PWE: 03/08/2007

Penn West Energy Trust is a Canadian Royalty trust specializing in oil and gas production. Canadian trusts are specialized business structures that are mandated to emphasize production and realizing capital (i.e. making money and paying unit holders) rather than a normal corporation’s business cycle. Trusts are able to pass most of earnings to unit holders with favorable tax treatment. Penn West have several oil and natural gas fields in western Canada, with a mix that is about 60-70% oil. They mainly focus on producing their reserves (as opposed to exploration), sometimes focusing on enhanced oil recovery techniques (EOR).

Current Price: USD $28.90

Upside:

They have estimated 9 years reserve life which does not include the majority of their promising Peace River project, the Pembina project and other plays. Calculated NAV based on booked reserves at a netback of $28/BOE is ~C$34 (US$29) so the prospective plays are “free”.
Currently paying a 12% dividend yield. And unlike some trusts, the dividend payout is more than covered by operating cash flow.
Oil and gas assets in a stable world region and easy access to US market.
Should have the ability to increase reserves and productions in the years to come.
Oil demand has not abated since the start of the century and peak oil production is nearing closer. The oil majors are no longer able to grow or even replace reserves at a reasonable pace and will have to look toward acquisitions to book reserves.
A premium is placed on assets that are in accessible parts of the world.
Working toward internalizing some of the infrastructure needed to bring production to market which should help margins.

Dangers

Peak oil could be a red herring and/or oil prices could plunge due to geopolitical manipulations.
Some of the non-booked projects may not meet projects. For instance, the Pembina CO2 recovery project looks promising but they have not been able to secure a commercial source of CO2 for 2 quarters. Oil sands may not be economically viable.
Domestic political troubles due to Canadian govt changing tax laws on royalty trusts which could drastically reduce dividends.
Foreign currency exposure to the falling US$ may reduce revenue while oil is priced in US$.
Labor and production costs rising in Canada may cut into margins.

The Reasoning:

One of those classic cases of buying the company at the cost of its assets. In this case, Penn West’s assets are strongly understated. They estimate 2-3 billion barrels in the Peace River project but have only booked 9 million barrels. They also have large tracts of undeveloped land that they are farming out to E & P firms. This has the potential for even more reserves. So basically, a fire sale on oil/gas resources in an extremely secure part of the world.
The reason PWE is so cheap was due to the nasty Halloween announcement from the Canadian government to tax income trusts differently. This hit the whole trust sector, not just PWE, as it would significantly reduce one of the main attractions of Can. Trusts (high yield dividends). In PWE’s case, this just made it a great buying opportunity for several reasons:

PWE mgmt has already stated that they are considering a switch to a corporate structure and focus more on expansion and exploration if the law is finalized. They are in a unique position to effectively execute due to the scope of their undeveloped resources and strong cash flow. While we would lose most, if not all of the dividend, we would get retained capital appreciation without taxes.
The Canadian government is coming under pressure to reverse or modify stance so nothing is quite set. The existing trusts will have a four year grace period and the minority parties have already used this as a political weapon.
There are upsides to either situation and in the meantime, we get paid to watch.

As peak oil production becomes more apparent, PWE’s assets will jump in value. In the meantime, we realize a 6-8% after-tax yield despite whatever the stock’s price does. The potential for price appreciation is enormous.
This company is very strong by these measures: DCF, EY (as measured by Greenblatt). It is also good in terms of fiscal workout and ROC. The projected target price is merely ok due to weakness in last quarter’s (and FY) profits.
Other prominent investment analysts who like PWE (and have a strong record): Zapata George, Bruce Berkowitz (who is a Buffett-style fund manager and picks almost more on management than anything else), and reportedly Murray Edwards (who used to run the company).

Management:

Integrity: B+. ???, CEO: Bruce Berkowitz doesn’t sign off without meeting management team so they must have impressed him. From conference calls: They don’t seem to be smooth-talkers so we can trust what they say. Their strategy is fairly straightforward and focused. They don’t overly obfusicate their intentions by using jargon. Just not overly-exposed to them.
Past Performance: B. This last year’s (2006) is hard to judge due to their increased finding and exploration costs (including 4 billion in future capital). The past results seem to be good. The company has a low debt-to-equity ratio (though also a low current ratio). They bring in lots of cash, have a steady stream of projects in the pipeline and seem to execute pretty well. Time will tell

Risk Measurement @ $30 1 year = +0.55

upside – 30% chance of going to $35 = .5 * $5 = 2.50
really up – 10% chance of $40 = .10 * 10 = 1.00
flat – 30% stays at $30 = .3 * - 5% of $30 = 1.5 * .3 = -0.45
downside – 20% chance of going down to $25 = .10 * -$5 = -0.50
slide – 5% chance of falling to $20 = .05 * -10$ = -0.50
free-fall – 5% below $20 = .05 * -$30 = -1.5. (highly improbably as NAV is a floor – ie someone would buy the company before it went to zero or even get to $15)

Over more time, the risks diminish greatly and if the stock languishes, that is blessing as it will allow us to build a stronger position.