1,2,3 Going Through Changes... Trust Changes.

Change is not always a bad thing. In fact, it can be a fantastic catalyst in ones life. Vaulting us from a simple mediocrity and static security towards the new and unknown. That's how I am viewing the approach of 2011 and the inherent effects of the new SIFT tax on trusts in this fine country. But although the shortsightedness of our fine government to cripple a great tax-efficient investment vehicle still leaves me standing stunned, I cant help but focus on some solutions... and distribution sustainability is looking fine.

For most energy trusts, 2011 will be the last year they operate within the trust structure, as many plan to convert into corporations prior to D-Day (Jan 1, 2011). Most of the converted or soon-to-be converted have expressed their intentions to continue as dividend paying corporations but with a more balanced mix between growth and income. However, there remain many questions and concerns about how this transition will unfold, the timing of conversion, distribution sustainability, tax shelter, and future growth potential just to name a few. Now, to hold them through the conversion or to get out is the question...

Distribution sustainability will depend largely on commodity prices, although most trusts have sufficient tax pools to offset cash taxes for several years beyond conversion. Most likely trusts will attempt to hold their distributions/dividends flat and allocate any excess cash flow to capital development projects instead of increasing the dividend. Growth will be an option for those trusts that have the right assets, but the one main advantage the trusts will have over existing intermediate E&P's is capital discipline, which will provide investors with superior returns over the long term.

Balance sheet strength will be paramount when looking at sustainability of the dividend and overall growth capacity, as this will gauge the ability to take on more debt to cover distributions during periods of weaker commodity prices.

Another focus to sustainability is found within the company's tax-pools. Under the trust structure, taxable income was essentially passed on to investors in the form of distributions, so energy trusts had minimal need for tax pools. As a result, many trusts built up sizable tax pools over the years which they can now use to reduce taxable income once they convert and become taxable. As tax pools are drawn down, companies will become more taxable and hence will have less cash to pay out to investors or reinvest in the business. However, it is important to keep in mind that ongoing capital expenditures are added to the tax pool base so these pools would never get drawn down completely, assuming the company remains a going concern.

Overall, the energy trusts will continue to offer attractive investment opportunities for the following reasons:

• They have sizable positions in legacy, low-productive assets where new horizontal drilling and multi-frac completion technology works best, providing significant long term development potential.


• They have the scale and access to capital necessary to successfully execute a resource play strategy.


• Continued improvements in drilling and completion technologies should lead to higher recovery rates over time and hence, contribute to reserve growth.


• They have strong capital discipline which should contribute to superior returns through a combination of underlying growth and income.

Happy investing. I will leave you with a quote I recently came across in a morning update from the fine gentlemen at "Hedgeye":

"Hope is not an investment process. The best process is in fact to get your brooms on the ice early and prepare for the market "bonspiel" while your competitors are still celebrating yesterday's successful "hit and rolls"." - Feb 18 Hedgeye comment (Men With Brooms)