Down trending markets are dangerous not just because investors lose money. They also make people afraid to trust their own judgment. And once you’ve gone there, you’re lost.

We’re now a year into what’s already been one of the more damaging bear markets in memory. Unlike the 2000-02 debacle, the action in the major market averages is far from disastrous. But we’ve seen real pain in the high-yielding fare that was so popular up to the peak.

The notable exceptions have been Canadian oil and gas producer trusts. The nine in the Canadian Edge Portfolio returned an average of nearly 50 percent in the first half of the year. Several other trust groups have also performed well, including energy infrastructure, REITs and certain natural resource trusts.

Market malaise has caught up to several of our holdings. The good news is, as long as the underlying business stays strong, distributions will hold and share prices will recover. That’s certainly the lesson from strong oil and gas trusts’ surge this year, after their pounding last year.

The trick is to focus on the companies that are holding up as businesses, even if their shares are sinking. You’ve got to be willing to sell if the business does unravel. But as long as the underlying fundamentals stay solid, your position will ultimately pay off.

As was the case in June, both July High Yields of the Month have lagged this year. Atlantic Power Corp (TSX: ATP.UN, OTC: ATPWF) has taken by far the harder hit, producing a negative total return of more than 15 percent. But Provident Energy Trust’s (NYSE: PVX, TSX: PVE.UN) 24 percent total return year-to-date is actually more out of step with the torrid gains in other oil and gas sector trusts.

The question: Are there real reasons to expect these trusts’ first half 2008 underperformance to continue or even get worse? If so, we don’t want to keep owning them. If not, there’s every reason to expect they’ll outperform in the second half.

Fortunately, I think the latter is the case for both. In Atlantic’s case, there appear to be two issues behind the late-June turbulence in its share price.

First, almost all of the power plants in which Atlantic has ownership interests run on natural gas, raising concerns that rising costs are eating into profit margins. Second, some investors are worried management will be forced to retire the debt portion of its income participating securities (IPS) while credit conditions are tight, putting an intolerable financial burden on the company.

Debt concerns were at the root of the recent share price plunge of fellow IPS Keystone North America (TSX: KNA.UN, OTC: KYSNF). And they were core to the total meltdown of US-based IPS Centerplate.

The good news is Atlantic is well positioned to deal with both of these challenges, and neither pose a danger to the now 12 percent-plus distribution. First, Atlantic isn’t an operating company in a true sense; it’s a portfolio of ownership interests in 14 US-based power plants and a major power line, California’s Path 15. Management contracts others to run the assets and instead focuses on doing what it takes to minimize risk to its overall cash flow.

Each project is funded by equity plus project-level debt, which is nonrecourse to Atlantic itself. The vast majority of the project debt is targeted to be paid off when the existing power sales contract expires. In other words, year by year, debt on individual projects drops and equity increases. The result is management will have an unlevered project when it looks for a new contract. The exception is the Gregory plant, of which the company owns a 17 percent interest, but which is accounted for as an equity investment, limiting debt risk.

All buyers of the output of Atlantic’s plants are rated investment grade. Most are regulated utilities, with the three largest buyers currently Progress Energy, Southern Company and TECO Energy. The rest are government entities—payments for power line Path 15 are guaranteed by the California government and backed by the state’s utilities—or substantial corporations such as DuPont. No single buyer comprises more than a single-digit share of overall sales.

The upshot is there’s very little real risk from project-level debt to Atlantic’s cash flows or distribution. That leaves the debt portion of the IPS as the only substantial recourse obligations on Atlantic’s books. As I’ve pointed out in past issues of Canadian Edge (see Search), Atlantic has the right to call this debt—essentially a note with an 11 percent interest rate—beginning in November 2009. Were it to do so, it would have to pay 105 percent of the note’s face value of CAD5.767 in cash, roughly CAD6.0554 per Atlantic IPS or a total of around CAD390 million.

Early redemption, however, is entirely at the option of Atlantic. In fact, it has until November 2016 to pay off the note portion, or effectively seven years during which to wait on the optimum conditions to refinance or pay off. And the payoff cost in principal will decline every year.

This past Sunday, I questioned CEO Barry Welch and CFO Patrick Welch (no relation) about their intentions for early repayment. In their view, there would be several reasons.

One would be to better balance cash flows to create a natural currency hedge for their US operations, which essentially comprise all assets at present. That would reduce exposure to a continuing drop in the US dollar. Currently, Canadian dollar outflows are hedged through 2011, so Atlantic is largely unaffected by currency swings. Paying off the debt portion of the IPS (paid in Canadian dollars) and replacing it with US dollar debt would eliminate a substantial portion of currency risk when those hedges expire.

Another reason to pay off the debt portion would be simply to take advantage of lower-cost financing. The current interest rate of 11 percent paid in Canadian dollars, for example, is quite high and more indicative of Atlantic’s financial position at inception in late 2004 than it is today. A lower rate of interest would leave considerably more funds available for expansion, which is needed for dividend growth.

At any rate, management is clearly motivated to act only if it’s in the best interest of shareholders of which the CEO and CFO own a sizable chunk. And with the equity portion of the IPS valued at only a little more than CAD2 a share—current price less mandatory principal payoff—it’s priced to yield nearly 20 percent. As long as Atlantic’s projects keep generating cash, that’s means no downside risk to IPS holders from an early redemption.

And unless management makes another acquisition, there are no other significant pending cash needs. The number of IPSes outstanding over the past year has been flat, while interest expense dropped. 



As for fuel costs, most are recovered automatically from Atlantic’s customers. The life of contracts is staggered, ranging from an earliest expiration of around 100 megawatts of capacity this year to 6 megawatts of a hydro project in 2037 and 2034 for the Path 15 power line. Path 15 rates are actively set by the Federal Energy Regulatory Commission, which has tentatively granted a 13.5 percent return of equity in Atlantic’s ongoing rate case. The case is currently in settlement phase, with a final return likely to be in that neighborhood.

Any fuel costs not automatically recovered are hedged in advance by Atlantic. The company’s purchase of an additional 50.1 percent interest in the Pasco plant in Florida did require locking down additional long-term supplies of natural gas at a time when prices were surging. Some of that additional cost may show up in second quarter cash flows. But future exposure is now nil. Moreover, Atlantic has some contracts that allow it to participate in rising power prices, which will offset the impact of higher gas costs from Pasco.

Admittedly, there are a lot of moving parts here, and everything depends on the skill of Atlantic’s 12 employees—soon to be 13—in identifying and managing risk. As with every other trust I recommend in CE, the company’s numbers are on trial every quarter to ensure they’re measuring up, with Aug. 13 the next key date.

At this point, however, it looks like market perception is far too grim for reality. That means a recovery is order, as well as continued generous distributions. Atlantic Power Corp remains a buy up to USD12 for those who don’t already own it.

Provident’s underperformance basically appears because of investors’ perplexity about the sale of its interest in BreitBurn LP (NSDQ: BBEP), which represented the bulk of its US assets. Many investors (myself included) had wrongly assumed BreitBurn was part of a move to head south and avoid prospective 2011 taxation. As it turned out, management cited restricted ability to raise capital as a reason for selling.

For the better part of this decade, Provident has ranked among the more aggressive trusts, acquiring fee-generating “midstream” assets and oil and gas production properties in the US and Canada. It was particularly aggressive through BreitBurn, in which it controlled virtually the entire general partner interest.

Selling its general partner and limited partner interests in BreitBurn will net the trust CAD345 million to reduce the CAD1.2 billion debt load. And the nature of the sale—essentially back to BreitBurn itself—eliminated the risk of selling on the open market.

The question is does this transaction make Provident Energy Trust more valuable or less? That will only be answered over time, but there are already strong indications shareholders will benefit.

For one thing, management has already broken out the numbers, with the sold operations considered “discontinued” as of first quarter results. And continuing operations supported the distribution amply. Meanwhile, expected production gains in Canada, rising realized selling prices for oil and gas, solid midstream results and falling interest costs should more than offset any loss of income from the sold operations on the overall second quarter bottom line.



Focusing on Canada will simplify management’s job, while funds freed up by debt reduction will speed expansion of the properties acquired over the past few years. It will also dramatically reduce currency risk from further US dollar weakness, which had been growing.

Moving headquarters south is no longer a viable escape strategy for 2011, and concentrating in Canada leaves the trust more exposed to prospective taxation. It may also, however, make Provident a more attractive takeover target, given its now very long reserve life, the natural hedge of the midstream operations and stronger balance sheet.

Only time will tell if management’s latest strategic move benefits shareholders the way previous ones have, such as the midstream assets purchase and expansion in the US. It is clear, however, that it’s reduced operating and financial risk, while selling an asset for a high price that was originally purchased at a low one.

There’s always the risk management has lost its touch. But the trust’s realized oil and gas first quarter selling prices–$75 per barrel and $7.82 per million British thermal units, respectively—are set to rise for some time to come as older hedges are replaced with higher-priced ones. That means little risk betting with them, particularly with shares selling for a sector low at one time annual sales. Provident Energy Trust is still a buy up to USD14 for those who don’t already own it.

For more information on both Atlantic Power Corp and Provident Energy Trust, visit the How They Rate Table. Click on the “.UN” symbol to go to the Web site of our Canadian partner MPL Communications for press releases, charts and other data. These are substantial companies, so any broker should be able to buy them, either with their Toronto or over-the-counter symbols. Ask which way is cheapest.

Note that both trusts’ dividends are considered qualified for tax purposes in the US. Tax information to use as backup for filing them as qualified—whether or not there are errors on your 1099—is listed on the Canadian Edge Web site under the Income Trust Tax Guide.

Also, as is customary for virtually all foreign-based companies, the host government—in this case Canada—withholds 15 percent of Provident’s distributions to US investors at the border. This tax can be recovered by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation, though unrecovered amounts can be carried forward to future years.

In contrast, Atlantic’s dividend is approximately 60 percent debt interest and 40 percent equity. Per the recently passed tax treaty between the US and Canada, the debt interest portion is no longer withheld at the border. As a result, Atlantic investors are withheld only on the equity portion, for an overall effective rate of 6 percent on the entire distribution.

Atlantic Power Corp & Provident Energy Trust
Toronto Symbol	ATP.UN	PVE.UN
US Symbol	ATPWF	NYSE: PVX
Recent USD Price*	8.00	11.33
Yield	13.1%	12.5%
Price/Book Value	4.45	2.63
Market Capitalization (bil)	CAD0.511	CAD2.930
DBRS Stability Rating	STA-3 (low)	STA-5 (low)
Canadian Edge Rating	2	4

*Recent USD Price as of 07/02/08