked and depressed dry gas market.

The ability to make lofty profits from NGLs has even made it worth companies’ while to scale up production of dry gas, just to get at the liquids that come along with it. To be sure, producers will do better if and when natural gas prices finally do start to pick up steam. But for now they’re seeing a strong new source of profits from “the other gas.”

To date much of the NGLs production surge has come from the lower 48 US states. But over the past few quarters we’ve seen Canadian companies step up to the plate, particularly the former royalty trusts. And much of the activity has been in the Western Sedimentary Basin, once a primary drilling area for gas but which has been hurt greatly by competition from shale.

One problem producers have had getting NGLs to market has been processing and transportation ability. That log jam, however, is beginning to break up, as energy infrastructure companies like Keyera Corp (TSX: KEY, OTC: KEYUF) and Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF) step up their investment.

Oil-focused producers are still far more likely to raise dividends in coming months, just as they’ve been the only companies to boost the past couple years. But as NGLs become increasingly more important, even the laggards could start seeing growth, and that, in turn, will return share prices to the upside as well.

“Room to Grow” highlights the growing role of NGLs at seven natural gas-weighted companies tracked in How They Rate, five of which are Canadian Edge Aggressive Holdings. The first column shows the NGLs as a percentage of overall output. The second column shows the growth of NGLs production over the past 12 months at each company. And the third shows the change in each company’s realized selling prices for NGLs.

Note that only data for ARC Resources Ltd (TSX: ARX, OTC: AETUF), Bonavista Energy Corp (TSX: BNP, OTC: BNPUF), Daylight Energy Ltd (TSX: DAY, OTC: DAYYF) and Progress Energy Resources Corp (TSX: PRQ, OTC: PRQNF) are as of second-quarter earnings. The rest should move closer to those four when their updated figures are released.

The first takeaway from the table is NGLs are still a relatively small portion of companies’ overall output of energy. Only Bonavista Energy currently derives more than 10 percent of output from them, though several other companies are close.

The second is that these companies have universally enjoyed higher selling prices for their NGLs, making them a much bigger part of profits than they are of overall output. That’s in large part a function of high oil prices, as well as the fact that NGLs can be exported and are a substitute in many areas for oil.

Third, these companies are devoting very real resources to developing NGLs. Daylight’s slight dip in output in the second quarter is mainly due to one-time events mostly beyond its control, including weather conditions and the fires that have raged throughout Canada’s energy patch.

Enerplus Corp’s (TSX: ERF, NYSE: ERF) push towards liquids, meanwhile, has been hampered by problems transporting energy out of its prolific Bakken properties.

Perpetual Energy Inc’s (TSX: PMT, OTC: PMGYF) push to produce more NGLs is a direct consequence of being almost entirely dependent on conventional natural gas production and a need to diversify in a chronically weak pricing environment. Management expects to see further robust growth going forward.

Safest First

The highest-quality companies on my list are ARC Resources and Enerplus, whose earnings are reviewed in Portfolio Update. Both are low-cost companies with long-life reserves, strong finances and long histories of thriving in all market environments.

ARC continues to ramp up its production, primarily from Montney Shale reserves management began intensively targeting in recent years. Output for the quarter surged 24.4 percent to 82,367 barrels of oil equivalent per day (boe/d), despite some production problems due to flooding in southern Saskatchewan and Manitoba as well as forest fires and pipeline shutdowns in northern Alberta.

A return to more normal external conditions should enable the company to easily meet its target of exiting 2011 with 90,000 boe/d of production. And the company’s disciplined capital spending program–recently increased to CAD690 million for the full year–should keep the momentum going well beyond that. Breaking it down, natural gas output rose 47.6 percent, NGLs rose 17.1 percent and condensate production jumped 58.9 percent, offsetting flat oil production.

As for realized selling prices, oil rose 34.9 percent to over USD97 a barrel, condensate surged 28.4 percent and gas liquids fetched 25.3 percent more. Even realized selling prices for natural gas stabilized at USD4.05 per thousand cubic feet, virtually identical to last year’s USD4.12.

ARC’s greater scale enabled it to cut operating costs per barrel of oil equivalent (boe) produced to just CAD9.22, down 19.5 percent from the year-ago quarter’s CAD11.46. Transportation costs per boe were cut slightly, and even royalty payments to the government slipped. That’s the same rising scale formula that’s powered ARC’s profitability over the past year, and it looks very much set to keep producing strong profits for the rest of 2011 and beyond.

There’s no significant near-term debt due, net debt to annualized cash flow ratio is just 0.9-to-1–one of the lowest in the industry–and borrowings are just 9 percent of total capitalization. That’s the conscious result of a very conservative financial policy.

Second-quarter funds from operations surged 21.7 percent, pushing ARC’s payout ratio down to just 41.1 percent. That’s low enough to support the company’s first dividend increase since July 2008.

ARC Resources is a buy for those who don’t already own it up to USD25.

Peyto Exploration & Development Corp’s (TSX: PEY, OTC: PEYUF) reliance on natural gas for more than 80 percent of its output makes it a bit riskier than ARC or Enerplus. But its extremely low operating costs, prolific reserves and increasing output of NGLs continue to make it attractive. And despite solid gains this year, the shares still trade well below conservative estimates of the value of its reserves of USD33 per share.

The company has paid the same monthly dividend of CAD0.06 per share since it converted to a corporation at the beginning of the year. Management has adopted a very conservative financial policy enabling the company to finance capital spending and dividends with cash flow that it’s unlikely to change.

That’s likely to keep a lid on dividend growth, at least until natural gas prices rebound. But Peyto Exploration & Development is a solid value and a bet on rising NGL production up to USD22.

Faster Growth

Aggressive Holding Daylight Energy had another very successful second quarter, as it continued to shift its output toward liquids, including NGLs. The payout ratio was steady at 41 percent, and the company ramped up capital spending to CAD133.4 million for the quarter, an increase of 115.8 percent over last year’s level. The company plans to spend CAD350 million for the full year.

Production was 13 percent lower than year-earlier levels at 36,814 barrels of oil equivalent and 6 percent below first-quarter tallies. That was largely due to a disruption at a natural gas plant and needed maintenance at the company’s light oil facility in June. Both should prove short-term factors, putting the company’s output back on track for robust growth.

Meanwhile, Daylight continues to enjoy robust realized selling prices. Its light oil fetched 40 percent more than it did a year ago. NGLs saw a 10 percent sequential gain from the first quarter and 23.3 percent year-over-year. Natural gas, meanwhile, saw a 1 percent higher price from the first quarter, though a 1 percent drop from year-earlier tallies.

Daylight’s selling price for natural gas during the quarter is below the market price prevailing thus far in the third quarter. That’s promising for future profit margins. Meanwhile, management is keeping a tight rein on costs, with operating costs per barrel of oil equivalent actually dropping 1 percent sequentially and 7 percent versus year-earlier levels, despite the problems with production mentioned above. Costs should go even lower as output returns to targeted levels.

Management still expects production to average 42,000 boe/d in the fourth quarter of 2011, though it’s now guiding down for the third quarter on the weather. That may delay any thoughts of a dividend increase, but given the price environment profits will stay strong.

As for the balance sheet, there are no significant maturities between now and the end of 2012, while the company has plenty of room under its credit line to finance more aggressive moves if need be. The stock has slipped a bit recently and now trades well below my buy target of USD11. That’s most likely due to cooling investor passions for all energy producers. But with its strong position in light oil, NGLs and natural gas in the Deep Basin core area, Daylight is a value for any conservative investor who wants to be paid a dividend for betting on energy. Buy Daylight Energy if you haven’t yet up to USD11.

Bonavista isn’t a CE Portfolio Holding but it is a strong company that’s well positioned for the growth of NGL output in Canada. Already at 17 percent-plus of total output, the company’s NGLs profit swelled in the second quarter of 2011, thanks to a combination of 5 percent greater output and a 26 percent jump in NGLs prices.

That helped the company offset a drop in gas prices and oil production, enabling it to hold funds from operations reasonably flat. Funds from operations per share were off 21 percent in the second quarter, due almost entirely to a 22 percent increase in outstanding shares of Bonavista. The payout ratio, however, still came in at just 36 percent.

Looking ahead, Bonavista should continue to see the benefit of liquids-focused capital spending. CAPEX on exploration and development surged 47 percent during the quarter from year-earlier levels, and management has authorized a full-year budget of CAD580 million to CAD600 million, versus a previous CAD345 million to CAD375 million. About CAD180 million will go to acquisitions to build scale in key operating areas. That should stanch the recent inflation in the company’s cash costs, which rose 14 percent over the past year, as production rose 3 percent.

Bonavista now expects to exit the year producing between 77,000 and 78,000 boe/d. That’s a dramatic rise from the 66,107 pumped in the second quarter, and it augurs well for earnings the rest of the year. So does the push ahead in the light oil rich Cardium region, as well as into NGL-rich Pine Creek, Rosevear Rock Creek, Hoadley Glauconite and Blueberry Montney.

There’s been no dividend increase since fall 2005, when the company went from a monthly rate of CAD0.275 to CAD0.33. Since then the payout has steadily dropped, pretty much in tandem with natural gas prices, and now sits at a monthly rate of just CAD0.12. Rising NGL output is the ticket toward pushing that higher. Meanwhile, Bonavista Energy is a buy up to USD32.

Progress Energy Resources has also never raised its dividend since converting to a corporation, when it cut its payout substantially. Even before that, however, its dividend was under pressure from a combination of falling natural gas prices and an aggressive expansion policy.

The good news is management has been able to stick with its development plans despite very tough conditions. Production has risen to 40,736 boe/d in the second quarter, and the company continues to aggressively develop an array of liquids-rich gas projects.

A newly inked strategic partnership with the Malaysian national oil company Petronas should be a major plus on that score. The latter is obligated to pay 75 percent of Progress’ share of capital expenditures on a portion of its Montney Shale assets, up to a total of CAD802.5 million. That deal is set to close by the end of next month.

Progress currently owns the industry’s largest Montney land position with some 900,000 net acres, 700,000 of which are roughly contiguous. The company’s goal is to double its production base over the next five years and is pushing 75 percent of its CAPEX budget toward the Montney. Exit 2011 production is now expected to reach between 50,000 and 52,000 boe/d, with overall production growing 13 percent.

That should ensure a sizeable increase in NGLs output. Meanwhile, the company’s balance sheet is healthy, with its CAD650 million credit facility undrawn as of this week. Debt-to-capitalization is low at just 13 percent, and a CAD75 million debt maturity (due Sept. 30, 2011) the only obligation to refinance or pay off between now and April 2014.

That’s a pretty good growth/production profile. Despite a relatively low yield, Progress Energy Resources is a solid total return bet up to USD14.

High Stakes

As longtime CE readers have no doubt surmised, Perpetual Energy presents much higher risks that the other six companies on my list. That’s because it’s highly leveraged and almost completely reliant on producing natural gas.

I’ve stuck with the stock in the Aggressive Holdings for two main reasons. First, I want to have one extremely high-stakes play on gas in the Portfolio, and this is the highest risk/return producer stock I track in How They Rate. Second, management has been extremely up front providing details about its business, despite the fact that they haven’t always been encouraging.

This includes an update of the company’s production and gas price management every time it declares a monthly dividend. Highlights of the mid-July installment include a current value of open hedging positions of USD2.8 million and a current calculation of production of 187,000 gigajoules per day, which equates to about 31,000 to 32,000 boe/d. Both are roughly in line with management’s earlier projections, as are locked-in prices.

The company is currently projected to release its second-quarter results on or about Aug. 10. At that time we should learn more about ongoing efforts to increase production of light oil and NGLs, funded by the 50 percent dividend cut earlier this year. My expectation is we’ll see growth as robust as we did in the first quarter.

But Perpetual Energy is only a hold for aggressive investors, not income seekers; only intrepid buyers willing to bet natural gas should buy up to my target of USD5.