Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) was going to spend a lot of time and money in Alberta this year, even before provincial authorities finally announced its plan to win back some of the oil and gas exploration and production activity it lost to Saskatchewan and British Columbia in recent years. But changes Premier Ed Stelmach and his eager-to-survive government describe in “Energizing Investment: A Framework to Improve Alberta’s Natural Gas and Conventional Oil Competitiveness” will make the biggest conventional oil and gas trust’s efforts in the province a lot more worthwhile.
On March 11 Alberta announced it would essentially undo what’s left of an October 2007 royalty regime makeover. As of Jan. 1, 2011:
- the top royalty rate on conventional oil wells will be 40 percent, down from 50;
- the top royalty rate on natural gas wells will be 36 percent, down from 50 percent;
- the minimum royalty rate for conventional oil and natural gas wells will remain 5 percent.
The current 5 percent first-year rate for new conventional oil and natural gas wells, which was to expire Mar. 31, 2011, is now permanent. The government will announce new royalty curves--the price levels at which specific rates kick in--by May 31.
The sliding scale for oil sands royalties--from 1 percent to 9 percent pre-payout and 25 percent to 40 percent post-payout, depending on the price of oil--is unchanged. The oil sands base royalty starts at 1 percent and increases for every dollar West Texas Intermediate (NYSE:WTI) crude is above USD55 per barrel, to a maximum of 9 percent when oil is USD120 or higher. The net royalty starts at 25 percent and increases for every dollar oil is priced above USD55 per barrel to 40 percent when oil is USD120 or higher.
Alberta has also made a familiar commitment to reduce regulatory burdens. But it also emphasized the importance to the province’s long-term economic health of exploiting its unconventional natural gas resources. The government introduced incentives to encourage adoption of new technologies that unlocked vast shale gas reserves in the US, backing its earnestness with cash; this is one type of problem where simply “throwing money at it” is likely to work.
The new royalty regime itself is an acknowledgement that front-end investment--particularly where innovative extraction techniques are absolutely critical to success, as in the long-lived Pembina field--in conventional production often demands new technology. “Energizing Investment” includes a pledge to explore still other ways “to recognize and account for the higher costs of new and advanced technologies needed to develop mature conventional oil and gas plays and unconventional natural gas.”
Finally, the government says it will try to get out of the way of new applications for upstream development and will continue to work with industry and academia to further research into such technologies.
All told, the greatest immediate impact--once the new rates kick in on Jan. 1, 2011--will come to producers and drillers in the Cardium light oil formation of the bountiful Pembina field, a play rejuvenated by improved drilling techniques.
Since late 2009 Penn West has forecast capital expenditures of anywhere between CAD700 million and CAD900 million for 2010. CEO Bill Andrew told Bloomberg News yesterday that his company would double its planned capital spending in Alberta. If Andrew’s commitment proves true, two-thirds of this budget will be directed to the province. This ratio would bring Penn West’s capital outlay ratio in line with the geographic concentration of its assets: Two-thirds of Penn West’s assets are located in Alberta.
Penn West controls more than half a million net acres in the province, what it describes as “a dominant land, production and infrastructure position in West Central Alberta including the emerging Cardium horizontal multi-frac plays at Pembina, Willesden Green, Leafland, Garrington and Sylvan Lake.” Recent drilling activity has shown much higher efficiency because of what’s known as horizontal multi-fracture technology. During its February 18 conference call to discuss fourth-quarter and full-year 2009 earnings management said Penn West would drill 250 to 300 net wells in 2010--most of them concentrated in these development opportunities.
Management described the 2010 capital budget as “a moving target,” dependent on the success of new initiatives. It’s safe to say the budget is likely to move Alberta-ward.
How to Ride the Long Cycle
If you still watch CNBC it’s probably because of the reality network’s all-too-infrequent sessions with the director of floor operations for UBS, Art Cashin. Art himself has become part of the drama, we must concede, what with “Dow 10,000” hats a little more than 10 years ago, though credit must be given to a wit that would pull one of those hats out again in late 2008, when that widely watched index of 30 US blue chips lurched over the magical but essentially meaningless barrier on the way down.
Art’s put in a lot time on the Street, so he has the on-the-ground experience through a couple turns in what he calls “the long cycle.” The iteration Art describes comprises alternating, 17.6-year periods of bull and bear markets. For example, the years from 1982 to 2000 constitute one bull cycle. Before that, from the apogee of the Great Society until the Reagan Revolution, was a long slog. And before that was the post-World War II boom that left the US in charge of the world.
Stories about “long cycles” are popping up more and more in the broader media, in last Thursday’s Toronto Globe and Mail, for example. The recurrence of such cycles--of varying lengths--is a powerful observation, one the increased study and understanding of which hopefully won’t distort its predictive value for what the next decades has in store for investors. What we have, in this construct, is a secular bear trend that, according to a more than a century’s worth of data, probably has about another decade to run.
At the same time, the problem Professor James Hamilton of the University of California, San Diego, describes also explains why we’re in a long-term bull market for energy, particularly crude oil:
University of Leeds Professor Joyce Dargay and New York University Professor Dermot Gately have a new research paper suggesting that projections from the DOE, IEA, and OPEC are underestimating the challenges ahead for meeting world oil demand.
Research by Baumeister and Peersman and Hughes, Knittel, and Sperling, among others, has documented that oil demand appears to have been much less responsive to price over the last decade than it had been in the 1970s. My recent study in the Brookings Papers on Economic Activity…concluded that this decrease in the elasticity is one of the key factors behind the oil-price run-up of 2007-2008. The surprise to markets in 2008 was that even $100 oil wouldn't be enough to prevent world demand from growing above 85 million barrels a day, and much more than 85 million barrels a day simply wasn’t going to be produced at that time.
Professor Hamilton relies on Dargay and Gately for the money quote:
[C]ompare two decades in which the price of crude oil has quintupled: 1973-84 and 1998-2008. After the price increases of the 1970’s, per-capita demand fell by 19% for the OECD and by 13% for the world as a whole. In the past decade, with oil price increases similar to those of the 1970’s, per-capita demand fell only 3% in the OECD; worldwide it actually increased, by 4%.
Economic activity will not grind to zero during the next decade. Rather, in the developed world spending decisions will be more focused on essentials. Frivolity, as a recent Gallup poll suggests, is out. Meanwhile, as the response to the mid-2000s shock indicates, demand from emerging Asia means we’ve entered a new era of permanently elevated oil prices. This is illustrated as well by the fact that oil hovers near USD80 per barrel amid what can only be described as a tentative economic recovery. And in the long term, as Professor Hamilton wonders, the world is going to have an extremely difficult time ramping up to 138 million barrels a day of production by 2030.
Resources such as Canada’s oil sands--and the conventional but hard-to-produce assets in Penn West’s Cardium play--are of ever increasing importance to North American energy supply and therefore to the world.
A New Investment Class
Cut-less or not, conversions continue to be universally bullish for income trusts this year. All the market requires, it seems, is just clarification of post-conversion dividends.
Crescent Point Energy (TSX: CPG, OTC: CSCTF) set a tone for oil and gas producer trusts with its decision to convert last year without cutting its distribution. It’s subsequently grown its production by more than 50 percent because the market loved its post-2011 dividend policy and virtually doubled the share price, allowing it to aggressively make acquisitions using its own stock.
And momentum for preserving dividends with trust conversions is still increasing. Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) and Pengrowth Energy Trust (TSX: PGF-U, NYSE: PGH) announced a cut-less conversions last week, along with solid fourth-quarter results, featuring payout ratios of just 48 and 41 percent, respectively.
That brings the number of no-cut conversions thus far in the oil and gas sector to five, versus one reduction and two eliminations. That, of course, doesn’t mean that every trust will elect to hold its distribution steady. In fact, some management teams still seem stuck on the idea that they have to cut in order to preserve operating cash flow for growth.
Again, as long as a producer trust has solid and undervalued assets under the ground, we’re going to stick with it, no matter what management does on the dividend. No-cut conversions, however, make the process easier and considerably more profitable in the near term.
Outside the energy patch, the servicer to the financial services industry Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF) fell sharply for two days after it announced a larger-than-expected 34.7 percent post-conversion dividend cut. The units, however, have since rebounded even more dramatically and now stand nearly 5 percent above their pre-announcement price on March 2.
Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) became the 23rd distribution-paying Canadian income trust to announce a no-cut conversion, announcing it will make the change by the end of 2010 while holding its annual dividend rate of CAD1.80 a share steady.
All this bodes well for the remaining trust conversions, the vast majority of which will take place between now and the end of 2010. But the really bullish implications are for the post-conversion era, when trusts are no longer trusts but the leaders of a new breed of high-yielding equity never before seen.
These companies pay taxes--but also outsized dividends that dwarf those of the typical US corporation. Rather than enrich themselves with bloated salaries and perks, the managers’ interests are firmly attached to those of ordinary shareholders. And as the growing wave of low and no-cut conversions proves, they’ve discovered it’s possible to pay out big and grow their businesses by efficient use of capital.
It’s certainly not rocket science that investors need yield more than ever before. And these companies have realized they can harness that demand to issue low-cost equity that can fund everything from acquisitions to asset construction. Asset growth, in turn, means cash flow growth, which means a greater ability to pay dividends.
Dividends are paid not from traditional earnings per share but from distributable cash flow after taxes and capital spending. Dividends are lower than they could have been had Canadian trusts maintained their favorable tax status. And yields are going to be lower than they’ve been in previous years, mainly because investors won’t require a yield premium due to misplaced fears about 2011.
Yields will still be multiples higher, however, than the kind of conventional stocks and bonds most advisors try to shove into clients’ accounts. They’ll also be paid in Canadian dollars, a currency that should continue to appreciate against the US dollar and also which provides protection from future inflation. That’s because it tracks the price of energy, which is certain to be at the root of any inflation swing.
Finally, US investors who hold these investments in IRAs and other tax-deferred retirement accounts are in line for an effective 17.6 percent dividend increase. While we continue to believe dividends paid by Canadian trusts and corporations should already be exempt from the 15 percent withholding of dividends under the Fifth Protocol of the US-Canada Tax Treaty, Canada looks set to continue withholding until the trusts convert to corporations, and start paying taxes in Canada.
Whatever the case, however, by the end of this year, US investors’ IRAs will no longer be withheld. That means 15 cents per dollar of dividends added back to their accounts, an effective 17.6 percent dividend increase for owners of converting trusts.
Ultimately, what we’re talking about here is a new class of dividend-paying stocks paying rising yields from a base of between 6 and 12 percent. And based on performance of US equivalents, the former oil and gas producer trusts will pay out in the teens when energy prices perk up again.
Those yields will rise further for US investors whenever the Canadian dollar gains ground. Unlike dividends paid by any other foreign stock or bond, they’ll be exempt from cross-border withholding. And there will be nothing more complicated than a 1099 to be filed, even for investors who hold them outside of IRAs.
Those who hold these investments through their transition from trusts to corporations will realize substantial capital gains, very likely in the neighborhood of 60 percent. But even those who come later to the party will be buying first and foremost into strong businesses with powerful growth prospects, as management continues to take advantage of opportunities and the Canadian economy surges forward.
Finally, investors can rest assured that these are companies that have proven themselves in the worst possible conditions over the past several years. Not only were they stress-tested by the economy and credit markets. But they also thrived despite the Canadian government’s restrictions on how they raised capital.
That’s something no US company had to go through. Now they’re set to benefit from what will soon be the lowest corporate tax rates in the developed world. Alberta-based oil and gas producers, meanwhile, will get a double bonus, as the provincial government rolls back royalty rates to get business going again.
It all adds up to a windfall gains this year and hefty yields and total returns thereafter--all with much less risk than investing in most US sectors. That’s all the reason anyone should need to buy Canada this year, particularly if you haven’t already.
Are you serious about investing in the Canadian story? Join Roger Conrad in sunny San Diego, California, April 23-24 for the 2010 Wealth Society Member Summit. You’ll have a chance to sit down with Roger one-on-one to talk about where to find the best ideas to generate total returns as Canadian income trusts convert to high-yielding corporations and how to position your portfolio for the year ahead.
Join Roger and his colleagues GS Early, Elliott Gue, Yiannis Mostrous, and Benjamin Shepherd at the historic Hotel del Coronado--one of the top 10 resorts in the world according to USA Today, one of the top 20 hotel/spas in the world according to Travel + Leisure, and the No. 2 place in the world to get married, according to the Travel Channel.
And on April 23-24, Coronado Island will also be the best place in the world for relaxation and profit. We’re expecting 72 degrees, sun and fun. You may find all details at www.InvestingSummit.com.
Call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table. Space is limited.
David Dittman is Managing Editor of Personal Finance.
Disclosure: "No Positions"