For the second month in a row, no oil and gas producer trust cut its distribution. Equally important, first quarter payout ratios—distributions as a percentage of distributable cash flow—registered a solid decline from fourth quarter tallies.

That’s a pretty clear sign even the weaker producers have now adjusted to the current level of oil and gas prices. And with energy prices—particularly natural gas—firming up in the past few months, payout ratios should continue to decline throughout the year, particularly for the stronger trusts.

In addition to High Yield of the Month and new Aggressive Portfolio addition Advantage Energy Income Fund (AVN.UN, NYSE: AAV), Avenir Diversified Income Trust (AVF.UN, AVNDF) also comes off the Watch List. The trust’s first quarter payout ratio fell to just 59 percent, as strong results at its real estate and financial services arms more than offset the impact of flat oil and gas production and falling energy prices.

Some 70 percent of Avenir’s funds from operations now come from outside the energy production sector. In my view, shareholders would be best served by a future sale of the trust’s oil and gas reserves, as those operations are too small to be viable long term. But the rest of the trust—which includes ownership of the valuable EnerVest fund group—is very solid, and the reserves could fetch a premium price. Avenir Diversified Income Trust is again a buy up to USD8.

No one should ignore the fact that the fortunes of Fairborne Energy (FEL.UN, FELNF), Focus Energy Trust (FET.UN, FETUF), NAL Oil and Gas Trust (NAE.UN, NOIGF), PrimeWest Energy Trust  (PWI.UN, NYSE: PWI) and Shiningbank Energy Income Fund (SHN.UN, SBKEF) all move in lock-step with the ups and downs of energy prices, natural gas in particular. All five producer trusts posted respectably low payout ratios in the first quarter, indicating they’ve adjusted to current gas price levels.

In addition, Focus, NAL, PrimeWest and Shiningbank all posted solid production gains, and Fairborne’s held firm despite less output on its lands from third-party developers. Most encouraging, PrimeWest and Shiningbank have announced a merger that should leave both in much better shape to handle the long-term vagaries of the gas market. Fairborne Energy, Focus Energy Trust, NAL Oil and Gas Trust, PrimeWest Energy Trust and Shiningbank Energy Income Fund are now off the Watch List and rate holds.

There are still a handful of producer trusts paying out too much. One of these is Pengrowth Energy Trust (PGF.UN, NYSE: PGH), with a payout ratio coming in around 100 percent. The trust has so far avoided a distribution cut in this cycle, and management cites a number of ephemeral factors for the shortfall, projecting a much-lower ratio by the second half of the year. Hold Pengrowth Energy Trust.

More at risk is smaller Enterra Energy Trust (ENT.UN, NYSE: ENT), which posted a payout ratio of 88 percent. Like Pengrowth, Enterra’s high ratio is due in part to a shuffling of assets as management attempts to replace rapidly declining Canadian production with acquisitions in Oklahoma. But with production expenses rising 59 percent per barrel of oil equivalent over the past year, this is a situation everyone should avoid, at least until we see some better numbers.

Thunder Energy Trust (THY.UN, THYFF) shareholders should hold their breath until its CD4-per-share buyout by private capital is complete. The trust continued its death spiral last month, with production falling 14 percent, debt interest costs rising 130 percent and the payout ratio hitting 87 percent, despite recent dividend cuts. Vault Energy (VNG.UN, VNGFF) came in a little better but nonetheless registered a 9 percent drop in production. Shares are up on the speculation there might be a takeover offer. But both Thunder Energy Trust and Vault Energy are sells.

Finally, I’m not wholly convinced Canetic Resources (CNE.UN, NYSE: CNE), Daylight Resources Trust (DAY.UN, DAYFF), Harvest Energy (HTE, NYSE: HTE), Sound Energy (SND.UN, SNDFF), Trilogy Energy (TET.UN, TETFF) and True Energy (TUI.UN, TUIJF) are completely out of the woods for this cycle. All turned in decent first quarter results, but long-term cost and size issues remain concerns.

Harvest’s strong improvement, for example, was chiefly due to blockbuster results at its refinery operation, which offset a weak showing on the oil and gas production side. All of these trusts will benefit from the upward push in oil and gas prices I expect to unfold during the rest of the year. But in my view, there may still be some fallout from the big acquisitions they made last year when energy prices were higher. Canetic Resources, Harvest Energy, Sound Energy, Trilogy Energy and True Energy rate cautious holds for now, but I’m keeping them on the Watch List. Also still on the list is Daylight Resources Trust, which is a buy up to USD12.

Though oil and gas producers are firming up, energy service trusts had another tough quarter. Aggressive Portfolio holding Precision Drilling (PD.UN, NYSE: PDS) suffered its second dividend cut in the last five months, trimming the monthly payout another 32 percent to just 13 cents Canadian. The move was in response to the trust’s 30 percent dip in first quarter profits from 2006 levels as demand for its rigs plunged to its lowest level since 1999.

Energy prices today are no where close to where they were then, when oil briefly dipped under USD10 a barrel and gas sank under USD1 per million British Thermal Units. Nor are they likely to revisit those levels any time soon.

That means three things for Precision shareholders: First, this isn’t Armageddon. In fact, the downward action we’ve seen in the distribution should reverse with a vengeance later this year as prices firm and production revives. That’s because the trust relies on large producers like Encana that can easily ramp up output, just as they’ve tamped it down recently.

Second, the distribution reductions are as much about preserving capital for growth as they are adjusting to weaker market conditions. For example, Precision continues to expand its asset base in the US, where the drilling market remains robust and is less weather-sensitive than in Canada. That ensures faster growth when the market does turn.

Third, in the absence of an extremely unlikely 1999-style drop in energy prices, Precision is cheap and a solid takeover candidate in the consolidating services industry. That’s a big reason the shares held firm in the wake of the dividend cut.

Precision isn’t for the faint of heart. And with second quarter drilling trends looking weaker than the first quarter, no one can rule out more pressure on the distribution, despite the low 45.2 percent first quarter payout ratio. But as a super-charged play on recovering energy prices—and trust takeovers—there are few better bets. Precision Drilling is a buy up to USD30.

The only other distribution cut in the Canadian Edge universe last month came from former Portfolio holding Primary Energy Recycling (PRI.UN, PYGYF). I sold the electric power trust last issue in anticipation that management would be forced to make such a move because of a series of operations-related mishaps. Unfortunately, these appear to require long-term solutions, which will continue to put a strain on cash.

The trust is currently in negotiations with creditors to gain a waiver of covenants that restrict payment of distributions. Future payouts will depend as much on those as they will on getting the Harbor Coal partnership back on track and restarting the North Lake Energy Project boilers.

As I wrote last month, Primary still shows no signs of completely blowing up. But the Dominion Bond Rating Service downgraded its stability rating to STA-4 (high) and has kept it under review with “negative implications.” And until its operating problems are resolved, there’s a strong possibility all distributions will have to be suspended at some point. Conservative investors should continue to avoid Primary Energy Recycling.

Here’s the rest of the Watch List. Note several will come off the list in the next few months as they’re taken over by stronger entities.

Canetic Resources (CNE.UN, NYSE: CNE)
Clean Power Income Fund (CLE.UN, CEANF)
Connors Brothers Income Fund (CBF.UN, CBICF)
Countryside Power Income (COU.UN, COUUF)
Daylight Resources Trust (DAY.UN, DAYFF)
Enterra Energy Trust (ENT.UN, NYSE: ENT)
Essential Energy Services (ESN.UN, EEYUF)
Fording Canadian Coal (FDG.UN, NYSE: FDG)
Freehold Royalty (FRU.UN, FRHLF)
Harvest Energy (HTE.UN, NYSE: HTE)                          
Newport Partners Income Fund (NPF.UN, NWPIF)
Paramount Energy (PMT.UN, PMGYF)
Peak Energy Services (PES.UN, PKGFF)
Precision Drilling (PD.UN, NYSE: PDS)
Sound Energy (SND.UN, SNDFF)
Sun Gro Horticulture (GRO.UN, SGHRF)
Thunder Energy Trust (THY.UN, THYFF)
Tree Island Wire (TIL.UN, TWIRF)
Trilogy Energy (TET.UN, TETFF)
True Energy (TUI.UN, TUIJF)
Vault Energy (VNG.UN, VNGFF)
Wellco Energy Services (WLL.UN, WLLUF)
Westshore Terminals (WTE.UN, WTSHF)

Prorogue Elephant

It’s been a nasty political season north of the border, “a parliamentary sandbox of mindless mud-slinging,” according to Greg Weston of the Edmonton Sun. The three federal parties out of power, looking to capitalize on the weaknesses of a long-in-the-tooth minority government, have ganged up to chip away at Conservative legislative proposals, behaving, in the words of government whip Jay Hill, as “a coalition government cooking up deals behind closed doors.”

Hill and the Tories responded with an aggressive playbook. Don Martin, political columnist for the National Post, came into a copy and described it as follows:

A secret guidebook that details how to unleash chaos while chairing parliamentary committees has been given to select Tory MPs.

Running some 200 pages including background material, the document–given only to Conservative chairmen–tells them how to favour government agendas, select party-friendly witnesses, coach favourable testimony, set in motion debate-obstructing delays and, if necessary, storm out of meetings to grind parliamentary business to a halt.

Martin’s May 17 column revealing the Tories’ game plan led to a May 28 clear-the-air session in advance of Parliament’s final push into a scheduled summer recess. But there’s little hope any of the four federal parties will abandon the turf they’ve staked out.

Prime Minister Stephen Harper seemed to be cruising toward a galvanizing late spring election, but perceived failures on environmental policy, Afghanistan and the 2007 federal budget have left him with little hope of winning a majority any time soon. And he may be gearing up to reset the game.

Members of Parliament returned to Ottawa May 28 for the final stretch before the summer recess amid rising speculation the Conservatives will “prorogue” Parliament early.

“Prorogation” is the “abrupt end to a parliamentary session and all parliamentary business, brought about through the recommendation of the prime minister and proclaimed by the governor general.”

The principal effect of ending a session by prorogation is to terminate business. Members are released from their parliamentary duties until Parliament is next summoned. Parliament is still constituted (all members remain as members and a general election is not necessary), but all orders of the body (bills, motions, etc.) are expunged. All unfinished business is dropped and all committees lose their power to transact business, providing a fresh start for the next session. No committee can sit during a prorogation. Bills which have not received Royal Assent before prorogation are “entirely terminated” and, in order to be proceeded with in the new session, must be reintroduced as if they had never existed.

The Tories want to quickly pass the budget bill and then cut the parliamentary session short before the Liberal-controlled Senate can ratify Liberal MP Pablo Rodriguez’s private member’s bill implementing the Kyoto Protocol. 

The government doesn’t need any support from the opposition parties and can simply prorogue the House before the parliamentary calendar expires. 

But once you prorogue Parliament it’s not as easy to start it up again as it is after a normal recess. Harper couldn’t just call Parliament back on one day’s notice. He would have to have a throne speech, the official opening of Parliament and the throne speech debate before they can get to whatever emergency debate might come up.

Bay Street Beat

CE Aggressive Portfolio recommendation Trinidad Energy Services Income Trust (TDG.UN, TDGNF) was the top-scoring income trust, clocking in with an average 4.833 rating. Portfolio mainstays Vermilion Energy Trust (VET.UN, VETMF) and Yellow Pages Income Fund (YLO.UN, YLWPF) continue to inspire similar confidence on Bay Street, Canada’s equivalent of Wall Street.

Vermilion earned a 4.75 out of a possible 5 in a survey of average analyst ratings of stocks in the S&P/Toronto Stock Exchange Composite Index, while Yellow polled a 4.615 average.

Deep driller Trinidad has largely escaped the slowdown afflicting most of the drilling sector, and its equipment is mostly tied up under long-term contracts that ensure strong cash flow streams even in tough environments. Trinidad has rallied from my December 2006 recommendation point but still has upside on its operational merits as well as for its takeover potential.

Advantage Energy Income Fund (AVN.U, NYSE: AAV) didn’t get much love on Bay Street, drawing a 2.25 average rating, but management’s aggressive, proactive distribution cut earlier this year has left the fund in good position to capitalize on rising natural gas prices. Conservative Portfolio recommendation Algonquin Power Income Fund (APF.UN, AGQNF) also fell on the low end of analyst esteem, but walking away from Clean Power Income Fund (CLE.UN, CEANF) left it with more cash to expand its assets and retire debt.

TimberWest Forest Corp (TWF.UN, TWTUF) and Provident Energy Trust (PVE.UN, NYSE: PVX) were among those with the lowest average ratings as well. TimberWest reported first quarter results in line with numbers for the same 2006 period, even as it continues to evaluate its real estate holdings for a possible spinoff of assets. Such a move would unlock unitholder value.

Recent Aggressive Portfolio addition Provident Energy’s midstream operations stabilize cash flow, and its US operations make about a third of operations immune to the proposed tax on distributions. A falling payout ratio–atypical in the trust universe in recent times–makes it even more attractive. 
  
Following Up

In the April 2007 Canadian Currents, we discussed four non-trust, dividend-paying companies and one more risk-capital story.

Here’s an update on those five recommendations. 

Norbord (NBD.CN, NBDFF) closed at CD8.02 April 5, the date we first recommended the stock as a long-term play on a US housing rebound. The “rebound” part of the story is still viable, although it may be a little further out on the time horizon.

Norbord announced the permanent closure of an I-joist plant in Juniper, New Brunswick. The company had temporarily shuttered the facility in November.

The stock is up more than 15 percent from our entry point. Buy Norbord up to CD9.

The Bank of Nova Scotia (BNS.CN, NYSE: BNS) reported earnings of CD1.04 billion (CD1.03 per share), up 16 percent from the CD894 million recorded in the same period a year ago.

Scotiabank’s international division continues to produce tremendous revenue, while domestic banking showed strong underlying growth. Total revenue was CD3.2 billion, up 13 percent. The bank also said it would increase its quarterly dividend by 3 cents Canadian to 45 cents Canadian per common share. The dividend increase will be payable to shareholders of record as of July 3. The international division was responsible for CD293 million, or 29 percent, of the bank’s total net income.

Scotiabank announced several acquisitions in the quarter, including a 10 percent investment in Puerto Rico’s First BanCorp and a 24.99 percent stake in Thanachart Bank, Thailand’s eighth-largest financial institution.

Continue to buy Bank of Nova Scotia.

Manitoba Telecom Services (MBT.CN) earned CD52.9 million (80 cents Canadian per share) in the first quarter, up from a profit of CD44 million (65 cents Canadian per share) a year earlier. Revenue was off 2.9 percent to CD466.6 million from CD480.4 million because of lower legacy revenue from Rogers Communications and AT&T, which are moving their telecom traffic to their own networks. Revenue from growth services–wireless, high-speed Internet, digital TV and Internet-based communications services–rose 9.7 percent to CD173.9 million in the quarter.

Manitoba Telecom is shifting its business mix from legacy services such as landline local and long-distance calling to the growth areas. Those growth services made up 37 percent of total revenue during the first quarter, up from 33 percent in the first quarter of 2006. Wireless revenues grew 13.9 percent to CD61.3 million on an 11.6 percent rise in its cellphone customer base to 360,778 at March 31.

The company expects 2007 revenue to be between CD1.875 billion and CD1.925 billion and earnings per share to be between CD2.30 and CD2.50. Manitoba Telecom Services remains a buy.

Russel Metals (RUS.CN, RUSMF) reported a 23 percent drop in first quarter profit as sales declined, but it also raised its quarterly dividend. Russel earned CD28.7 million (46 cents Canadian per share), down from CD37.3 million (71 cents Canadian per share) a year ago. Sales during the quarter fell 7.8 percent to CD684 million from CD741 million.

The company raised its quarterly dividend to 45 cents Canadian per share. Russel Metals is a buy up to CD32.

Canadian Hydro Developers (KHD.CN) reported first quarter production increases across all three power generation technologies it employs. Hydro generation was up 15 percent year-over-year on a gigawatt hour (GWh) basis mostly because of improved hydrological conditions in British Columbia. Wind generation increased 5 percent from year-earlier production and biomass was up 9 percent.

The company reported a 65 percent increase in revenue over the first quarter of 2006 to CD14.7 million. Canadian Hydro reported earnings of CD8.5 million (1 cents Canadian per share).

The company’s Melancthon II project received final approval from the Ontario Minister of the Environment; it now requires approval by the Ontario Municipal Board at two separate hearings, July 30, 2007, and Sept. 11, 2007. Ontario is facing a power-supply shortage, and Canadian Hydro’s environmentally friendly solution should be welcomed.

The company has, to this point ,met all technical environment requirements. Canadian Hydro Developers remains a buy up to CD7.50.