Canadian Energy Trusts Look Cheap: Harvest Is Well Positioned

The deflationary credit contraction has significantly strengthened over the past year and most analysts are beginning to accept the condition. Holders of capital are seeking safety and liquidity for their capital. Many have been selling most of their assets. Particularly oversold appears to be the Canadian royalty trusts particularly in the oil and gas sector.

The implications of Peak Oil Theory are staggering. Oil is extremely important for the United States economy and the need to access cheap and reliable imported oil is even more vital. Foreign dependence makes domestic consumption of about 21 million bbl/day compared to about 7.5 million bbl/day particularly disturbing. Due to fixed costs in infrastructure these ratios are unlikely to decline. There are many ways to play the oil and natural gas sector ranging from the oil majors (like XOM, COP, CVX, BP, TOT, etc.) to refineries (like TSO, VLO, etc.) to VLCCs (like FRO) and Canadian oil and natural gas royalty trusts (like HTE, PVX, PGH, ERF, etc.)

Gold is a currency. Commodities are produced because they add value to society. Oil is the lifeblood of the modern worldwide economy and is integral in all aspects from food to aerospace. The value gold adds to society is in performing mental value calculations.

The historic gold to oil ratio is incredibly consistent.

Currently oil appears to be extremely cheap when priced in gold. Additionally, almost everyone agrees the Federal Reserve Note rally is fundamentally unsound as it is tremendously encumbered.

As the deflationary vortex has strengthened the price of Canadian oil and gas royalty trusts have plummeted.

For example, over the past year Harvest Energy Trust (HTE) has fallen from about US$20 to US$8. It appears that market may be pricing in systemic collapse complete with breakdowns in food distribution accompanied with riots. Assuming that is not the case, the current prices have resulted in many outstanding bargains in my opinion.

Harvest Energy Trust was founded in 2002 and headquartered in Calgary, Canada. Harvest engages in exploration, development and maintenance of petroleum and natural gas properties along with a gasoline refinery. Harvest currently has 154.5 million shares outstanding as of December 31, 2007 it had a net total proved plus probable reserves of approximately 192,297 million barrels of oil equivalent. Harvest pays a monthly distribution of C$.30 and has a payout ratio of 66% of cash flows. This is extremely low for them historically. To some extent the cash flows are protected and hedged through an extensive program with the intent to provide stability to the monthly distribution.

The North Atlantic refinery appears to have been an albatross around the income statement. The Canadian dollar has significantly weakened against the Federal Reserve Note Dollar. Oil and natural gas prices have significantly fallen over the last several months. Proposed Canadian tax laws have been clarified and enacted. Harvest is extremely well positioned with over $3B in ‘tax pools’ to draw upon to shield income.

The Canadian oil and natural gas royalty trusts were originally designed and intended as retirement vehicles. The goal of Harvest management is to create long-term shareholder value. Harvest currently has more than one barrel of oil per share with a payout ratio significantly below 100%. Oil is and will remain a large component of the worldwide economy. The oil price appears extremely cheap when priced in gold. The Federal Reserve Note Dollar’s fundamentals are abysmal and according to GATA’s contentions it is extremely overvalued relative to gold. Therefore, it appears that the discounted future cash flows from Harvest when priced in gold are beginning to look like an attractive place to allocate capital for a few years. For example, should the Federal Reserve Note Dollar collapse then tangible assets are owned so one’s capital is preserved.

These are some key ratios for determining value calculation. Worst case scenario oil prices continue to fall and the Federal Note Dollar continues to strengthen which will weaken Harvest’s extremely attractive yield from the current approximately 30% (depends on your tax situation). Long term put options can easily be purchased to preserve capital investment. The cash flow makes it more stable than the VLCCs and refineries and the North American production makes it safer than the oil majors.

For these reasons Harvest appears to be fairly cheap and a good opportunity.

Disclosure: Long physical gold and long HTE. No other positions in corporations mentioned.

Comments

[NOWHEREMAN:]

Thank you very much. Now wait for the diatribe from the PWE crowd. IMHO

2008 Dec 12 06:35 AM

[quitethefool:]

The Canadian oil trusts are all ridiculously underpriced. Even after taxes and dollar conversion, HTE, PWE, and the others are returning over 20% a year just in distributions! (They are so beaten down right now that they probably are also going to get over a 100% capital gain appreciation over the next year or so.) If you had a financial analyst or a hedge fund manager who was getting that kind of return in this kind of market he would be bragging about it in full page advertisements in the WSJ.

2008 Dec 12 07:12 AM

[longoil:]

Most Canroys are bargains right now. Long investors will be rewarded. I like HTE, PWE, ERF and COS.WF myself.

Unlike high tech stocks, real estate and financials that were real bubbles based on pure speculation, oil prices have dropped because of the depression-like recession the entire world is in currently.

According to the EIA, the demand for oil is projected to increase from 88 mbl/day to 130 mbl/day over then 25 years. Production has flat topped at 88 mbl/day since 2003, despite all the new projects (oil sands, deep sea oil, etc) that being brought on board. Alternative energy technology consists less than 10% of the global energy mix and is very slowly ramping up and will take 40 to 50 years to displace fossil fuels.

The next 20 to 30 years will be good for conventional energy investments like oil, gas and coal. Canada offers the unique opportunity (via Canroys) to invest in energy on the open stock market and in a stable country that respects the rule of democracy (unlike most oil producing nations in the world today).

2008 Dec 12 08:59 AM

[tinman:]

In 3 years, the trusts should pay off nicely but HTE will have to cut the div again next year to around $1 US. I think there are better yield plays now, especially convertibles.

2008 Dec 12 10:23 AM

[Larry Belle...:]

Good article in theory, but you missed way too many key points.

1) The Alberta Royalty regime changes have been a major hit to many companies, in regards to the Cash Flow from their existing wells (there has been some relief for certain depths on the new wells). This has been part of the reason for the downfall, as Stelmach has not softened his stance to the extent that the Patch wants.

2) The Federal Government's proposed changes to the Income Trust structure in 2011 have left many of these companies in doubt, regardless of what tax pools Harvest may have built up. The usual feeding system was for a company such as this to be taken over by a Canadian Major (EnCana/PetroCan, etc), or by a Foreign company looking to add to its reserves. Without the mechanism, it will be tough to see a good long term for Harvest.

3) While the costs have come down in Western Canada, the Drilling costs are still quite high, as well as many of the Services (Fracturing, etc). The current prices (at least in Alberta) still make it prohibitive. While they have properties in Kindersley, this isn't enough to balance out, as that area is using the same drilling services out of Red Deer, Alberta.

4) While I haven't personallly analyzed Harvest, I have heard many Analysts talk about their high leverage, which is not good in this time of the Credit Crunch.

There are much better plays out there than Harvest. Companies such as Crescent Point (Bakken play, I have no position) provide a better return, and less exposure to Alberta. Another option is a company such as Canadian Oil Sands (no position) that has already settled their Royalties issues.

Personal Disclosure -- I live in Calgary, and have most of these companies (including Harvest) as customers.

2008 Dec 12 10:33 AM

[Steven Ward:]

The market discounts 6 months out to a minimum. HTE's
price is a reflection of further dividend cuts.

2008 Dec 12 10:33 AM

[Trace Mayer:]

LOL. I have thick skin and good ear flaps like a camel. I have nothing against PWE it is just that this article was about HTE.


On Dec 12 06:35 AM paultaut wrote:

> Thank you very much. Now wait for the diatribe from the PWE crowd.
> IMHO

2008 Dec 12 12:14 PM

[Trace Mayer:]

Good issues Larry. I still think HTE is a good value even with these issues though. For the particularly cautious the put strategy I suggest would help mitigate more potential downside. With $3B in tax pools will shield a lot of income which may go out towards their RLI. Harvest is unique because of North Atlantic so crack spreads which are bound to turn around eventually will play a role.

Given the political pain the canroys seem to cause, the decreased energy prices and the fractured Canadian government do you think there is any chance of the tax proposals getting shelved?


On Dec 12 10:33 AM Larry Bellehumeur wrote:

> Good article in theory, but you missed way too many key points.

>

2008 Dec 12 12:19 PM

[macsmart:]

If Harper does go down in flames in Canada as he might, the 2011 tax changes will be rescinded and the Canroys would likely double in price.

2008 Dec 12 12:47 PM

[bindlepete:]

If you think Canadian hydrocarbons will come back big time, as I do, these Trusts make a lot of sense. The revision in the Tax Law is optimistic but then it is Canada, and they might reverse it. Some reasonable politicians up there.

The real big bet is PetroBank in my opinion for the Canadain future. Their technology for insitu recovery for tar sands is proven out. ( Higher yield, better oil, and lower in cost). They are now enterting the expansion phase and they bet the company and won on the Bakken. Their Columbian play is just iceing on their cake.

I own a mess of Can Roy's and a lot of PBG.to

2008 Dec 12 01:11 PM

[longoil:]

Macsmart,

I don't like Harper either, but he is the lesser of the three evils.
His government said they would not convert the income trust structure prior to the election, but they flat out lied and did it anyways. I think he did all his damage already, they other guys can only make things worse.

A Liberal government would not only keep the Harper changes, but probably add carbon taxes as well to the energy companies.

An NDP government (God forbid !!!) would keep the Harper changes, add carbon taxes and raise all corporate taxes. Remember, these guys are borderline Marxist and "Tax and spend" is their mantra.

2008 Dec 12 01:14 PM

[Larry Belle...:]

To reiterate some of the previous comments, I don't see Finance Minister Flaherty changing his tune on the 2011 Conversion. He said so in a Press conference last week. The Liberals have discussed how they would change things, but I think when they saw the tax losses of some of the larger Corps moving over to Income Trusts, they too would panic.

I do agree that things look good for 2010 and beyond for the Canadian Patch....I just think that there is no rush to buy any of them. I do like PetroBank, but don't like some of their South American exposure.

I never really did like the Income Trust model for many Intermediate Oil companies, as it is more suited for larger producers in my mind (the Pengrowth, EnerPlus and Penn Wests of the world). I'd still prefer a large cap with good Oil Sands exposure, like Suncor (small position in).

Cheers
Larry

2008 Dec 12 03:23 PM

[Jackie:]

what is COS.WF?

2008 Dec 12 04:42 PM

[argumentum ...:]

Re larry above;If you had bothered to do any reading at all you might have come across the PricewaterhouseCoopers independant study on income trusts wherein it documents that IT's produce more tax revenue than corp's.Personal tax rate 33%+-.EFFECTIVE corporate rate 6.5%.There is a stong possibility the Lib's will kill the tax as there is no rationale to it other than great confusion instilled by it's proponents i.e.competitors with product which failed to compete but with deep pockets and influence particularily over the cons.
and "cheers" to you larry.Ron.(can you read between the lines,larry?)

2008 Dec 12 07:14 PM

[JCCIII:]

Jackie, I think he meant COSWF.PK or maybe COS-u.TO

2008 Dec 13 05:37 PM

[calvino:]

When the VIX comes down and hedging the shares will become economical again, the Canroys will see a move up. I think it will be significant.

2008 Dec 14 12:29 PM

[yank:]

argumentum:
You are correct about the Price Waterhouse study on these trusts. Additionally CanAccord Adams did a similar comprehensive study of these trusts and pointed out very clearly that the "tax leakage" argument by Flaherty was completely bogus and could not be supported by facts. Have all those Candian pols forgotten why they created the trust model? It was the most economical and efficient way to develop reserves. And the baloney argument about tax losses being too large doens't hold water either. Ask yourself this question. Why were Candian REITs exempted from this tax proposal while the energy royalty trusts were not? After two years Flahery still "doesn't get it". Forcing the trusts to convert to corporate status like ECA, IMO, and others will result in:

1. Less oil/nat gas production.
2. Less royalty/tax revenue.
3. Less employment in the energy sector.

If you doubt my argument, just look up the "effective tax rate" that ECA and IMO pays to the Govt. It's in the low teens. That is a helluva lot lower than the current tax rate these trusts pay. Harper's people are just plain incompetent.

Yank

2008 Dec 15 11:00 AM

[rcolby7:]

How would the demise of the conservative party affect the 2011 tax change? I thought the Liberals were against this and would change it if back in power/


On Dec 12 10:33 AM Larry Bellehumeur wrote:

> Good article in theory, but you missed way too many key points.
>
>
> 1) The Alberta Royalty regime changes have been a major hit to many
> companies, in regards to the Cash Flow from their existing wells
> (there has been some relief for certain depths on the new wells).
> This has been part of the reason for the downfall, as Stelmach has
> not softened his stance to the extent that the Patch wants.
>
> 2) The Federal Government's proposed changes to the Income Trust
> structure in 2011 have left many of these companies in doubt, regardless
> of what tax pools Harvest may have built up. The usual feeding system
> was for a company such as this to be taken over by a Canadian Major
> (EnCana/PetroCan, etc), or by a Foreign company looking to add to
> its reserves. Without the mechanism, it will be tough to see a good
> long term for Harvest.
>
> 3) While the costs have come down in Western Canada, the Drilling
> costs are still quite high, as well as many of the Services (Fracturing,
> etc). The current prices (at least in Alberta) still make it prohibitive.
> While they have properties in Kindersley, this isn't enough to balance
> out, as that area is using the same drilling services out of Red
> Deer, Alberta.
>
> 4) While I haven't personallly analyzed Harvest, I have heard many
> Analysts talk about their high leverage, which is not good in this
> time of the Credit Crunch.
>
> There are much better plays out there than Harvest. Companies such
> as Crescent Point (Bakken play, I have no position) provide a better
> return, and less exposure to Alberta. Another option is a company
> such as Canadian Oil Sands (no position) that has already settled
> their Royalties issues.
>
> Personal Disclosure -- I live in Calgary, and have most of these
> companies (including Harvest) as customers.

2008 Dec 16 10:37 AM

[Oil Lover:]

Oil that Originates from Canada has many obvious advantages over that which originates from the USA Gulf Coasts and from any of The Middle East Countries for the following obvious reasons...

The Oil companies do not have to contend with the terrible weather extremes of the Hurricane Prone Gulf of Mexico Coastlines.

Canada, despite the on again and off again policies of it's Goverment with regard to Oil Trusts, is a stable country with little if any instability such as that caused by internal strife such as exists in many Middle east Countries,,,,

Since the Oil produced by Canada all comes from inland sources there is virtually no likliehood of interruption of flow due to undersea Pipleine breakage or loss due to the current Piracy problems experienced by Other Oil companies depending on Tanker transport of product.

The Dividend payoff to retired U.S.A investors, even after the 15% Foreign Tax levied on dividends payed to American investors, is currently very generous and will remain an excellent source of Retirement income even if Dividends currently paid by CANROYS is considerably cut due to the current worldwide financial Fiasco..

The huge supply of Oil in the Oil Sands reserves, despite some environmental concerns which the large Oil companies are sure to overcome in future will be a near inexhaustable source for dozens of years.

So called renewable "Green" energy sources will soon prove to be inadequate to rely upon as a replacment for fossil fuel and Nuclear energy sources since there are so many limitations on Wind and Solar in terms of cost to produce and space needed per megawatt of production.

I am a holder of Penn West Energy Trust. What is there not to like about PWE?

2008 Dec 17 09:54 AM