Question of the Week: Canadian Energy Trusts

Includes: BNEFF, CPG, DUK
by: Roger S. Conrad

Here’s this week’s most asked question from readers; I hope you find it interesting.

  • I read an opinion piece on Seeking Alpha this week that seemed to discourage investment in Canadian energy producer trusts. Could you comment?

Let me start with where I agree with James Keller, the author of How Oil and Gas Investors Can Prepare for the Energy Trust Corporate Conversion.

First, virtually all oil and gas producer trusts--as well as Canadian income trusts from other sectors--are almost certainly going to convert to corporations sometime between now and the end of 2010. Admittedly, there is the possibility the Canadian government will change the law between now and then, as the Liberals and Bloc Quebecois are still at least publicly supportive of extending trust status.

The ruling Conservatives, however, appear pretty dug in at this point. And as I’ve said repeatedly since Finance Minister Jim Flaherty announced the 2011 trust tax back on Halloween night 2006, no one should count on the Canadian government to roll back its actions.

Second, some trusts are much better positioned than others to make the switch. To be sure, there aren’t many weaklings left. The stress tests of the past three years have exacted a harsh toll, forcing trusts to rely on their own resources with little access to outside capital even as their core businesses have been hit by the recession.

And no group has been hit harder than oil and gas producers, whose cash flows have dropped in tandem with energy prices over the past year. Those that are left are going to make it as corporations. But some are much better positioned than others to absorb the new taxes and maintain their current distribution rates.

Third, the criteria cited by Mr. Keller for easier conversions are right on. That’s basically a “clear path” to growth in output and reserves, a facility for technology and a conservative financial structure. Since in 2004 I’ve been an advocate of a “rifle approach” to the sector that he advocates, meaning you’ve got to be selective.

Finally, I agree that Crescent Point Energy (CPGCF.PK) is the best example thus far of a successful conversion.

Now to what I find fault in: There’s no basis for making a declarative statement that “when an energy trust converts to a corporation, they most likely will cut their dividend.”

We may well see more trusts cut dividends than not. But producers converting so far have clearly based their decisions on energy prices. If you forecast dividend cuts, you’re essentially making a forecast for lower oil and gas prices. The conversion itself has little to do with it.

Mr. Keller cites seven “energy trusts” as the basis for his study. In reality, however, only five of those seven are actual energy producers. The other two are energy services companies, an industry with very different dynamics. He also left out one of the converting trusts, True Energy, which has since become Bellatrix Exploration in a deal completed in early November.

Of the six trusts that have converted, the four that reduced distributions upon conversions are all focused on natural gas production. All four released statements upon conversion that they were making their move to be “growth” companies. In reality, however, they had no choice. Mainly, gas prices had fallen so far that cash flow had dried up. It was stop producing and wait for higher prices, dramatically weaken balance sheets by taking on more debt or else cut dividends.

In stark contrast were the two oil-focused trusts that converted--Crescent and Bonterra Oil & Gas (OTC:BNEFF)--neither of which cut dividends a penny upon conversion. Bonterra did have to cut dividends rather dramatically in late 2008, from a monthly rate of 32 cents Canadian in October to a low of just 12 cents in February. Its actions, however, are the exception that proves the rule.

Mainly, oil prices cratered from nearly $150 a barrel to as low as $30 a barrel over that time, and dividends followed them down. Meanwhile, as oil has recovered this year to the $70 range, so have Bonterra’s dividend, now 16 cents Canadian. That’s roughly half its level of summer 2008, when oil prices were slightly more than twice current levels.

I’ve never claimed to be a mind-reader. But I don’t think I have to be to say energy prices played a pretty decisive factor in determining what converting trusts wound up paying in dividends. And if anything, there’s every indication energy prices will be even more paramount when the remaining trusts announce their conversions.

One big reason is the superior stock market performance of trusts that have elected to maintain dividends. Management may save some cash by cutting dividends and applying the money to growing resources. But if making that cut results in a lower share price--and worse undermines investor confidence--it’s going to be a lot harder to raise outside capital, probably for a long time to come.

Conversely, holding the dividend does mean a bigger outlay of current cash flow, which all else equal means less funding available for growth. The thing is, however, all else is definitely not equal.

In fact, if holding dividends translates into a higher share price--as it has for Crescent--the converted company will actually be able to grow faster than if it cuts. Last month, for example, Crescent boosted its Bakken land position with the acquisition of TriAxon Resources. The all-stock deal would have cost Crescent a third more had it tried it before conversion, when its shares were 50% cheaper.

Again, I’m no mind-reader. But the example of Crescent certainly hasn’t been lost on trust managements. And I’ve heard more than one executive remark that he’d much rather follow the Crescent Point example than that of cutters like Progress Energy Resources, which, like Crescent, has a rising production profile but in severely depressed natural gas.

Finally, dividend cuts or no, investors’ total returns in trusts are going to depend on expectations. The question is whether or not the post-conversion dividend rate is above what investors expect, or what’s reflected in its share price. If a trust beats expectations, its share price is going to rise. If it misses, it will drop at least initially.

For a long time following Jim Flaherty’s trust tax announcement Halloween night 2006, trusts’ prices were depressed by the misconception that 2011 taxation means virtual liquidation. The early converters have at least dispelled that fear. But there’s still the perception that huge, crippling dividend cuts await, a belief that’s well reflected in Mr. Keller’s Seeking Alpha piece.

As a result, producer trusts currently sell at steep discounts to the value of their reserves in the ground. The bar of expectations is extremely low and will likely remain so until dividend policies are confirmed.

On the other hand, low expectations are relatively easy to beat. And that, in my opinion, is almost certain to be the case for most producer trusts, triggering Crescent-like windfall capital gains for many if not most.

There’s even a silver lining for dividend cutters: Of the 25 trusts from all sectors to convert to corporations early--dividend-cutters and dividend-holders alike--the average gain since conversion announcements is more than 30%. And that’s encompassing some of the worst market action most of us have ever seen.

Legendary billionaire J. Paul Getty once said the key to riches was to buy what no one else wanted; or, more colloquially, when there’s blood in the streets. Many high-yielding investments met that criterion when the market rally began in March. This is one that still does. And that’s even despite a double in the S&P/Toronto Stock Exchange Income Trust Index from those lows.

Disclosure: No positions