Canadian Energy Trusts: The Best Long Term Income and Dollar Hedge? (Part 2)

by: Cliff Wachtel

Part 7B of The Income Investor’s Collapsing Dollar Survival Guide


See Part 7A.


See Part 1, Part 2, and Part 7A of this series for the full story.


See Part 3 for the full details, but here’s the summary.

We’re seeking stocks of strong companies that mostly earn and distribute a high dividend in a non-USD currency and have a dominant position in a market for an essential product or service.

In this installment, we’ll begin exploring opportunities in the best single country in the world for stocks that combine high reliable dividends and USD hedge, Canada.


For those seeking to diversify out of the USD, the CAD is one of the best alternatives. See Part 7A for the full story.

A. Grand Banks

The short version is that the Canadian banking system is among the healthiest in the world. It mostly avoided the entire subprime mess. While they feel some effects of the worldwide slowdown, banking and real estate are stable, credit is available, there is no major bailout needed from the government.

Thus supply of CAD will not be expanding by orders of magnitude, unlike the USD, for massive bailout programs, and the CAD should retain its purchasing power far better.

B. The Loonie Is a Commodity Based Currency

Because commodity exports are such a large part of the Canadian economy, the CAD tends to follow prices of energy, and other key commodities like grain and iron ore, etc. Thus they have all fallen together in the current slowdown.

However, as world populations continue to expand, even less than robust recovery will ultimately drive essential commodities higher. Higher commodity prices and far less expansion of the CAD money supply will support a long term appreciation of the CAD against the USD.

Of course, there are other factors influencing how the CAD and USD fare against each other and other currencies, and the Australian Dollar shares much of the CAD’s USD hedge characteristics. Nonetheless, the CAD is a compelling hedge against the USD.

5. Canadian Oil and Gas Producer Income Trusts - The Big Picture

The best of these already have the price and dividend cuts behind them, still pay high yields at current prices, and probably will continue to do so even if there are further dividend cuts. They will likely double or triple both yields and prices as energy inevitably recovers. Thus for those who can wait 12-18 months, these stocks have the highest likely price appreciation potential of any high dividend stock.

In addition to further temporary energy price declines, risks to these include currency risk (the CAD falls further) and overall market risk (shares move down with the overall market). Some of these are thinly traded, and thus can be extra volatile in either direction. There is also some uncertainty about how tax changes in 2011 will affect these trusts.

The recovery of both price and dividends, however, is only a matter time.

As noted in Part 7A, current prices for oil and gas are about USD 40 and 4. These prices are well below global reserve replacement costs for oil and gas are about USD 80 and USD 8, and also below production costs for many unconventional sources like deep ocean wells, Canadian tar sands, and shale oil properties. Falling energy prices are causing future supply cuts as existing and developing production sites are being scaled back or shut down.

For all the talk about wind, solar, and other alternative sources, they simply aren’t ready to begin seriously replacing traditional fossil fuels (coal included, but that’s a later discussion).

This global supply destruction makes new highs in energy prices inevitable, and the longer prices stay down, the greater the ultimate price spike that must follow. Also, all of the selections below sell at large discounts to book and net asset value, and are thus takeover targets.

Last year shareholders of PWI got about 30% over market value for their shares in a takeover.

Thus the rewards of current yields and very strong potential for robust price recovery more than justify the near term further downside risk.

Note: Canada has a 15% withholding tax for US shareholders, which can be recovered as a tax credit by submitting IRS form 1116 with your tax return.

All amounts quoted are in U.S. Dollars unless otherwise noted. All stock symbols are New York Stock Exchange unless otherwise noted. Yields are as of the day prior to publication.

6. Energy Income Trusts – Specific Recommendations

Take only partial positions until energy prices appear to have stabilized, but be ready to load up on these as the market begins to show interest. Both prices and distributions will soar as energy recovers, giving you high yields and capital gains.

A. Advantage Energy Income Fund (NYSE:AAV)

Buy under 3, Strong Buy under 2.5 ONLY IF YOU DON’T NEED THE INCOME and are willing to speculate on the price and dividend recovering, or a possible takeover.

AAV recently suspended dividends until further notice. It chose to use cash to continue development and not jeopardize present survival or future growth. That was the smart move. Because AAV is heavily levered to energy prices, both yield and price will soar fast when oil and gas prices recover, which is likely within the next 24 months.

Natural gas is 67% of output, and is the cleanest fossil fuel, is widely available, and there are plenty of power plants set up to burn it. Thus it’s the quickest, cheapest green fix, and it will benefit more than any other fuel in the near term from the move to cut carbon emissions.

AAV is greatly expanding production and reserves at low cost. For example, it has recently hit a massive new reserve at its Montney Shale property in Alberta, which almost triples its annual oil and gas production at a very low finding and development cost of CAD 3.48 per barrel of oil equivalent. With close to 450 other drilling sites, the picture could get even better.

The recent dividend suspension spurred a selloff from its base of income investors, driving the price back to all-time lows around USD 2.28, meaning that AAV now sells for about 20% of net asset value of reserves. This extreme bargain price (along with its early conversion to a corporation) will ultimately bring in growth investors, and also makes it a prime takeover candidate.

B. ARC Energy Trust (OTCPK:AETUF)

Buy under 13, Strong Buy under 10. Yield 19% prices in dividend cut, which with current payout ratio around 40% seems unlikely unless energy falls much further.

Like its brethren, it has suffered multiple distribution cuts – 4 since August alone.

However, Q4 results blew out expectations. In short, earnings, reserves, and payout ratio improving, debt and costs falling. The good news includes:

  • Reserves up: Proven reserves (at least 90% chance of development) up 5%, probable reserves (at least 60% development chance) up 60%. Proven reserve life extended to 10.4 years.
  • Costs down: Finding, Development and Acquisition costs (FD&A) for proven reserves cut 40%.

C. Claymore/SWM Canadian Energy Income Fund (NYSEARCA:ENY)

Buy under10, Strong Buy under 8. For those that want to buy a basket that attempts to mimic this sector. Unfortunately, many good assets are not widely traded enough for this fund, which is why I prefer to cherry pick individual stocks.

D. Enerplus Resources Fund (NYSE:ERF)

Buy under 20, Strong Buy under 16. Yield over 9%. Along with Vermillion (mentioned below), ERF is the safest bet on energy for high income and dollar hedge.

At current dividend levels, its payout ratio is a very conservative 29% of Q4 distributable cash flow, making further cuts unlikely barring a radical further decline in energy prices. Management has been here before, having profited even during the major energy price decline a decade ago. Debt/equity is only 15%. Annualized cash flow is about double that of debt payments – among the lowest debt burdens in the industry.

Over the past year, ERF increased its diversified and high quality overall proven reserves by 10% to 9.4 years. Oil sands reserves are up 70%. At current prices ERF sells for about half its asset value, and that’s BEFORE considering the oil sands properties.

With low debt and operating costs, ERF can stay profitable even with oil around USD 10, making this one of the safest energy bets.

Its upside potential is enormous. As the most well known in its industry, it’s a favorite among large investors, and its shares are the first to be bought and last to be sold. When its shares peaked in 2006 at USD 60, it was a smaller company, without the vast natural gas, oil sands and shale assets it has since acquired.

E. Peyto Energy Trust (OTCPK:PEYUF)

Buy under 8, Strong Buy under 6.Yield 36% at current price around USD 6.5 even after the recent 20% dividend cut from USD 0.15 to 0.12, prices in more cuts.

Long term survival appears assured. Proven reserves up 16.9% and are now up to 17 years, and industry best. Debt remains modest even with this expansion, and operating costs are among the lowest in the industry.

F. Provident Energy Trust (PVX)

Buy under 4, Strong Buy under 3. Yield over 14%.

As of this writing Q4 results were not yet available. Proven conservative management, and at current prices sells for around half of book value and 24% of sales, is worth the risks.

G. Vermillion Energy Trust (VETMF.PK)

Buy under 19.25, Strong Buy under 18.25. Yield over 9.5%.

Along with ERF, Vermillion is the top choice of the group for a bet on energy for income and USD hedge. A testimony to its strength, it is the ONLY one that has not needed to cut distributions.

Global production up 5%, debt cut in half and soon to be entirely eliminated upon completion of pending sale of its stake in Verenex (OTC:VRNXF). Global diversification has helped it take advantage of much higher gas prices in Europe and Asia than in North America. Low payout ratio of just 33% leaves abundant cash for development, acquisitions and distributions. The firm believes distributions can be maintained with oil and gas at USD 40 and 3.85.

While deep energy price declines could hurt the distribution, Vermillion executives own around 9% of the company, so they’re well motivated to keep shareholder interests in mind.

Disclosure: I have positions in most of the above mentioned investments.