Seeking Alpha
Research analyst, dividend growth investing, portfolio strategy, special situations
Profile| Send Message|
( followers)  

Peyto Energy Trust [PEY-UN.TO] (OTCPK:PEYUF) is a Canadian energy trust involved in the development and production of natural gas in Alberta's deep basin. As at December 31, 2007, the total Proved plus Probable reserves were 164.8 million barrels of oil equivalent with a reserve life of 21 years as evaluated by the independent petroleum engineers. Production is weighted approximately 83% natural gas and 17% natural gas liquids and oil.

The Peyto model is designed to deliver growth in its value, assets, production and income, all on a per unit basis. The model is built around three key principles:

• Use technical expertise to achieve the best return on capital employed, through the development of internally generated drilling projects.

• Maintain a low payout ratio designed to efficiently fund a growing inventory of drilling projects.

• Build an asset base which is made up of high quality long life natural gas reserves.

Operating results over the last nine years indicate that these principles have been successfully implemented. This business model makes Peyto a truly unique energy trust. Below is a partial section of a press release from May 7, 2008 which helps show why Peyto is a well-structured and carefully managed trust.

Peyto Energy Trust ("Peyto") is pleased to present the operating and financial results for the first quarter of the 2008 fiscal year. Peyto is an explorer and producer of unconventional tight gas assets in Alberta's Deep Basin and, due to its trust structure, is able to flow profits from the success of that business to its unit-holders in the form of distributions. The success of Peyto's strategy has resulted in the growth of both assets and distributions over time.

Peyto is well known for owning high quality, sweet gas assets that exhibit long reserve life, low operating costs and high revenue per BOE. The following summarizes the Trust's foundation:

• Long reserve life – Proved Producing 13 years, Total Proved 16 years, Proved plus Probable 21 years

• Low operating costs - $2.68/boe, three months ending March 31, 2008

• High revenue natural gas - $54.09/boe before hedging, $56.41/boe after hedging, three months ending March 31, 2008

• Low base general and administrative costs - $1.19/boe, three months ending March 31, 2008

• High field netback – $42.70/boe, three months ending March 31, 2008

• High operatorship – operates over 95% of its production

• Cash distributions – cash distributions of $44.4 million were 63% of funds from operations for the three months ended March 31, 2008

• Low debt to funds from operations ratio – 1.6:1 (net debt, before provision for future compensation, divided by annualized first quarter 2008 funds from operations)

• Distribution growth – distributions have been increased 5 times; they have never decreased, and are now 87% higher than when the trust was formed in July, 2003

• Since inception , Peyto has raised a total of $410 million issuing units from treasury, accumulated earnings of $772 million, and distributed $667 million to unit-holders

• Transparent capital structure - no convertible debentures, no exchangeable shares, no stock options, no warrants

The first quarter was highlighted by sustained distributions, increasing natural gas prices and improved financial flexibility. The following summarizes performance highlights of the business for the first quarter of 2008:

• Capital expenditures – $33.1 million was invested into finding and developing new natural gas reserves, down from $35.5 million in the previous quarter, but up from $30.5 million in Q1 2007

• Production - decreased 5% from 21,305 boe/d in the first quarter of 2007 to 20,342 boe/d in the first quarter of 2008

• Production per unit - decreased 4% per trust unit from the first quarter of 2007, after adjusting for net debt and future unrealized performance-based compensation

• Per unit funds from operations – decreased 9% from the previous year to $0.67/unit

• Commodity prices – natural gas prices, both before and after hedges, were lower in Q1 2008 with prices averaging $7.93/mcf and $8.49/mcf, respectively, versus $8.17/mcf and $9.77/mcf in Q1 2007

• Hedging – a $4.3 million gain for the three months ending March 31, 2008 was realized

• Distributions per unit were unchanged from the fourth quarter 2007 while the cash payout ratio decreased by 1% to 63%. A total of $44.8 million or $0.42 per unit was distributed to unit-holders in the first quarter of 2008

• Net debt increased 7% from $427 million in Q1 2007 to $460 million in Q1 2008. This leaves available borrowing capacity of $90 million on bank lines of $550 million

Natural gas volumes recorded in thousand cubic feet (mcf) are converted to barrels of oil equivalent (boe) using the ratio of six (6) thousand cubic feet to one (1) barrel of oil (bbl). This could be misleading if used in isolation as it is based on an energy equivalency conversion method primarily applied at the burner tip and does not represent a value equivalency at the wellhead.

(1) Per unit results are adjusted for changes in net debt (including future performance-based compensation) and equity. Net debt is converted to equity using the March 31 unit price of $17.30 for 2007 and $19.48 for 2008.

Quarterly Review

During the first quarter 2008, Peyto maintained the improved capital efficiency achieved in 2007, investing $33.1 million into drilling and connecting new Deep Basin gas wells. Drilling and completions accounted for $26.9 million, while well-site equipment and pipelines accounted for $5.6 million. Additional seismic data was acquired for $0.5 million, accounting for the balance of the capital expenditures.

In the first quarter, the Trust drilled 15 gross (12.9 net, 86% working interest) gas wells, completed 17 gross (13.5 net) gas zones and brought 14 gross (11.4 net) zones on production. Production for the quarter averaged 20,342 boe/d down from 21,134 boe/d in the previous quarter due to the steep initial decline from the additions in Q4 2007 which exceeded the new production additions of Q1 2008.

Operating costs in the first quarter 2008, reflecting increased methanol consumption during winter months, were $2.68/boe, up from $2.25/boe in the fourth quarter of 2007, but down from $2.84/boe in Q1 2007. Elimination of third party processing costs in the Chime area and increased processing income contributed to the year over year reduction. Despite continued upward pressure on labor, chemicals, fuel and power costs in Alberta, Peyto has maintained its low cost advantage, leading the industry by a wide margin.

Royalties to the province of Alberta totaled $19.3 million in the quarter, representing 18% of sales or $10.40/boe. Further clarity by the Alberta government regarding the New Royalty Framework was announced on April 10, 2008, with the incentives for deeper gas exploration being partially re-established. Unfortunately, previously announced pricing curves were not modified, and therefore much of the recent natural gas price improvement will result in increased royalty rates in January 2009. Those increased royalty rates would lessen the positive impact to funds from operations that would have otherwise been derived from higher gas prices. Peyto's independent engineers have assessed the impact of the new royalty framework on the value to t he Trust's reserve assets and determined that the overall impact on net present value is similar to that of funds from operations but much less pronounced.

Natural gas prices for the first quarter 2008 averaged $8.49/mcf, after hedging gains of $0.56/mcf, while liquids prices averaged $83.45/boe, after hedging losses of $2.84/boe. The combined impact of Peyto's forward sales resulted in a total hedging gain of $2.32/boe. The high heat content, premium gas price Peyto achieved, combined with its low operating costs resulted in field netbacks of $42.70/boe for the quarter.

Peyto underwent its annual bank review in the quarter and despite the recent uncertainty in lending markets, the Trust's banking syndicate has increased bank lines from $525 million to $550 million. With quarter end net debt at $460 million, this leaves $90 million in available bank lines.

Activity Update

Peyto tied-in an additional 6 wells in April before spring breakup caused road bans, preventing further activity in the Trust's core areas. A return to field operations in late May to early June is anxiously anticipated as the Trust plans on expanding the capital program for the year to between $150 and $175 million. Peyto's core areas offer year round access which enables the Trust to accelerate capital spending in the summer months when much of the industry is inactive, ensuring better quality services at competitive pricing.

Marketing

Natural gas demand exceeded supply in 2007 and it is expected this trend will continue through 2008. The US working gas in storage is currently at the mid point of the five year average and well below last year at this time. European natural gas prices are significantly higher than North America and as a result, LNG imports into the US are much lower than last year as cargos are redirected to Europe and Asia. All of these factors are contributing to higher North American natural gas prices. A strong Canadian dollar, however, means Canadian gas supplies are achieving a price that is net of the transportation cost to ship it to southern US mar kets.

A strategy of forward selling a portion of the Trust's production to secure prices for upcoming distributions and capital programs has worked successfully in the past. This strategy will result in Peyto's realized price trailing the current market price by twelve to eighteen months and will be reflected as a hedging loss as commodity prices strengthen and a hedging gain as they weaken. Since natural gas prices can be unpredictable, this systematic use of forward sales smoothes out the fluctuations in realized price that would otherwise cause volatility in funds from operations.

As of March 31, 2008, Peyto had committed to the forward sale of 21,460,0 00 gigajoules [GJ] of natural gas at an average price of $7.35/GJ. This translates into a price of $8.59/mcf (17% premium) due to the high heat content nature of Peyto gas production. Had these contracts been closed on March 31, 2008, the Trust would have realized a loss of $37.9 million.

Outlook

The reduced activity levels of the last year afforded the Peyto team time to build upon the inventory of top quality, Deep Basin drilling prospects. Now that market conditions have improved, it is time to capitalize on those opportunities, deploying the execution proficiency the Trust has gained over the last nine years. The financial flexibility that was retained during a time of high costs and lower natural gas prices enables Peyto to accelerate this capital program prior to the realization of higher commodity prices and greater funds from operations. This will not be done, however, at the expense of unit-holder returns on capital. Ongoing results will be monitored continuously to ensure they meet expectations. This expanded capital program can be funded with a combination of funds from operations, bank lines and equity. Unit-holders are encouraged to visit the Peyto website at www.peyto.com where there is a wealth of information designed to inform and educate investors.

I would also recommend that any interested investor read the quarterly report from the President of Peyto at http://www.peyto.com/ia/pmr/20080502PMR.pdf. The President and CEO, Darren Gee, in my opinion lays out a masterful report and shows why he is so optimistic about natural gas and Peyto's future. It isn't just hype. It contains clear info on capital investments, dividends & distributions, and even on Canadian tax issues.

I've owned shares of Peyto for over two years. When natural gas prices were low they were still able to pay a dividend that made it worthwhile to wait and hold. Now that gas prices are rising it has helped the share price.

It wouldn't surprise me to see the price-per-share pull back to around the $20 range, perhaps even lower, and that would be a good place to begin accumulating shares or add to current positions. I'm going to increase my position if the share price falls below $19 and have a GTC order in with positive expectations.

Go to Peyto's web site in the meantime and get to know this remarkable total-return energy trust for yourself. You might become as bullish about it as I am.

Disclosure: Long

Source: Peyto Energy Trust: A Truly Unique Energy Investment