Advantage Energy Income Fund Well Placed for Changes in Canadian Taxation

The business plan for Advantage Energy Income Fund (AAV), an oil and gas [O&G] royalty trust based out of Calgary (Alberta, Canada) calls for acquiring and developing O&G reserves in Western Canada. The fund sports a monthly dividend policy, which is popular among Canadian Royalty trusts. For U.S. investors these distributions are:

• Qualified dividend income.
• Subjected to a non-resident withholding tax of 15%.

To be eligible for the withholding tax credit, the fund needs to be purchased for a taxable account. Tax deferred accounts like an IRA cannot claim the credit, which renders investments in such foreign royalties unattractive. Unlike their American counterparts, CanRoys are exempt from paying taxes on the distributions till 2011. Also, their operations and asset base seem perpetual, as they are allowed to expand by investing or acquiring other assets.

The fund has 154 million barrels of oil equivalents (boe) in proved and probable reserves, with a reserve life span of 11.8 years. The natural gas weighting of the fund based on reserves is at 58% and by production at 65%. The higher weighting in gas classifies the fund as gassy, as the prospects are dependent more on natural gas prices than on oil prices. As of the 3^rd quarter of 2007, daily production stands at 29,236 boe/day. 2008 production is expected to reach between 32,000 and 34,000 boe/day as volumes from the July 2007 Sound Trust Acquisition get factored in.

Advantage's production and reserves are concentrated within three areas located in Alberta, northeast British Columbia, and southeast Saskatchewan. It operates approximately 85% of its production base.

Business Issues:

Early December 2007, Advantage announced a dividend cut of 20%. This tightening was expected, as the Canadian dollar gaining strength along with depressed natural gas prices does not work in favor for the company. The size of the dividend cut was the sticker shock, and the price per share slipped more than 10% following the announcement from an already depressed $10.25 per share. Even after the dividend cut, the yield was still pretty high at 14%, and with the price dipping another 15%, the yield is attractive at 16%. Below is a look at natural gas prices over the years and the correlation to Advantage’s distribution and payout ratio:

Year	Natural Gas Average Pricing	Distribution	Payout Ratio
2007*	7.30	1.35	~85%
2006	6.86	2.66	101%
2005	7.98	3.12	84%
2004	6.08	2.82	93%
2003	6.07	2.71	88%
2002	3.71	1.73	89%

• 2007 information above is for the first 9 months.

Advantage’s dependency on natural gas prices is mitigated by the following factors:

• Hedging – The company has an active hedging program that aims to hedge roughly 50% of production. For the fourth quarter of 2007, approximately 42% of the net natural gas production is hedged at an average floor price of $8.09/mcf and an average ceiling of $9.42/mcf. For the first quarter of 2008, it has hedged 22% of the net natural gas production at a floor price of $8.85/mcf and a ceiling of $10.19/mcf.
• Asset Diversification – Over the years, Advantage has steadily managed to increase its oil reserves as a percentage of total reserves.
• Waning competition from the majors - Drilling and production in Canada are down, as majors are not channeling revenue into gas drilling and that will have an impact going forward.

Advantage, along with other Canadian royalty trusts, is negatively affected by a Canadian tax law change that comes into effect in the 2011 timeframe for existing trusts. At that point, the tax-exempt status on distributions expires, and the trusts will pay taxes as regular corporations. Advantage is well positioned to minimize the effect of these taxes for an extended period of time, because of the existence of $2B in tax pools in its books. This hidden asset is valuable and should allow Advantage to escape the negative impact of the tax law change for the foreseeable future, after the 2011 timeframe.

Provincial royalties is another area that has a potential impact on Advantage. Specifically, Alberta recently unveiled plans for increased royalties in the 2010 timeframe. The risk is fairly contained at the moment as royalties are tied to the rate per well: Advantage has a huge amount of lower rate wells and so the impact is little.

Outlook:

Natural Gas Prices are expected to hold steady in the $7-$8 range for an extended period of time limiting the potential return for Advantage shareholders. A contrary opinion is that as gas-to-oil price ratio is the highest in history, and, should the oil prices stay high, natural gas price should follow suit to approach historical levels for that ratio. In either scenario, Advantage is cushioned, as it has been able to operate profitably when natural gas prices stayed around the $7 mark.

Advantage’s stock price performance over the last two years was well below average, as the price slid from 20-something per share in early 2006 to be below 10 recently. However it is noteworthy that in the previous four years the stock price did quadruple. The total returns including distributions over the life of the trust (formed 2001) have been reasonable at around 20%. The following factors in combination paved the way to create the current attractive valuation for these trusts:

• Confusion regarding the effect of the tax changes,
• Concerns surrounding its increasing debt, as Advantage funded several acquisitions with debt in the past two years, and
• The negative surprise for investors in the size of the latest dividend cut.

Advantage’s price per share is attractive using a number of evaluation measures. Being a relatively small company with a fairly large amount of debt leaves Advantage vulnerable to a drop in oil and gas prices. This risk should be weighed against the fact that the valuation is very reasonable when making an investment decision.

To summarize, Advantage is an aggressive/risky holding operating on the gamble that energy prices will stay elevated going forward. Given the valuation and the tax pool status, it is a good choice as an income holding in energy portion of stock portfolios.

Disclosure: We have a long position in Advantage Energy Income Fund (AAV).

Comments

[erniem:]

PWE and PVX are two alternatives that may provide investors with more reserves, stability, and in the case of PWE, similar tax benefits with a large oil sands exposure. AAV was grossly overpriced two years ago.

2008 Jan 16 09:26 AM

[ejhickey:]

All of the Canroys have had a nasty habit of imitating submarines in the last few months. While the monthly dividends are nice I suggest that one be very aggressive in trying to pay as little as possible per share for AAV or any other Canroy.

2008 Jan 18 12:35 PM

[whisperonth...:]

Better late than never? Oil didn't drop yet, and I still love the dividends. Of all the stocks I took a loss on this tax year, the trusts were not in the list. I also pick up pennies when I see them.

2008 Mar 23 08:21 AM