Two things make me uncomfortable as an investor and an advisor. One is when a stock or trust posts great business results but continues to get punished in the market.

By hanging in there, you’re obviously betting that the sellers are wrong. And if the numbers you’re looking at prove flawed—or start to unravel—you’ve got to be unemotional enough to cut your losses.

On the other hand, the operating rule is pretty simple: As long as the business numbers shine, the market will eventually change its perception of the stock, and the red ink will quickly fade to black. Consequently, you hold on as long as the numbers do.

The second thing that makes me a bit edgy is more tricky: How do you treat an investment that’s really taken off? In a very real way, this is a happy problem. Should you take money off the table, or do you let it ride?

This year, we’ve been blessed with some truly monster gains in our oil and natural gas trusts. Some are more or less dramatic reversals of the prior years’ losses, such as 60 percent returns in gas-heavy Advantage Energy Trust (NYSE: AAV, TSX: AVN.UN) and Paramount Energy Trust (TSX: PMT.UN, OTC: PMGYF). But other moves—such as ARC Energy Trust’s (TSX: AET.UN, OTC: AETUF) 60 percent jump and Vermilion Energy Trust’s (TSX: VET.UN, OTC: VETMF) 20 percent lift—have taken their units to all-time highs, well above pre-Halloween 2006 levels.

The obvious catalyst for the jump is skyrocketing energy prices in recent months. And although oil’s explosion has definitely grabbed the headlines, natural gas’ surge has been by far the more important for our trusts.



For one thing, until this move, gas had lagged oil since late 2005, and most trusts produce at least half their hydrocarbons from gas. For another, oil is priced in US dollars, so the sliding greenback has been eroding the value of oil sales in Canadian dollars.

As anyone who’s bought energy knows, however, it’s a volatile market in which profits can quickly evaporate or even become losses under the wrong conditions. The question now: How far can these fuels run, and what happens to trusts’ distributions and share prices if they collapse?

Here’s how I see it. First, there’s little to suggest we’re coming to the end of the energy bull market that began in the late 1990s with oil at less than $10 a barrel.

True, we’re seeing an increase in alternative technologies—particularly hybrid vehicles—that has the potential to reduce oil consumption meaningfully in the countries that can afford to adopt them. As my colleague Yiannis Mostrous, co-editor of Vital Resource Investor, reminded me this week, however, there’s a big difference between what people in developed countries can afford and what’s true in countries where demand growth for oil is greatest, such as China and India. And that definitely applies to hybrid vehicles, which are still quite pricey.

As for new oil and gas production taking up the slack, the war for the Arctic we highlighted in the May 27 Maple Leaf Memo may signal the development of a new North Sea at the North Pole—ironically an area that only global warming from burning fossil fuels could make accessible. But here, too, real production is almost surely decades off; the cost of development is literally unfathomable at this point. The same holds for the Tupi Field off the coast of Brazil, which will require drilling through a mile of salt under the ocean floor, among other unprecedented feats of engineering.

Reversing bull markets in energy basically means shifting the balance of power from producers to consumers. That takes years and massive investment, and we’re nowhere close.

On the other hand, no market moves in a straight line up or down. And just as even the most vicious bear market is often interrupted by outbursts of optimism, the healthiest bull is occasionally gored by events that shift perception to the negative.

There are many more catalysts now for a retreat in oil and gas prices than there were even a few months ago. Trying to figure out what percentage of oil prices’ rise is caused by rank speculation isn’t my avocation. Nor do I really see the point because speculation always accompanies volatile markets such as energy and commodities in general.

It’s undeniable, however, that energy’s rise over the past several years has spawned a sizeable group of investors who believe they can’t lose buying oil and gas producer stocks. In fact, a good many indiscriminate buyers have entered the market recently, bidding up everything in sight regardless of quality.



That’s a pretty good sign things are ready to cool off and shake out the weak hands before energy moves higher still. Then there’s the fact that we’re entering an election year, with the ruling party increasingly desperate to hang onto at least some power in Washington. Bringing down oil prices—and prices at the pump—by hook or by crook may not be possible, but there are plenty of people motivated to do what they can. And, coincidence or not, oil prices did come down meaningfully prior to the 2004 election.

A temporarily strengthening US dollar is another way oil prices could be sent into reverse in the near term. And there’s considerable global pressure afoot on the US government to do just that, particularly in the myriad nations that have pegged their currencies to the US dollar.

Finally, there’s the possibility—increasingly dim, in my view—that US economic weakness will wind up setting off a global recession and, more likely, that emerging Asia will take more drastic steps to control rising inflation that will reduce energy demand. China, for example, is in the process of forcing consolidation of smaller factories.

Any of these factors has the power to knock oil and even natural gas off their respective perches in coming months. And, although the impact would almost surely be temporary, it could have a devastating impact on many energy stocks, as panicked newcomers stream for the exits.

One-Sided Risk

Trust prices, too, would be vulnerable in the event of a sharp, near-term pullback for oil and gas prices. The risk, however, is pretty much one-sided: It’s all toward share prices over the short term.

In contrast, we’d have to see oil and gas prices practically cut in half to threaten producer trusts’ distributions at this point. In fact, more increases are on tap the rest of this year, even if oil and gas spot prices should come down significantly from here.

As I’ve pointed out, the key is realized prices for selling oil and gas. Even the trusts that sell most aggressively on the spot market didn’t realize an average first quarter selling price anywhere close to the current spot price. The reason is hedging. That’s locking in a set price or range of prices for future output using options, futures, forward sales and other methods.

Trusts hedge a large chunk of their output because they always have to be sure they’ll have the cash to fund development, keep current with interest on debt and bank credit lines, and pay their monthly distributions. That means they mainly benefit from higher energy prices with a lag because they’re able to replace lower-priced hedges with higher-priced ones. On the other hand, they’re not impacted immediately by falling oil and gas prices either, as hedges lock in both ways.

In the current market, the more a trust has hedged, the lower its realized selling prices and the lower its cash flows. Paramount Energy Trust was one of the trusts with a big hedge position, mainly to “lock in” value from last year’s acquisition of properties from Dominion Resources. The good news is those hedges will come off and be replaced by much higher-priced contracts in coming months. That means a quantum jump in cash flow for Paramount going forward.

In addition, like all serious oil and gas producers, trusts hedge systematically rather than speculatively. That means, even if oil and gas prices do go into full reverse, it will be a while before it has any negative impact on earnings, if at all.

How far would oil and gas prices have to fall to have an impact on trusts’ distributions? Consulting the Oil and Gas Reserve Life Table, realized selling prices for oil were $90 a barrel or less for most trusts, while natural gas averaged less than $8 per million British thermal units (MMBtu). Meanwhile, the average distribution payout ratio at those selling prices was less than 60 percent.

The first point is that trusts would be able to maintain payout ratios of less than 60 percent, even if oil came back to $90 a barrel and natural gas to $8 per MMBtu. In fact, because they’re already locking in higher realized prices with hedging at today’s futures curve, they’d likely see payout ratios go even lower.

Payout ratios, of course, will be increased to the extent distributions are. Last month, for example, ARC Energy hiked its payout by 20 percent. Meanwhile, Peyto Energy Trust (TSX: PEY.UN, OTC: PEYUF) lifted its distribution by a more-modest 7.2 percent, pointing to an increase in proven producing reserve life from 11.5 years to 13 years because of an aggressive development and exploration program.

To really threaten the strongest trusts’ distributions, oil would have to come down to at least $60 a barrel and stay there. For natural gas, the bar is even lower, mainly because the price was depressed for so long. A prolonged move to less than $5 per MMBtu would bring pain, particularly to the weakest.



Short of that, however, it’s salad days for oil and gas trusts and a golden opportunity to position their businesses to face the challenge of 2011 trust taxation.

For some, the work seems already done. Vermilion Energy, for example, suspended its dividend reinvestment plan last month. The reason: The trust’s distribution plus its considerable capital expenditures for development only add up to about 60 percent of cash flow. Despite getting more aggressive in Canada and Australia than originally planned, management simply decided it didn’t need the money.

Others such as Daylight Resources Trust (TSX: DAY.UN, OTC: DAYYF) and Penn West Energy Trust (NYSE: PWE, TSX: PWT.UN) remain hard at work making acquisitions. In late May, Daylight announced the takeover of Cadence Energy in a CAD301 million deal that will boost its overall output by 17 percent.

The deal unites the pair’s interests in the Sturgeon Lake South Leduc oil pool and is typical of the kind of transaction Daylight likes—properties it already knows well. It also boosts Daylight’s tax pool position to well more than CAD1.1 billion and still leaves safe harbor of CAD400 million for the rest of 2008 to do more share issues for deals. All in all, this is the kind of move we’re buying Daylight for. Daylight Resources Trust is a bargain up to USD12.

Penn West is still working to absorb this year’s mega-acquisitions of Canetic Resources and Vault Energy. But that hasn’t stopped Canada’s largest conventional oil and gas trust from launching a CAD126 million bid for Endev and its estimated 3,500 barrels of oil equivalent in daily production.



Penn West has come under fire lately from a well-known blog for alleged accounting discrepancies, including a wide difference between funds from operations and standard operating cash flow. The share price has become quite volatile as it’s gone higher and is apparently also a target of options traders.

However, the big picture is the trust has added a great deal of new production at a time when energy prices are off to the races. That’s a formula for covering a lot of ills, particularly with realized prices for oil and gas well below spot because of hedging.

What’s true of Penn West is true of virtually every other oil and gas trust. I’m still a seller of Enterra Energy Trust (NYSE: ENT, TSX: ENT.UN), largely because it’s vastly inferior to every other trust. But barring a halving of oil prices and a more than halving of natural gas, it’s hard to see how this industry can’t do well across the board in the rest of 2008—trusts’ reward for outlasting a truly Darwinian challenge over the past two years.

Game Plan

So what’s an investor to do? First, keep in mind the long-term trend for energy is still very bullish. Staying on board with that should be everyone’s first priority.

Second, continue to focus on the higher-quality trusts. Sure, Enterra has had a big gain this year, as rising energy prices have at least temporarily taken it out of its death spiral. But as is the case in any industry, you’re always going to do better with the best businesses, and you don’t have to sweat a surprise collapse.

Third, if you have a big gain in a particular trust or trusts, don’t be averse to taking some of the profit off the table after a steep run-up, like the one we’ve just had. That’s especially true if you own some of the weaklings that have run, such as Enterra.

As for the oil and gas producers in the Aggressive Portfolio, I’m not selling any of them at this time. I am, however, keeping a tight leash on my buy targets. Basically, I’ll only raise them if trusts’ cash flows and distributions justify it.

I did, for example, raise ARC Energy Trust’s buy target to USD30, reflecting robust first quarter earnings and its 20 percent distribution increase. Nothing else I’ve seen so far justifies doing the same for any other oil and gas trust.

In fact, I’m cutting Penn West Energy Trust’s buy target back to USD34, pending how its second quarter earnings emerge.

One of the hardest lessons I’ve had to learn both as an investor and an advisor is to maintain discipline not to chase stocks higher that run past value-based targets. I believe there’s still a lot of value and upside in top oil and gas producer trusts over the next three to five years and that the best are still quite cheap. But there are also going to be plenty of ups and downs in this energy bull market. And there’s no substitute for patience and focusing on value in this often-volatile sector.

Best of the Rest

If the question for sizzling oil and gas trusts is whether or not to take profits, the challenge in slumping business trusts is figuring out which are true bargains and which are cheap for a good reason.

The good news is the Canadian Edge picks generally came through the first quarter in good form earnings-wise. Some trusts, such as our infrastructure picks, had blockbuster quarters as they brought new cash-generating assets on stream. AltaGas Income Fund (TSX: ALA.UN, OTC: ATGFF), Keyera Facilities Income Fund (TSX: KEY.UN, OTC: KEYUF) and Pembina Pipeline Income Fund (TSX: PIF.UN, OTC: PMBIF) all turned in superb numbers and show every sign of continuing to do so. All are strong buys at prices listed in the Portfolio table below.

Not surprising, our utility trusts were less spectacular on the growth front but nonetheless did the job of covering their big distributions handily. Even Boralex Power Income Fund (TSX: BPT.UN, OTC: BLXJF) appears to have found the proper level for its payout.

Algonquin Power Income Fund (TSX: APF.UN, OTC: AGQNF) continues to find new ways on the margins to boost profitability. In mid-May, the trust inked a deal with an investor in one of its plants that effectively gives it cash and some power plant interests at a price well below book value in exchange for a modest number of Algonquin shares.

Meanwhile, Macquarie Power & Infrastructure (TSX: MPT.UN, OTC: MCQPF) stands to be a major beneficiary of a planned CAD8 billion investment by parent Macquarie Bank in Canadian infrastructure. That promises to lift its 12 percent-plus distribution further.

Along with Atlantic Power Corp (TSX: ATP.UN, OTC: ATPWF) and Bell Aliant Regional Communications Income Fund (TSX: BA.UN, OTC: BLIAF), these utility trusts are all in solid shape. Their average yield of well more than 10 percent is one of the most generous in the world, and their businesses are virtually recession proof.

As we’ve seen in recent months, even they can be volatile. And as the beating that Boralex took shows, not even they are immune from business setbacks. All five, however, are currently cheap and solid buys at the prices in the Portfolio table. Ditto my four CE Portfolio REITs, which are highlighted in this month’s Feature Article.

Even the best performing of these 12 trusts have lagged well behind the oil and gas winners this year. All of them, however, have shown as businesses that they can weather whatever comes at them. They’re excellent bedrock for any portfolio, as well as a great counterweight to a possible near-term correction in energy. That also goes for High Yield of the Month Yellow Pages Income Fund (TSX: YLO.UN, OTC: YLWPF), which has taken on a lot of water this year on perceived–but unsubstantiated–recession risk.

That leaves basically five trusts that face challenging business conditions and have lost ground in the market place: Ag Growth Fund (TSX: AFN.UN, OTC: AGGRF), Arctic Glacier Income Fund (TSX: AG.UN, OTC: AGUNF), Energy Savings Income Fund (TSX: SIF.UN, OTC: ESIUF), GMP Capital Trust (TSX: GMP.UN, OTC: GMCPF) and TransForce (TSX: TFI, OTC: TFIFF).  

All of these are franchise businesses that have grown rapidly the past few years to become major players but appear to have hit a snag in recent months. Arctic has gotten tangled up in a US Dept of Justice investigation of the ice industry in which it hasn’t yet been named as a target but which has attracted a number of lawsuits. Ag has been plagued by operational problems that have prevented it from taking advantage of runaway demand for agricultural equipment.

Energy Savings is seeing a drop off in customer additions from the US economic slowdown. GMP has suffered from very weak conditions in Canadian deal-making activity, in large part because of tight credit market conditions. And TransForce has been hit by a slowdown in transport because of the weak US dollar, high fuel prices and the slowing North American economy.



Of the group, Ag has the easiest road to proving itself and has already set the stage for doing so as management maintains its line problems are now solved. The rest are more dependent on forces outside of their control.

It’s encouraging that things will have to get a lot worse for their distributions to really be at risk. GMP, for example, covered its distribution with first quarter cash flow despite, in the words of its CEO, the worst business conditions in more than 20 years. And despite the troubled economy and a very real hit from the weak US dollar, Energy Savings’ payout ratio was still just 61 percent.

After converting to a corporation on May 20, TransForce now has plenty of cash flow to spur growth. And the company has wasted no time moving in inking a CAD100 million loan agreement with a private capital firm a week later.

Finally, just as its CEO had promised us, Arctic Glacier had no surprises in its first quarter earnings. Rather, it announced another major acquisition in the US, a possible sign its legal problems aren’t as bad as its deeply discounted share price now indicates.

Truth be told, these are the trusts that have me most on edge here in June 2008, and I watch them closely every trading day for signs they’re truly weakening. So far, signs point to full recovery, probably later this year. As long as that’s the case, I’ll be sticking with them but with one caveat: No one should double down on them or any other recommendation.