The demand for oil has gone down in tandem with the worldwide economic meltdown, and oil inventories have risen.

According to World Energy Outlook (WEO) 2008, primary demand for oil (excluding biofuels) rises by 1 per cent per year on an average.  It is estimated to go from 85 million barrels per day in 2007 to 106 million barrels a day in 2030.  Responding to the high gas prices at the pump and the slowing economy Americans cut oil consumption drastically in 2008.  According to the Federal Highway Administration, Americans drove more than 100 billion fewer miles (160 billion fewer kilometers) between November 2007 and October 2008 than the same period a year earlier, making it the largest continuous decline in American driving in history.  Data released Wednesday by the U.S. Energy Department’s Energy Information Administration, show demand for gasoline fell 3.3 percent in 2008, although it was down just 2.2 percent in the past four weeks.

Meanwhile, U.S. stockpiles have risen at the key storage facility in Cushing, Oklahoma.  The U.S. government reported rise in crude stockpiles again last week despite expectations for a steep drop, suggesting demand continues to be weak. For the week ending December 26, crude inventories rose by 500,000 barrels.  Analysts had expected a drawdown of 1.75 million barrels.

Where ultimately will oil end up in 2009 and beyond is anybody’s guess, but we have estimates from a number of analysts.  Merrill Lynch forecasts oil prices to average $50 a barrel in 2009.  Deutsche Bank cut its earlier forecast for average oil prices from $60 to $47.50.  Jim Ritterbusch, president of Ritterbusch and Associates says oil prices may have further to fall, however, before rebounding to an average of around $60 next year.  Citibank has optimistically estimated future oil price at US$70 for 2009 and US$75 for both 2010 and 2011.

There have been a flurry of reports about distribution/dividend cuts by the Canroys.

Citibank analyst Richard Roy forecasted a general 20% distribution cut by the Canroys.  Enerplus Resources Fund (ERF), Penn West’s peer, has already cut its monthly distribution from Canadian $0.47 to $0.38 in November, and to $0.25 in January.  Of course, its distribution had spiked to $0.47 for just two months in September and October benefiting from high oil prices.  It had ranged between $0.40 and $0.43 before then.  A distribution cut from $0.43 to $0.25 is about 40%, which is pretty drastic.  Enerplus says that their capital spending and distribution levels for 2009 are based on the current forward commodity prices of US$52.83 per barrel.

PWE has not come out with a formal announcement about distribution cut or the level of its distribution cut.  It plans to substantially reduce capital spending in the first six months of 2009 compared to the $525 million spent in the first six months of 2008.  It also plans to sell properties currently producing approximately 3,400 barrels of oil equivalent per day for approximately Canadian $147 million, and to use the proceeds to reduce bank debt.  Its goal is to enhance its financial flexibility for potential strategic acquisitions in 2009.

The other concern with PWE and other Canroys has been the impact of Canadian SIFT tax on the Canroys starting in 2011.  It appears that PWE is well-positioned for the least possible impact till 2013.  It says it is likely to retain trust structure till 2013, and is unlikely to pay any cash taxes till then.  It is likely to pay 8% to 12% cash taxes starting in 2013 after the end of tax-free conversion to corporate structure in 2011 and 2012.

Summing up, I believe Penn West would be declaring a distribution cut in the range of 20% to 35%.  That will bring down its monthly dividend per unit to about Canadian $0.27 to $0.22 from $0.34.  Assuming the current exchange ratio to hold, it would amount to about US $0.22 to $0.18 per month.  At the current stock price of about $11, it is still a healthy yield.  However, the yield is okay but not as attractive at the original purchase price of $17.  As of now, there is a loss of principal in the Penn West stock purchase for me.  However, I believe with economic pick up the price of oil will go up.  It would be prudent for me to hold the stock for now rather than sell and realize a loss.  What do you think?

I wish you a very happy, joyous, and prosperous new year 2009.

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I expected lower dividends in line with falling oil prices.  The Canroys have generally maintained their distributions till October.  Enerplus Resources Fund (ERF) is the first to reduce monthly cash distribution level from $0.47/unit to $0.38/unit effective with the November distribution payment.  That is about a 20% reduction in dividends.

I am anxious to see what Penn West comes out with.  A similar reduction would not be too drastic.  The stock price seems to account for that already.

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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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