NorCalSavant

Penn West Energy Trust is one of largest Canadian oil and gas royalty trusts listed on the NYSE. Its estimated production for 2008 is in the range of 195,000 – 205,000 barrels of oil equivalent (boe) per day. At the end of 2007, it had an overall reserve-life-index (RLI) of 10.5 years. Its current management target is to distribute approximately 67-72 percent of its cash flow to unit holders.

These Canadian oil and gas royalty trusts or Canroys, as they have come to be called, have historically offered attractive dividends with annual yields in the range of ten to fifteen percent. They pay out dividends monthly instead of quarterly allowing for better compounding of dividend income. And unlike their US income trust counterparts, they can make new asset acquisitions to extend their lives.

Recently these Canroys have taken a big hit in the stock market. The first systemic concern has to do with their tax status. The Canroys were able to give out big dividends because under Canadian law their distributions to unit holders were not taxed. However, Canadian federal legislation enacted on June 22, 2007, implements a new tax (the SIFT Tax) on certain publicly traded income trusts and limited partnerships, referred to as Specified Investment Flow-Through (SIFT) entities. Under the new law, starting in 2011 these income trusts will not be able to deduct a portion of their distributions to unit holders from income for assessing corporate taxes. As such, Canroys investors run the risk of substantially lower dividend distributions starting 2011. Penn West Management believes that they will be able to avoid prematurely triggering the SIFT Tax, i.e. before 2011.

The second more recent issue has been the substantial drop in the price of oil. It has been widely feared that the demand and consequently the prices for oil will stay low in tune with the expected word wide recession in the short to medium term. As oil and energy stocks have taken a beating on the stock exchange, so have the Canroys.

At the current stock price, Penn West Energy Trust appears to be an attractive investment in the short to medium term. Its current dividend is about $3.60 assuming current monthly dividend to hold constant over the next twelve months for a current yield of more than 20%. The question is whether the actual dividend over the next 12 months would be that much.

Rough Calculations

It is hard to guess exactly what the average price of oil would be for the next 12 months. Using financial data from Penn West’s second quarter 2008 report and conservatively assuming an average price of $50/boe for the next 12 months, no risk management (hedging) price gain, and an average daily production of 200,000 boe/day, the gross revenues should be approximately $3.65 billion over the next 12 months. Using funds flow/gross revenue ratios from the first two quarters of 2008 and 2007, the funds flow is computed to be $1.97 billion or about $5.24 per unit. Assuming a very conservative distribution at 50% of funds flow, the annual distribution computes to about $2.62 per unit. At the current stock price, that is still a very healthy yield.

Ignoring the upside potential of higher than assumed oil prices, the downside risk of gains from dividend payout being offset by a drop in stock price in the next year appears low for an investor, because eventually the world economic engine, and the demand and price of oil should pick up. However, as the corporate tax liability and dividend payout could change structurally in 2011, the stock needs careful ongoing monitoring to keep up with management’s policies and decisions in light of the expected and/or unexpected changes.

P.S. — Today is Diwali, also known as Deepavali, the festival of lights. Here is wishing happiness and joy to all on the occasion, and a very happy celebration to those who would be celebrating in some way.

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