by James Keller
James Keller is an analyst with Thermopolis Partners, a hedge fund specializing in commodity stocks, and is located in Jackson Hole Wyoming. Thermopolis Partners is an infrequent contributor to Oil and Gas Investments Bulletin.
Canadian income trusts became one of the most popular investment vehicles of this decade – for Canadians, Americans and other foreigners as well; they allowed companies to pass on a high income stream to their investors in a time of low interest rates.
Seven energy trusts in Canada have now converted to corporations, three years after the “Halloween Massacre” of October 31 2006, when Canadian Finance Minister Jim Flaherty said the government would end the tax benefits of the income trust structure in 2011.
How have these seven stocks performed, and what lessons are there for investors who own the remaining trusts? After studying the dividends and stock prices of these seven, and comparing them against the S&P/TSX Capped Energy Index, we have come up with a handful of conclusions:
- When an energy trust converts to a corporation, they will most likely cut their dividend.
- Investors need to use a rifle approach when investing in trusts as the overall trend in beta-adjusted stock prices before and after conversion is negative.
- The tax implications of converting are almost insignificant because tax pools may shield income from corporate-level taxes for years to come; but companies that are early to convert are choosing to focus on growth and less on income (monthly distributions) for their shareholders.
- If income is your reason for owning trusts, then you need to find those trusts that are protecting your income through a successful hedging program and/or management’s intent to continue to pay a high dividend yield after conversion.
- Crescent Point Energy has been the best performing trust to convert so far; therefore, I have used them as a short case study on what to look for in the remaining trusts which have yet to convert.
If you own a long list of energy trusts, you face the risk of losing significant dividend income upon conversion, and those trusts may underperform their benchmark in anticipation of that negative catalyst. The best course of action for income investors in our opinion is to concentrate their portfolio into those energy trust companies that exhibit the following characteristics: Strong organic growth, benefits from technology and hedging discipline. The companies with all these characteristics provide the best chance to weather the upcoming corporate conversion storm.
Recent Trust Conversions
Since 2006, there have been seven energy-related trusts that have converted to corporations - Fairborne (OTCPK:FAIRF), Bonterra (OTC:BNEFF), Crescent Point (CSCTF.PK), Progress, Advantage (NYSE:AAV), Trinidad Drilling (OTCPK:TDGCF) and Eveready (OTC:EVRDF). Although we only have a limited data set, we are still able to glean some conclusions that may help individual trust investors get prepared for the eventual conversion of all trusts to corporations.
The chart below is a per-share representation of all energy trust dividends since November of 2006. Chart 1 includes the seven corporations listed above and the 22 remaining in the S&P/TSX Capped Energy Trust Index.
Chart 1 shows that dividends were fairly steady among energy trusts until the end of 2008. The decline in dividends from late 2008 through early 2009 was a result of the 2008 credit crunch and collapse in commodity prices. Energy trust dividends, as the chart above describes, were impacted to the tune of a 50% cut in dividends paid between July, 2008 and April of 2009. This circumvented the income protection feature which normally leads to relative outperformance during a market dislocation. Looking forward, could the conversion deadline have the same effect as the credit crunch described above? The answer as described in the following paragraph is YES.
Chart 2 shows the percentage drop in dividends, starting 6 months before conversion and 3 months after. The dividend percentage changes in Chart 2 are “normalized” for the same time period of each trust’s conversion against all other energy trusts in the data set used in Chart 1 (“Normalizing” these dividends for Chart 2 eliminates the commodity price noise that caused many of the trusts to cut their dividend in late 2008 and early 2009; i.e., Chart 2 shows how much more the dividends of the converting trusts were cut in excess of the other trust’s dividend cuts during the same period).
First, it is quite obvious that when an energy trust converts to a corporation, they will most likely cut their dividend. Many of these early trust conversions were a result of the company looking to allocate capital toward growth projects as opposed to dividend payments. Therefore, trust investors must weigh the benefits of higher potential growth against the loss of dividend income.
However, as in the case of Crescent Point, some companies may not need to cut dividends, so if you are reliant on the large income stream that trusts can provide, it will be necessary to look more closely at your trusts in order to pick out those that may not cut their dividends dramatically (or at all). Crescent Point was able to keep their dividend constant after conversion because they have a strong hedging program in place that allows them to smooth out the volatile nature of energy commodity prices. Management also maintained the intent to continue to pay a high dividend as opposed to allocating that capital to growth projects that may not have fit within their long-term business plan.
The next question is: How did the seven trusts trade before and after they announced and completed their corporate conversions? Chart 3 below shows the beta-adjusted performance of an equal-weighted portfolio of the seven trusts that have already converted to corporations. In other words, Chart 3 shows how the seven trusts performed after adjusting for fluctuations in the overall energy market (I used the S&P/Capped Energy Index to calculate each trust’s beta since November 1st, 2006).
Looking at the Price Trend chart above, you can see that owning trusts prior to their announcement to convert to a corporation is a one-way ticket to losing “Alpha”. When it becomes apparent to investors that they face the potential loss of income from a cut in dividends after conversion, the trust begins to underperform its benchmark by roughly 15% in a 6-month period.
However, when you start to look at individual names within that seven trust group, one stands out as a positive outlier: Crescent Point. Chart 4 below illustrates the “Alpha” that Crescent Point gained as a consequence of their decision to convert to a corporation and maintain their dividend. This is another reason why an investor needs to pay very close attention to the intentions of the management teams running their trusts in 2010.
Based on the charts above, if you owned Crescent Point throughout their conversion from a trust to a corporation, you did much better than those who owned other trusts that went through the conversion process. What characteristics made Crescent Point such a positive outlier? The following discussion of what worked for Crescent Point can be applied to the trusts in your current portfolio to see if they make the cut in 2010.
Crescent Point has been focused on long term growth through both the drill-bit (with high IRRs in the Bakken) and acquisitions of companies with significant positions in key long-term plays (Lower Shaunavon and Viking formations for example).
Does your trust have a clear path for growth? Will they see production growth as well as reserve growth? Can they grow their land base? How many drills can they afford to have turning, and is that number growing?
But the most important question to ask is: How much will that growth cost? It is important to look at Internal Rates of Return (IRRs) when a company is drilling for growth (which should also increase their Reserve base).
If they are going to grow through acquisition, it is helpful to look at all of the available acquisition metrics to make sure they don’t overpay. For example, some deals look expensive based on flowing barrel metrics but are cheap based on potential resource reserve metrics.
Technology has always been a key driver in the oil and gas industry, but within the last decade, the pace of technological advances has picked up dramatically. Large shale formations are now in play because of advanced fraccing technology while mature fields may also be able to significantly increase productive capacity from advances in secondary and tertiary technologies. Finding and drilling for oil and gas has never been easier or faster due to advances in underground mapping and drilling technologies. We are focused on those companies that both create and successfully utilize technology for the benefit of their stakeholders.
Crescent Point has been a leader in the adoption of new fraccing technologies that have allowed them to gain increasingly greater recoverable reserves from each successive batch of wells. In addition, finding and drilling costs have declined rapidly as inefficiencies are hammered out of their technologically-driven drill programs.
2008 was the ultimate test of how your trust’s management handled their finances. Oil went from $90 to $140 to $34! Many energy trusts raised dividends, then eventually cut them back by just as much or more by the end of 2008. Crescent Point was one of the few energy trusts that did not cut their dividend in the last 12 months. This illustrates their successful use of financial discipline. They have a policy in place to consistently roll over hedges on a significant portion of their future production. While this has the effect of muting upside in a rising price environment, it also has the effect of protecting the company from oil price volatility.
I’m not suggesting that every trust should have the same hedging plan in place, but I am suggesting that if income is your reason for owning trusts, then a hedging program is essential for those trusts that you do own. If your management teams seem to be shooting from the hip, it may be time to jettison that position. The energy space is by nature an extremely volatile environment, and further volatility that can be introduced by poor financial management should be avoided.
Finding the Widget Factory
The oil and gas industry is extremely capital intensive, which can make it difficult to make money over an extended period of time. But there is one model which can achieve this goal in the oil and gas business: The Widget Factory. A widget factory spreads fixed costs over an increasing production base which allows for an increase in unit profitability as production increases.
We look for those oil and gas companies that have a large resource base and decreasing unit variable costs (finding, drilling and production costs are decreasing). Companies that are applying technology to infill drilling programs are prime candidates to become widget factories – a large undeveloped land package in a proven, low risk oil or gas field. Ultra Petroleum was a great example of a widget factory in the Jonah Field in Wyoming, and Crescent Point’s Bakken play currently exhibits these characteristics.
How Thermopolis Partners Has Played the Trust Conversion
Out of the seven trusts that have converted to corporations, we have owned 2 of them in the Fortuno Capital Fund: Crescent Point and Eveready Income Fund. We owned Crescent Point in size for all of the reasons stated above (and still do). We also owned Eveready Income Fund for its rapid growth trajectory, quality management, and high dividend yield. Eveready did not make it through 2008 unscathed by any means; however, a few months after they converted to a corporation, their intrinsic value was recognized when they were taken out by a strategic buyer at a nearly 200% premium in April of this year.
As a trust investor, the next few months will be critical for your portfolio. If you plan to own a long list of energy trusts in 2010, and you plan to own them for income, you face the risk of losing significant dividend income, and those trusts may underperform their benchmark in anticipation of that negative catalyst.
The best course of action is to focus your efforts on those energy trust companies that exhibit the following characteristics: Strong organic growth, benefits from technology and financial discipline.
A simple way to find out if you’re on to a blossoming widget factory is to look at a trust’s online presentations. Look for large contiguous land packages that overlay a large resource base in place. Call management and ask them what the trend in their finding and development costs have been and where they see them going and why.
We don’t own Vermilion Energy Trust (VETMF.PK) at this time, but they have shown a history of financial discipline (they did not cut dividends in 2008 and 2009), strong production growth with a large resource base and the application of technology to decrease finding and development costs.
Even though the 2011 trust conversion deadline looms near, there is still time for investors to locate and focus on these types of companies in order to maintain a high level of dividend income in the years to come.