Will ARC Energy Trust be Forced to Cut Distributions?

ARC Energy Trust (AETUF.PK) recently announced that its budget for 2009 will be $585-million, which represents a 10% year-over-year increase. The aggressive capital program is targeted at unlocking value from the Montney natural gas play in northeastern British Columbia, which is considered potentially one of the largest economically viable resource plays in North America. However, while analysts remain confident in the company’s approach, its plans raised some concerns given the current economic environment and they may force ARC to cut its distributions or take some strategic action.

UBS analyst Grant Hofer said:

The trust is now moving aggressively from building its Montney resource, to exploiting it. ARC’s Montney play has clearly evolved into a company-maker for what was already an exceptional oil & gas company.

He noted that ARC plans to spend more than half of its budget in the region that also includes northwest Alberta, with $140-million directed primarily to the Dawson area, where an independent reserve update provided a 15% boost to the trust’s total reserves. This further validation is expected to lead to strong finding and development costs in years to come, while ARC’s production outlook that includes a 13% anticipated increase in 2010, is the strongest in the sector, Mr. Hofer said in a recent report.

The higher capital program next year combined with a lower-than-expected production forecast has forced Canaccord Adams analyst Kyle Preston to cut his financial estimates for ARC. He noted that while its payout ratio and debt levels have risen substantially in 2009, the potential payoff comes in 2010 when its Montney production more than doubles.

However, its high payout ratios suggest ARC will need to make another distribution cut to help fund its expanded capital program. It currently stands at C$0.24 per unit, which includes a base distribution of C$0.20 per month and a C$0.04 top up.

Mr. Preston said:

Our forecasts assume ARC uses up all of its existing credit capacity, which could place the trust in a position to raise new debt or equity; however, we would expect ARC to cut distributions before pursuing either of these options.

He added that he expects a cash shortfall of roughly C$290-million. With around C$295-million of spare credit capacity at the end of the third quarter, this is barely enough.

The Canaccord analyst noted that ARC has identified other funding options such as potential asset sales, distribution re-investment program proceeds, issuing new debt or equity, or bringing a strategic partner on board to help fund the Dawson gas plant.

Mr. Hofer at UBS said the only drawback from recent developments at ARC is this need for external capital to fund the expanded budget. He also said it may seek new equity if the market is receptive.

Clearly the trust’s management believes the Montney plan is too significant to ignore or delay and further. At the same time, it also expects both debt and equity markets will improve in the next year.