The Bullish Case for Penn West Energy

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If I were a politician, I would change my last name to Honestman. Now there's a name you can trust!

Even though they are about to become rarer than an honest politician, I believe that investors can still find trustworthy names among the Canadian royalty trusts (or "Canroys") before new tax rules take effect in January 2011.

Penn West Energy (NYSE: PWE  ) has formed the nucleus of this Fool's long-term energy exposure for several years running, and below I will attempt to share my rationale for holding onto my own investment through the looming conversion from a royalty trust to a traditional corporate structure.

As the largest of the energy Canroys, and the leading producer of light and medium oil in western Canada, Penn West Energy possesses a scale, a well-diversified asset base, and even a track record of impressive growth that I believe will serve the company well through the looming transition.

What a long, strange trip it's been
The Halloween massacre of 2006, a steep sell-off in all Canroy shares following Canada's announcement of an end to their tax-exempt joy ride, presented an opportunity for entry into the red-hot energy sector that this Fool simply could not ignore. For the next two years, I patted myself on the back while collecting gorgeous monthly dividend payments for double-digit annualized yields.

Of course, my premature celebration of a stock well chosen was destined to be challenged.

When the floor fell out from beneath the energy markets in September 2008, Penn West units went along for the free fall with a gruesome 75% collapse in per-unit price to an adjusted March 2009 low of $6.07. Suddenly, that Halloween massacre didn't look very spooky anymore!

Unable to stomach selling these high-quality units at such a loss -- particularly in the face of what then became an annualized dividend yield of 22% -- I held this position straight through the commodity collapse and to the present day. Sure, the dividend payments have been chopped down substantially from their glory days; but at a present annualized yield of 8.5%, the monthly payouts have continued to provide a strong incentive to stick around.

All the while, Penn West piled multiple landmarks of strategic growth atop those lofty cash dividends by completing five acquisitions in less than three years. It is precisely that proven ability to achieve significant growth despite a hefty cash flow drain from those dividends that I believe makes Penn West a name Fools can trust through the conversion. When the company sets the new dividend later this year, I expect a sensible balance between growth and income to prevail.

The moment of truth approaches
Penn West will execute its conversion to a corporate (non-trust) capital structure at the end of this year, and the fine print regarding what to expect will be issued during the fourth quarter. Already, however, we have enough information to paint (with broad strokes) a picture of the resulting corporation.

For starters, income investors will be pleased to note that Penn West will not go the way of recent convert Enterra Energy, which axed its dividend altogether while making the switch to a growth-focused corporation under a new name and ticker symbol: Equal Energy (NYSE: EQU  ) . Advantage Oil & Gas (NYSE: AAV  ) , which jumped in front of the deadline by converting to a growth company midway through 2009, has underperformed Penn West units since that time on a total-return basis.

Particularly given the role that income undoubtedly played in attracting existing investors, I believe that maintaining at least a modest income component will prove a common characteristic of the more successful converts through next year and beyond.

Precision Drilling (NYSE: PDS  ) , another recent convert that discontinued its dividend when making the switch from Precision Drilling Trust, has cited company debt as the primary obstacle to reinstituting a payout. Precision -- a popular five-star pick among Fools (with nearly 1,700 votes of confidence in CAPS) -- offered no specific guidance regarding when investors might look forward to a touch of income to accompany the onshore gas contract driller's solid growth prospects.

By contrast, the new Penn West will pay a sensible dividend after calculating sufficient cash flow to provide for both sustaining capital and growth capital. An explicit promise to continue payouts after the conversion formed a key element of this Fool's selection of Enerplus Resources Fund (NYSE: ERF  ) as a vehicle for royal returns in natural gas.

Income is a handsome incentive, to be sure, but I see plentiful reasons to retain my investment in Penn West through the looming conversion.

Three more reasons to stick with Penn West

  • Penn West has effectively replaced recent production, maintaining a stable reserve life index above 11 years. The company appears well-positioned to continue that success through highly prospective exploration assets. Current reserves of 687 mmboe feature an oil-heavy mix (69% of reserves).

  • Following a strategic joint venture with China Investment Corp. (CIC), Penn West's Peace River oil sands project has effectively been fast-tracked for large-scale development by a massive injection of foreign capital. CIC picked up a 45% stake in the project, a 5% stake in Penn West units, and a substantial obligation to fund capital expenditures at the project. Now that oil has broken above $80 per barrel once more, we may find key oil sands plays like Peace River and the Fort Hills joint venture between Suncor Energy (NYSE: SU  ) , Teck Resources (NYSE: TCK  ) , and Total come back into focus.

  • Producing about 165 mboe per day, Penn West is already the largest of the energy trusts heading into this conversion event. Sitting upon a $2.25 billion bank facility, and cash flow from operations that topped $340 million in the first quarter, Penn West enjoys the necessary heft to continue its role as a major consolidator of Canadian energy assets.

Has the impending conversion to a non-trust corporate structure altered your opinion of Penn West as a long-term investment in the energy sector? More than 1,350 members of Motley Fool CAPS believe that Penn West Energy will outperform the S&P 500 going forward. Please join our vibrant community of investors if you have not already done so, and share your own valuable perspective on this and other quality stocks.

Fool contributor Christopher Barker can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets. He owns shares of Enerplus Resources Fund and Penn West Energy. Precision Drilling is a Motley Fool Global Gains recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (12) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 04, 2010, at 6:51 PM, leaf67 wrote:

    Good and accurate article.

    I know it is a short article but I think it should have mentioned PWE’s great drilling plan as that will really make a difference.

    Also the reduction of debt over the last year has really added value to PWE.

    Personally, I expect great things from PWE over the next 2- 5 years.

  • Report this Comment On August 05, 2010, at 1:40 AM, JadeJasper wrote:

    Not so good and inaccurate article.

    PWE produces more then 165 boe per day.

    Article is too positive. It forgets to mention the high risk of a very large dividend cut coming when PWE converts to a corporation.

    Even though the hugh debt has been reduced recently, it is still way too high in my opinion.

  • Report this Comment On August 05, 2010, at 1:44 AM, Puckplayr4 wrote:

    GREAT GREAT Article. Thank you! I've been buying heavily into PWE (before I knew what I was doing) just based on the Dividend yield and it seeming to make sense. Then I read about the Canroy and the upcoming conversion, and I had no idea what that mean to PWE so I've switched to buying BPT instead...but this article puts me a bit at ease and I think I'll put PWE back on my monthly purchase plan.

    Thank you

  • Report this Comment On August 05, 2010, at 1:32 PM, XMFSinchiruna wrote:


    Another Fool alerted me to the misprint, and PWE's daily production rate has been corrected above to read 165 mboe per day (instead of boe). Thanks for pointing it out.

    I'm sorry you feel the article is excessively positive. I in no way intended to underplay the certainty that the conversion will indeed result in a meaningful reduction of the dividend yield, but keep in mind that such a reallocation of cash flow would theoretically brighten the company's growth prospects beyond the impressive growth already realized during the bygone days of ultra-high dividend yield.

  • Report this Comment On August 05, 2010, at 1:38 PM, XMFSinchiruna wrote:


    Keep in mind that Prudhoe Bay production has been in a terminal state of decline for many years.

    [This excerpt is dated, as it comes from the above 2008 article. The present yield on BPT is 8.8%]

    On the surface, BP Prudhoe Bay Royalty Trust (NYSE: BPT) has some curb appeal with its 11.1% trailing dividend yield. Fools should be aware, however, that production from Prudhoe Bay, America’s largest producing oil field, has been in a consistent slide since the late 1980s.

  • Report this Comment On August 05, 2010, at 1:40 PM, XMFSinchiruna wrote:


    Thank you for pointing out those additional attributes.

    I look forward to looking back at the post-conversion performance of PWE shares after some time elapses.

  • Report this Comment On August 06, 2010, at 6:31 AM, urche wrote:

    I am thinking about whether add'l CANROY investment such as PennWest , Vermilion, Perpetual make more sense in a taxable vs. retirement account. Despite losing the 15% tax withholding by the Canadian Gov't, I have held these in retirement account because so doing vastly simplifies the tax reporting of monthly dividends and federal tax credit eligibility. As I understand it, after CANROYs switch to tax paying corporations, US investors will no longer have the 15% tax withheld. But will there be other taxes eligible for US Federal tax credits? if so, it might make more sense to hold converted Canadian energy companies in taxable accounts.

    What do you think?


  • Report this Comment On August 06, 2010, at 12:08 PM, silverminer wrote:


    I am the furthest thing from a tax expert, but as I understand it the taxation rules on dividends are likely in a state of flux just now as Washington hammers out the details.

    Perhaps someone with better knowledge of the relevant tax structure would care to render an opinion?

    Sorry I couldn't be morehelpful in this regard.

  • Report this Comment On August 06, 2010, at 12:08 PM, silverminer wrote:

    P.S. silverminer = TMFSinchiruna :)

  • Report this Comment On August 12, 2010, at 12:04 PM, jkipling wrote:

    The looming structure switch is in a way affecting my decisions regarding PWE. I am absolutely not selling a single unit until it happens to collect every last dividend cent. Even then I may not sell for years. I'm thinking when oil is $500 a barrel might be a good time to sell, but we'll see.

  • Report this Comment On August 17, 2010, at 3:35 PM, Jbay76 wrote:

    What about other CanRoys like Provident energy Trust?

  • Report this Comment On September 04, 2010, at 12:36 AM, jxlot077 wrote:

    What do you think the dividend might turn out to be when the conversion happens ? Also, do you think the company is worth the price it is trading at now or would it be better to wait and buy when the conversion happens ? When Royalty trusts are converted do they generally rally, decrease in stock price or stay stagnant ? Thanks for any information you can provide. I am really interested in the Canadian Roylaty Trusts and think an article on what they are, why they are worth investing in and whether or not they should be bought now or after the converion, would be awesome.

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