Advantage Energy Income Fun AVN-U, TSE
February 17, 2003 - 8:04am EST by
2003 2004
Price: 13.66 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 400 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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AVN-U, TSE, C$13.66
AVNNF, OTC, $9.06

Long time members may recall Search Energy, a Canadian E&P that converted into a royalty trust called Advantage Energy Income Fund (AVN-U-TSE or AVNNF in the US). Last year AVN’s total return (stock price plus divvies) was 80+%. I think 2003 shapes up to be another banner year, and here’s why.

AVN is 78% Naz Gas (they brilliantly swapped out their heavy oil for NG a while back), with a 10.2 yr. Reserve Life. Current divvie payout is 18cts Cdn./mo. to yield 16%. The payout ratio for the 4th Qtr 02 was 70-75%, pretty much in line with other energy unit trusts. Mgmt: The 4 principles were senior execs at Enerplus and the mgmt agreement is rather unique. Mgmt has taken a much smaller mgmt fee upfront, in exchange for a percentage of the total return to shareholders above 8%. This aligns mgmt’s incentives with our interests and guarantees that deals are done to make money and not just increase the fee base. Additionally, mgmt can elect to take their incentive comp. in units or in cash. This past year they took it in units, with the units on their yearly high no less. Additionally, they have been buying units on the open market—as recently as a month ago. Mr. Gary Bourgeois is very accessible to investors with questions.

The firm has done 3 secondaries and 1 convertible placement, raising a total of C$157.5MM. In 2002 they bought Gascan (C$74.3MM) and Best Pacific (C$51.7MM). In the Gascan acquisition, they acquired the Medicine Hat property, in Alberta, which was, quite simply, a stellar purchase. In Apr02 AVN drilled 41 wells and recompleted 19; in Sept02 they drilled 58 wells. They had a 100% success rate. This added 16mmcf/d at a cost of C$20MM or C$7500/boe/d; They added to the reserve life and increased production PER UNIT, a tremendous value enhancement. This was a production increase of 333% with more low-risk drilling to come.

Naz gas markets are currently in turmoil, with massive drawdowns pointing to our first-ever sub-700mmcf April storage figure. US production is down 6% YOY, with well completions down 34% YTD. EP, with huge NG reserves, appears to be reducing/abandoning CapEx for now to husband cash; others are behaving similarly. In Canada, production is down 2-3%, and well completions are down 22% YTD. Additionally, the elephantine Ladyfern development has a 65% yearly decline forecast. Near-month NYMEX NG futures have recently pierced $6mmcf, and the Jan04 contract is up to around $5.30. AVN’s hedges all expire by Mar 1st, giving them the ability to: sell into the tight spot market, lock in high rates into next winter, some combination of the two, or go naked long NG indefinitely. Assuming NYMEX NG at $5.30 and WTI Crude of $29, AVN has about 33cts (Cdn) of CF per unit, net of debt interest. They currently pay out 18cts Cdn per month, but this will likely go up to 22-23cts. This is still only a payout of 65-70% of cash flow.

What of the “war premium” in oil you may ask? The Jan04 WTI crude future is trading around $28/bbl, not far from the assumptions used above. My own opinion is that the war premium in energy is much less than presumed, and the higher price is symptomatic of other problems like Venezuela and Mexico, which are more intransigent. Additionally, NG is a lot like real estate, meaning “location, location, location”. I’m oversimplifying, but oil can be put on a tanker and floated anywhere, to some extent. NG needs infrastructure to get it to the end user. Thus, the fact that they are burning it off as a nuisance in Nigeria doesn’t help the homeowner in North Dakota. The energy stocks and Unit Trusts have not rallied since the memory of the painful whip 2001-2002 is still freshly seared in investors’ minds. A big difference this time is that a lot of industrial demand was permanently destroyed by either switching to oil or moving their operations to countries with local NG resources, so the elasticity is not there. The supply response is apt to be muted by the problems the EP's of the world are experiencing, and by the heavy debt a lot of E&P's are struggling with as a vestige of the last bull move. Additionally, as more electrical generation came on line, it was heavily NG, since it is clean and unobtrusive. Low water levels at Western Hydro facilities imply a shortfall from these sources. Everyone hates coal and nukes. (Well, ok, I don’t.)

So, the gist of the argument is, as the evidence and pricing show, that NG has moved to a “permanently” higher price range, likely to be in the $4-7 range. There is a good chance of a NG crisis, which could drive gas to $10 again. Unit trusts historically have paid out 90% of CF. Using the above assumptions of AVN generating 33cts Cdn/mo., and paying out 85% of that, gives a divvie of 28cts Cdn. A reasonable historical yield for Unit Trusts is 14%, which would give us a price of C$24. If a NG crisis occurs, AVN could even be bought out just for its reserves, since the supply response is muted and will lag anyway. Energy Unit Trusts as an asset class are way undervalued, with AVN being the most drastically undervalued, considering its heavy NG generation and increasing production.


1) Dividend increase(s)
2) Increasing PER UNIT production
3) "Free call" on a NG train wreck, with buyout implications.
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