Value idea: Peyto Energy Trust

Natural gas is at extreme lows as it should; there is tremendous supply in the system. Storage is almost full. There will be no where to put extra production. The reason is the vast discoveries of shale gas. North America is abundant with natural gas contrary to what was believed of North America peak gas. Even with a harsh winter I do not think the supply picture will improve.

However I believe that goods or assets can't sustain prices below its average production cost over the long term. Sure there will be some divergence in some periods but it should return to equilibrium eventually. The question is when. I am not going to speculate on that as it is going to be a crap chute at best.

However a good position if I can find a way to participate in the price recovery of natural gas, while I get some downside protection and a margin of safety. I think Peyto Energy Trust (Pey.un) gives me this proposition. Peyto is :

Canada-based energy trust. The Trust’s principal business activity is the exploration for, development and production of petroleum and natural gas in Western Canada. As of December 31, 2008, the total proved plus probable reserves were 998.3 billion cubic feet equivalent (166.4 million barrels of oil equivalent) with a reserve life of 23 years. Production is weighted approximately 85% natural gas and 15% natural gas liquids and oil.

I like Peyto for the following:

• hedge book for half of their production of the next 12 months at an average price of $7.5 per mcf
• low debt to capitalization and good coverage of debt service and dividends
• low cost producer of natural gas. currently their operating costs per BOE is $2.56 as of their latest quarter
• long life reserves
• the cost structure for the most part is variable and gets reduced with lower revenues.
• cheap valuation where its Entp. Value to NPV is .57, a measure to value the company to its discounted cash flow from reserves in the ground.
• The current dividend yield is Distribution is 15.5%. The coverage of the distribution is good but if gas prices continue its decline it will be halved.
• I get good odds betting on natural gas plays. The upside is potentially large while the downside is limited. We are already at a decade low of natural gas price. Most Natural gas producer did not participate fully in the recent rally and lag the indices by a wide margin.
• And a very good management, extremely good management.
• My catalyst will be the revision to mean in natural gas prices as most likely it can't keep going down. We are in a period of supply and demand imbalance and there should be an equilibrium found in the next 12 months.

What can go wrong:

• Payout ratio is trending higher, which is understandable given the weak revenue figure. Peyto has already cut its distribution and it could a further cut is probable.
• Natural gas is the "widow maker" and can be very volatile. There is no reason it can't go to low $2s per mcf.
• Their operating lines can be shut or reduced if credit environment deteriorates further. Producers rely on operating lines to fund operations and exploration.
• Royalties are influx in the government of Alberta and can be very fickle to factor in analysing operations. Couple years ago royalties has been hiked on gas producers but once the bust has set in it was reconsidered.
• The conversion to corporate entity issue. Trusts will be subject to regular corporate taxes in 2011 so this is issue is hanging on Peyto and all trusts alike.

A note: This is a Canadian trust equivalent to master limited partnership in the US so it will have personal tax consequences that will have to be taken into consideration when purchasing