Investing Daily

The recent turmoil engulfing the global financial system and economy has had a significant impact on all businesses. There’s a great deal of uncertainty about where we’re headed in 2009, which makes it all the more important to understand how tight credit conditions, for example, will affect day-to-day operations for companies.

Some businesses face more difficult roads than others. You can see that variation in the microcosm that is the Canadian Edge Portfolio, but in the main our recommendations have used cash flows made possible by strong operating conditions to position themselves to withstand the further stress the global financial crisis and corresponding economic downturn better than most companies. Companies saddled with disproportionate amounts of debt before the global financial system buckled face rocky rides.

What can be said generally about CE Portfolio trusts is that they entered this tumultuous period in positions of relative strength. Oil and gas trusts, in particular, used significant second quarter windfalls to pay down existing debt and fund capital expenditures.

Some, such as ARC Energy Trust (TSX: AET-U, OTC: AETUF) and Enerplus Resources (TSX: ERF-U, NYSE: ERF) have already taken prudent steps to ensure long-term sustainability of their distributions.

The quickest way to understand a trust’s ability to cope is to look at its payout ratio; lower rates correspond to greater financial flexibility because excess funds from operations can be invested in capital expenditures for the long term or be utilized to repay debt and reduce leverage.

Declines in commodity prices will directly impact cash flows, payout ratios and use of debt to fund development projects going forward. Banks are faced with reduced capacity to lend, which limits trusts’ access to capital and will push borrowing costs higher.

The current environment is challenging for all, but relatively conservative balance sheets and capital structures put solid oil and gas trusts in position to weather the storm better than most.

Second quarter cash flows set up oil and gas trusts to deal with what happened to global credit markets following Lehman Brothers’ Sept. 15 implosion. The test will be whether they can live within their means during times of fiscal constraint while still replacing production.

The lending capacity of all financial institutions has been diminished, and risk premiums have increased. These issues may impact oil and gas trusts and how they approach financing alternatives for capital programs and manage cash flow in the future.

ARC Energy Trust’s decision to roll back its top-up distributions, which have taken its monthly payout to CAD0.20 per unit once again, indicates this type of decision-making: ARC has an enormous present opportunity to exploit its Montney natural gas assets, and given all the factors at play, a judicious “cut” in favor of devoting cash to long-term growth means the trust will be able to sustain a strong distribution well into the future.

Under ordinary circumstances, a cut is cause for concern; these, however, are not ordinary times. ARC has decided to fund its Montney development activity internally rather than increasing costs by accessing debt or diluting unitholders with a new equity issue.

In April 2008 ARC renewed its syndicated credit facility, extending the maturity date to April 15, 2011. ARC has approximately CAD270 million of unused credit available under the facility.

ARC will refinance a total of CAD28.8 million in senior secured notes during the next 12 months through its credit facility. As at Sept. 30, ARC’s net debt-to-annualized cash flow from operating activities ratio was 0.8 and its net debt-to-total capitalization ratio was 13.3 percent, conservative by any standard.

ARC’s business remains strong, its assets are of top quality, and its financial position allows it to fund internal development prospects with an eye on paying a sustainable distribution well into the future.

Enerplus Resources’ long-term debt increased from Dec. 31, 2007, to the end of the second quarter of 2008 by CAD301.6 million mainly because of the CAD330.9 million of debt assumed on the Focus Energy Trust acquisition. Enerplus did, however, reduce long term debt by CAD68.7 million during the second quarter with the excess cash flow resulting from high commodity prices.

Enerplus recently made two cuts to its distribution, reducing the monthly per-unit payout to CAD0.25. Those moves must be considered, as is the case with ARC, in light of current unprecedented stresses on the global economy. The reductions are all about preserving financial flexibility.

Enerplus plans to devote CAD300 million to capital expenditures in 2009, a 45 percent cut from 2008 levels. Roughly CAD240 million will be spent on conventional oil and gas projects in Canada, about CAD35 million in the US. CAD25 million will go to oil sands operations.

Discussing the distribution cut, Enerplus management said in a statement, “We intend to preserve our financial strength and maintain flexibility in order to position us to take advantage of future opportunities to add quality assets in an increasingly attractive acquisition market.”

Enerplus maintains one of the strongest balance sheets in the industry and has a long track record of developmental success.

Energy prices cratered in 2008 on macroeconomic fears. We haven’t seen the kind of permanent demand destruction, movement to alternatives or new conventional supplies come on stream of the magnitude that ended the 1970s energy bull market.

In fact, those forces have likely been set back months, if not years. As a result, energy is set to be among the very first markets to respond. And the one-day surges of 10 to 15 percent in the prices of producer stocks we’ve seen periodically in recent months are pretty good indications of how explosive the recovery may become.