ChangeWave 'Trusts' Natural Gas

01/24/2003 12:00 am EST

Focus:

Tobin Smith

Founder and Chief Research Analyst, NBT Equity Group

"Natural gas is experiencing a fundamental shift toward consistently higher prices," says Tobin Smith, editor of ChangeWave Investing. "There is supply/demand imbalance which we call a ChangeWave that is caused by fundamental shifts in the fabric of an industry. Investing in these trends is a great way to make money. As such, we are adding a Canadian natural gas trust to our income portfolio." Here's his analysis.

"I forecast natural gas prices above $4 per million BTUs because of three related ‘ChangeQuakes’ or major trend changes that are transforming the industry. First, the large producing fields are mostly tapped in the US. Second, corporate exploration companies that need to rebuild balance sheets are unwilling to explore new deep-water reservoirs until they are convinced $4 natural gas is here to stay. And third, the death of power and natural gas trading in the wake of the Enron and other energy industry scandals has reduced the price volatility exponentially. At the core, prices are up because supplies are down.

"With natural gas trusts are on fire, I want to add PrimeWest Energy (PWI NYSE), a Canadian trust, to our income portfolio. We forecast natural gas prices moving higher from here and stabilizing over the $4 level for all of 2003. As you know, it's getting tougher and tougher to find natural gas; it is also more expensive to drill for new fields. Our strategy is to seek out the trusts that are buying existing fields of gas at significantly lower acquisition prices and continuing to extend their overall reserves. The Canadian trusts are better structured for this acquisition growth strategy.

"Royalty trusts eliminate the exploration risk; they only buy existing producing fields and then do additional drilling and enhancements on a positive cash flow basis. PWI is a $642 million market cap player that is newly listed on the NYSE. It sells at a 20% premium to its proven reserves, which is at the very low end of these assets. Leverage is 2.2 times debt to cash flow (which is high), but I assume PWI will sell additional equity units to refinance. This is how these trusts add reserves—they borrow money to buy additional property and then repay the debt with additional equity raises.

"PrimeWest forecasts a 17.7% payout this year, but I think it will be more like 19% with higher gas prices. (They own 68% natural gas and are adding new natural gas fields over oil.) About 30% of your payout is considered a ‘return of capital’, which shelters your income. This takes the pre-tax return to over 20%. You only pay taxes on return of capital when you sell the units, which we will when gas prices drop below $4 or we get a huge move in the stock. I expect PWI to trade to a 35% premium to net asset value or a 15%-20% higher price from here plus grab 20% in dividends this year. That's 50% profit and a check in our portfolio every month. Let's buy PWI under $18 with a target of $24."

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