Canadian Income Trusts:

By Roger Conrad

The Top 6 Canadian Oil Trusts or Canadian Energy Trusts to Buy Now
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ike politics, everyone these days seems to have an opinion on energy: Where the price of oil is headed, what the government should or shouldnt be doing about it, how dependence on Middle East Oil is damaging our economy, why global warming does or doesnt matter, why renewable energy is necessary, you name it. As investors in Canadian oil and gas producer trusts and dividend-paying corporations, its critical that we dont buy into all the bull. Rather, the key is to stay focused on two main points. First, despite the price crash of the past 12 months, the underpinnings of the long-term energy bull market are still very much alive and well. Mainly, global demand is set to rise exponentially in coming years, as the developing world raises its standard of living. And the industrys current base of production doesnt come close to meeting it. Second, despite a dramatic recovery from their lows of early March, the best Canadian producers are still extremely cheap. Not only do they trade at huge discounts to the value of their reserves in the ground, but theyre battle tested against the worst possible conditions. Their debt, never really very high, is at its lowest level in years. And despite record volatility in the prices of their principal products, theyre having few if any problems accessing credit. Dividends have been cut back sharply in tandem with falling energy prices over the past year. But yields are still in double-digits and are now protected by extremely conservative assumptions for realized selling prices, which in turn are backed by systematic hedging. Costs are falling, spurred by penny-pinching management but also by the long-awaited drop in production costs due to extremely slack conditions in the energy services business. And even 2011 taxation concerns are receding, as more trusts iron out their plans and most confirm intentions to remain dividend payers after taxation kicks in, at least to the extent the prevailing level of energy prices allows. Enterra Energy Trust (TSX: ENT-U, NYSE: ENT) and True Energy Trust (TSX: TUI-U, OTC: TUIJF) are still fighting for their lives. Burdened by heavy debt, both should largely be avoided.
Maple Leaf Memo

But the best of the biggest are not only hunkered down to survive whats left of this recession theyre well-positioned to cash in on the inevitable recovery of energy prices, as the global economy stabilizes and energy demand growth returns to the torrid pace it held up until last summer. To be sure, there are still formidable near-term risks. Producing natural gas remains a barely profitable proposition at current prices and a serious drag on profits for many highdebt companies leveraged to producing gas. Oil has been a considerably more profitable business this year. But its surge hasnt been driven by indicators on the ground, such as actual demand growth and inventories. Rather, oil prices have been a high-beta speculation on how fast and hard the global economy will bounce back from the disaster of the past year. It may be only a matter of time before oil is again trading at USD100 a barrel. But whats sent it higher thus far is basically a sharp reversal of the negative sentiment on the global economy that drove Black Gold to its doom in the second half of 2008. And as the jagged volatility in this market demonstrates day in and day out, the trend could certainly reverse again, should the economic news turn gloomy or even if enough investors decide its time to take profits on what they deem to be a bear market rally. Torrid rallies like the one weve seen for energy prices and Canadian producers since early March have a way of sucking in the skeptics and then running out of gas without warning. My fear is that many of those who sold out at the bottom a few months ago are now returning, thinking the coast is clear.

Return of the Bull .................................... page 2 My Favorite Producers .......................... page 4

ARC Energy Trust Enerplus Resources Paramount Energy Trust Provident Energy Trust Vermilion Energy Trust

Should things go awry, theyll likely be the first to stampede out, and prices will fall that much faster. Id like nothing better if oil prices never revisit even the 50s again. But with the economy this weakand natural gas prices this lowits hard to argue that the industry is in the pink of health. And as long as the energy market is trading on prospects rather than hard current business news, youd better be prepared to hang in there if prices do take a near-term hit on a swing in sentiment.

As Ive said throughout this bear market, I want to ride this one all the way up. And as long as my oil and gas trusts are hanging in there as businesses, Im going to stick with them throughout the ups and downs. All of the Aggressive Holdings have demonstrated their ability to weather even the worst storms, mainly the one were in now. All are strong buys and excellent ways to garner high cash flow as we wait on the next leg of this energy bull market to unfold.

Return of the Bull

Given that this is the worst global recession in 80 years, its no surprise that global energy demand has been walloped over the past year. Even the fast-growing economies of Asia reduced their intake for a time. Meanwhile, in the developed countries, use has plummeted, led by dramatically reduced demand from heavy industry. This demand destruction has created the illusion that energy is no longer in short supply and that arguments like Peak Oil theory, so popular just a year ago, are a bunch of bull. In reality, however, the long term supply/demand situation just got dramatically worse, as the crash in prices basically stymied conservation, use of energy alternatives and new production. No matter how bad things may be for the world economy, it isnt always going to be in the sorry shape it is now. Its highly debatable how long it will take for growth to revive, given the recent extreme shock to the system. And many may question whether or not government efforts to pump up growth will wind up helping or hindering the ultimate recovery. Whats not debatable, however, is every slump in human history let alone American history has been followed by a recovery. And this recession is looking progressively more and more like those of the 1970s, which was followed by rapid inflation, than the Great Depression of the 30s, which was followed by years of despondency. It may take some months. But conditions will eventually stabilize and the global economy will return to growth. And when that happens, demand for energy will also recover, with the rebound greatest in the developing world as standards of living rise. Even in the developed world, energy demand is only down because of the recession and is certain to rebound when the economy stabilizes. The dramatic drop in gasoline prices since last summer coupled with tight credit have eliminated the desire and wherewithal for the kind of permanent adoption of new technology to reduce energy consumption, such as the massive switch to small cars was to the 70s. And no amount of government intervention in Detroit will make a dimes worth of difference until those conditions reverse decisively.
Maple Leaf Memo

As for supply, it wasnt adequate for the task last summer, after several years of record capital spending on new development. And it surely isnt now, after nearly 12 months of unprecedented supply destruction, i.e. the cancellation of literally hundreds of projects around the world to increase production. Canadas oil sands alone have seen a steep cutback in spending. So has the development of much-ballyhooed shale gas in the US. The end of the 70s bull market for energy was dramatically hastened by the mass adoption of nuclear power in the US, which replaced the roughly 20 percent of electricity generated by burning oil. In contrast, hype aside, all of the growth of spending on wind, solar, geothermal and other renewables in recent years has yet to produce even 2 percent of US electricity. Moreover, the energy renewables are chiefly replacing is coal, and the process actually requires greater use of another fossil fuel, natural gas. Thats because utilities must have backup capacity to meet demand if the wind isnt blowing. The discovery and development of conventional oil and gas resources in the North Sea broke the monopoly power of OPEC in the 70s and was thus one of the most important factors ending that energy bull market. In contrast, all the discoveries this time around have been unconventional sources of energy, such as shale gas, Canadian oil sands and undersea reserves off the coast of Brazil. All require much higher prices than conventional energy to be competitive and are clearly not economic today. As a result, they do little to lessen dependence on the still much cheaper oil being produced in hostile nations in the Middle East and elsewhere. Most alarming is the cautious sentiment in the industry regarding new production thats grown out of the energy price crash. Some data indicate the pace of drilling rigs going off line may be slowing in some areas of the world. But the number in service is still falling. One reason is that, while oil has rallied to nearly USD70 a barrel, natural gas still cant hold over USD4 per million British thermal units (MMBtu). As a result, producers are still thinking about how they can cut costs to save cash, rather than how to ramp up new output for profit.
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Last month I moderated a panel of executives from three large Canadian producer trusts with sizeable US shareholder bases: Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF), Pengrowth Energy Trust (TSX: PGF-U, NYSE: PGH) and Penn West Energy Trust (TSX: PWT-U, NYSE: PWE). One of my questions was at what level of energy prices would they ramp up drilling and distributions again. Their unanimous response was that prices would have to stabilize at a much higher level to stir them from otherwise very defensive postures. As an investor, thats quite comforting in one sense. It means these trusts have built in very conservative assumptions to budgeting, hence their current level of distributions. All three also remain focused on holding down debt and keeping costs under control as the best way to outlast the crisis. That should help their chances of surviving a low-price environment and staying on track to participate in a recovery. It also means, however, that in the future the people running these trusts are going to be even more skeptical than usual when it comes to reacting to increases in energy prices. Even during last years price spikebefore anyone had any inkling of how far prices could fall in its aftermath trusts were far more interested in using their cash windfalls to enhance their long-term sustainability by cutting debt and expanding reserves than in increasing output meaningfully. This time around, any additional cash flow they gain from higher energy prices will almost certainly be used first and foremost to trim debt, possibly dramatically. Priority two will again be to expand long-term reserve bases and then return some to long-suffering shareholders, most likely as share buybacks and possibly as special cash distributions. Only if management is fully convinced that higher prices are here to stay will they really ramp up output. And thats likely to take a prolonged period of much higher oil and natural gas prices than what we have now. This cautious sentiment is reflected across the industry. The upshot is when the global economy does revive and demand picks up, few are going to really believe better times are at hand. That means supply increases are going to lag demand growth, quite possibly for years. As my colleague Elliott Gue pointed out at a recent conference sponsored by my publisher KCI Communications in Washington, DC, it generally takes a year to get a producing

project back up to speed after its been shut or to bring a new project on stream once a go decision has been made. That lag is likely to be a lot longer this time around, as producers skepticism restricts them to revving up only their highest percentage projects until they get comfortable about energy prices. For proof of how producers emotions can keep supply off the market, all you really have to do is look at the last decade of oil price history, starting with the bottom for oil of less than USD10 a barrel in the late 90s. Every time oil hit a new price threshold, it had to prove itself capable of holding it, from USD20 to USD30 to USD40 to USD50 and so on all the way up to USD150 in mid-2008. Some of the largest players like ExxonMobil (NYSE: XOM), which accumulated a cash hoard of USD30 billion this decade by refusing to ramp up investment, never relented in their bearishness until prices finally broke down this year. The upshot: Given the carnage and pain of the past year, energy producers will be even more reluctant to ramp up output this time around. That will continue to keep supply off the market even after demand has noticeably revived in the developing world and very likely after its fired up again in the US as well. Real recovery may not happen this year or even in 2010. But oil and gas prices are eventually going to take out last summers highs. In fact, its going to take the same factors that ended the 70s energy bull market, the same factors that have ended every commodity bull market in human history, to restore the balance of market power to energy consumers, where it was during the 90s. Those factors are: real demand destruction from permanent conservation; a switch of meaningful energy production capacity from fossil fuels on the par with the move to nuclear power in the 70s; and a genuine discovery of fossil fuel supplies thats cost competitive with current conventional sources. None of those developments are even possible at todays low energy prices. Moreover, all have been rolled back dramatically by the last years catastrophic drop in energy prices. They will eventually end this bull market, as they have all others. But thats only going to be possible after oil and gas make at least one more extremely profitable run for the roses.

Maple Leaf Memo

My Favorite Producers

*Picks and buy targets updated as of 9/22/09

Currently our basis for analysis on recommending companies is a mix and mash a companys assets, financial and operating strength, and distributions relative to current prices. The only exceptions are the high-debt weaklings and trusts that appear to have run up past fair value. My favorites by far are my core five: ARC Energy Trust (TSX: AET-U, AETUF), Enerplus Resources Fund (NYSE: ERF, TSE: ERF.UN), Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), Penn West Energy Trust and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF). Slightly more aggressive are smaller gas weighted trusts Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF) and Paramount Energy Trust (TSE: PMT.UN), as well as midstream/upstream play Provident Energy Trust (NYSE: PVX). The five core plays offer lower yields than some producers but they offer by far the best combination of balanced production, conservative finances, healthy reserves, low costs and seasoned management. And thats the best formula for weathering the rest of this recession and riding the energy price recovery to come, as well as scoring high and secure distributions. The two aggressive gas plays give us a solid bet on whats still in my view the highest potential fossil fuel. Thats both for use in North America and for its export potential, once liquefied natural gas (LNG) infrastructure can be turned around to export rather than merely import, as is the case today. Provident, meanwhile, is an asset-rich special situation that stands to profit richly this year from the yawning gap between natural gas and oil prices. If you own other trusts, rest assured that a buy means a buy and that a hold means a hold. My Canadian Edge portfolio picks arent the only selections that measure up on my criteria. And note that theres considerably more information available on all producer trusts in the Oil & Gas Reserve Life Table, including reserve life, debt, dividend history and various data on operating and finding costs. The Portfolio picks, however, are my favorites because they measure up the best to my criteria, and thats what Im going to focus on here. On the bright side, however, production remained steady, and the trust was able to continue executing its development program while keeping debt low. And thats in effect what Im looking for in continuing to hold producers in this battered market. ARC shares have noticeably surged from their early March lows. But theyre only about half the all-time highs they reached last summer. My bet is theyll get there again, though there will be a lot of ups and downs on the way. Buy ARC Energy Trust up to USD17 if you havent already.

Income Trust #2
Enerplus Resources has held its distribution constant since its last cut back in February. It has, however, found abundant savings from streamlining its reserve development program, putting the Kirby oil sands project on ice and placing greater emphasis on developing its Bakken properties. Even under a best-case, Kirby wasnt going to produce until 2011. Meanwhile, the Bakken properties have greatly exceeded expectations and are providing immediate cash flow. The company did record a seven percent boost in output from last years levels but expects to gradually curtail that to rein in costs, at least until theres some evidence of recovering energy prices. Given the steep decline in realized selling prices for oil and gas of recent months, the February distribution cut was necessary to enable cash flow to cover capital spending plus distributions, and thereby eliminate the need to take on more debt. Management now expects a total coverage ratio of 100 percent or less for full year 2009 and debt-to-12-month trailing cash flow is just 0.6. As for the longer term, Enerplus has numerous opportunities to ramp up output when the time is right and conservative finances ensure it will have the means as well. And management has affirmed it intends to be a big-dividend-paying entity long after 2011 taxation. Buy Enerplus Resources Fund if you havent already up to USD25.

Income Trust #1
ARC Energy Trust, has been ratcheting back its distribution in recent months, pretty much in tandem with natural gas prices. Thats in part because gas is roughly half of the trusts output. But its also because of ARCs successful development of property in the Montney Shale area of British Columbia that management believes could transform its reserve base just as the initial energy pools at its founding did over a decade ago. ARCs first quarter saw both revenue and cash flow per unit slide sharply due to much lower realized selling prices for oil and natural gas output. Netbacka measure of profitability calculated by subtracting basically all costs from revenue fell to CAD21.16 per barrel of oil equivalent from CAD44.81 a year earlier.
Maple Leaf Memo

Income Trust #3
Paramount Energy Trust could well have been in dire straits as a 100 percent natural gas producer, given the continued plunge in the price of its only product. Managements policy of aggressive hedging to ensure cash flows, however, continues to pay off richly, as have its recent acquisitions of fresh reserves and strategic dispositions of other assets. Realized selling prices for natural gas fell only 11 percent in the first quarter year-over-year, less than half the drop in spot prices. And that gap has almost surely widened sharply in the current quarter. The result is a huge hedge-book profit that the trust has been able to monetize for instant cash to pay off debt and increasingly to buy back shares. One thing Ive always been impressed with about Paramount is the extraordinary level of detail they provide with regard to projecting their payout ratio and debt cover4

age, based on various pricing scenarios. The current numbers project strong dividend coverage even at CAD3 natural gas. Thats certainly not reflected in Paramounts current market valuations. But it is a good reason for those who want an aggressive gas bet to buy Paramount Energy Trust up to my target of USD 5.

Income Trust #4
Peyto Energy Trusts management decided some time ago that preserving and expanding its reserve base would be a better use of its time and money in a bad market for energy than simply ramping up production. As a result, output slipped another 6 percent in the first quarter versus yearearlier tallies as the trust focused on costs and increased its proven reserve life to 17 years, more than giant ExxonMobil itself. Net debt was cut from year-end 2008 levels, as the trust accomplished this without issuing significant new capital. In its latest conference call Peyto management stated it can run its gas wells with natural gas at a market price of less than CAD2 per MMBtu. Thats basically half the operating costs of its typical rival, and it points to the trusts tremendous staying power in an otherwise extremely volatile industry. Looking ahead, the trust has numerous opportunities to ramp up its output from its huge base of lands and has been biding its time building up its geologic knowledge as well. And management affirmed once again in its first quarter 2009 conference call that it intends to be a dividend-paying entity, either as a converted corporation or even a trust in 2011 and beyond. Buy Peyto Energy Trust up to USD12.

Provident doesnt yet rate in my core producer group, its the still-pending lawsuit from Quicksilver Resources (NYSE: KWK) stemming from the latters purchase of Providents interest in the BreitBurn Energy Partners (NSDQ: BBEP). The latter has since suspended distributions due to falling natural gas prices, and Quicksilver has cried foul on the purchase terms. At this point theres been little word on the case, and a settlement is certainly possible. But until theres more clarity, Provident should be considered more speculative than the core five. Note that the suit is almost certainly a major reason why Provident continues to trade at a discount to other trusts. Provident Energy Trust is still a buy up to USD6 for those who can handle the legal risk.

Income Trust #6
Vermilion Energy Trust remains one of the three trusts that havent cut their distribution once over the past year. The reasons are all in its first quarter numbers. Cash flow did fall, mainly due to lower realized selling prices for its energy in North America. But sharp gains in Australian production offset lower output elsewhere for a solid sequential output gain from fourth quarter 2008 levels. And management once again kept the lid on operating costs and especially debt, which it could still zero out and then some once the pending sale of its 41 percent interest in energy developer Verenex (TSX: VNX, OTC: VRNXF) is completed. Net debt came in at just 0.9 times first quarter annualized cash flow, the best number in the industry. Longterm debt stood at just CAD168 million at the end of the first quarter, down from CAD500 million a year earlier. As Ive pointed out, one of Vermilions principal advantages is its location in European and Australian markets as well as North America. Gas prices especially remain sharply higher outside North America, and the trust has been able to realize sharply higher realized selling prices than its peers because of it. Management is reported to be looking into a range of acquisition opportunities, which it could do before or after disposing of the Verenex stake. That would certainly put it in position to be more profitable than ever when energy prices do recover from their swoon. The shares have risen sharply this year and have successively broken above a series of buy targets. As a result, Im not inclined to raise the buy target again beyond its current level of USD28. But Vermilion Energy Trust is certainly a buy below that price and a worthy holding for even the most conservative portfolios. Be sure to check out my premium product that focuses solely on Canadian Income Trusts; Canadian Edge.

Income Trust #5
Provident Energy Trust took down some 73 percent of its first quarter funds flow from operations from its midstream unit, assets that generate income based on the price spread between natural gas liquids (as tied to oil prices) and natural gas itself. Income from these operations is far steadier than that from upstream oil and gas production operations, providing a firm floor for the trusts finances and distribution, which it covered with a payout ratio of 65 percent. Upstream operations produced 11 percent less energy year over year, as Provident focused on controlling costs and limited capital spending in line with falling energy prices. Meanwhile, management concentrated its capital spending mainly on new midstream assets, which should create further cash flow stability in coming quarters. Capital spending was recently increased by CAD27 million for 2009 for midstream, basically doubling the original planned outlay. Net debt was a relatively low 1.6 times trailing 12-month cash flow, which again is steadier than that of pure producer trusts due to the midstream operations. If there is a reason

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Maple Leaf Memo