Take Advantage of “Mark-to-Mayhem” With This 20% High-Yield Play

As most everyone on planet Earth now knows, the big banks of America and Europe are in serious trouble. At the center of much of this trouble is a little provision called "mark-to-market" accounting.

The mark-to-market rule requires the banks to mark the value of their assets — which include large quantities of mortgage loans, among other things — to "market" price. That means updating the recorded value of these assets based on where they are traded in real time.

So, in a way, marking an asset to "market" is like updating its value to reflect the latest printout on the quote screen. After all, an asset is only worth what you can sell it for in a pinch. Sounds reasonable, right?

The trouble is, many of these bank assets are trading at ridiculously low prices… or even not trading at all. It’s a sticky problem because it makes it very hard to say how much these assets are worth.

Let’s say, for example, that you own a 2,000-square-foot three-bedroom house, well maintained and less than five years old, in a nice residential neighborhood on the outskirts of a desirable city (i.e. not Detroit).

If you put the house on the market and no one wants to buy it — that is to say, no bids come in for the time being — does that mean the house is worth zero? Or let’s say there is only one bid, from some practical joker who offers to take the house off your hands for $23,000. Does that mean the house is only worth $23,000?

If you had to run your finances on mark-to-market rules, one of those two would apply. You would have to account for the value of the house at either $0 or $23,000, even though the property could obviously fetch somewhere between five to 10 times that amount later on when people aren’t so panicked and the markets aren’t seized up.

Mark-to-Mayhem

This is why some critics refer to mark-to-market accounting rules as "mark-to-mayhem." The critics argue that credit and confidence are so scarce right now that the low-bid/no-bid trading environment makes little sense.

There are arguments in favor of mark-to-market accounting. The most powerful one is that, well, some form of objective standard has to be applied, and the big banks have handled things so badly they have forfeited any right to be trusted with an effort to make their own estimates.

The goal here isn’t to take sides in the mark-to-market debate, i.e., whether banks should be forced to strictly adhere to a real-time number or be given leeway to value assets based on the return of more rational times. (That’s a thorny question that will be wrestled with for a while.)

Instead, the point is that the "mark-to-mayhem" phenomenon is very real, both in the context of what’s happened to the overleveraged banks and what’s happened in the stock market. With fear and loathing about as widespread as it has ever been — a recent sentiment survey saw investor bearishness topping 70%, the highest ever — many high-quality market assets have been "marked to mayhem" too.

We’re going to take advantage of this situation with a beaten-down yield play oriented to a deeply beaten-down commodity: natural gas.

The Lowdown on Natural Gas

According to the EIA (Energy Information Administration), natural gas is the main heating fuel for more than half the homes in the United States. More than 62% of U.S. households also use natural gas in major appliances like stoves, water heaters and clothes dryers.

The EIA goes on to note that "natural gas is an essential raw material for many common products, such as: paints, fertilizer, plastics, antifreeze, dyes, photographic film, medicines, and explosives."

On top of that, "natural gas has thousands of uses and industry depends on it. It’s used to produce steel, glass, paper, clothing, brick, electricity and much more…"

The thing is, natural gas prices have fallen sharply in recent months, to their lowest levels since 2002. This is partly due to the collapse in the price of crude oil and partly due to the storage situation.

As of this writing, the EIA’s most recent tally for natural gas inventories was 1,793 billion cubic feet. That figure is a little on the high side for this time of year — about 13.8% above the five-year average.

natural gas demand is running about 15% below average too… likely due to a falloff in sales for many of the consumer products that use natural gas.

The EIA chart of U.S. consumption shows how natural gas demand can fluctuate from year to year. While demand rose sharply in 2007 and just barely in 2008, it is expected to decline in 2009. Again, this isn’t really a surprise when you pair up the serious economic contraction the U.S. is facing with all the varied uses for natural gas in consumer products.

This has all proven to be very gloomy news for natural gas producers. At the going low price (as of this writing) of $4 per million British thermal units, many natural gas fields no longer justify their cost of production.

If the price of natural gas falls even further into the summer — a possibility seen by some — the effects could be even harsher. Big producers like Chesapeake Energy (CHK:NYSE) have already seen their share prices pummeled along with their profit outlooks.

So, for right now, the situation in natural gas looks grim. But the good news is that most all the grimness is already reflected in share prices. natural gas producers are priced as if the outlook will be bleak forever and decent profits will never return. But things can change…

The Financial Times notes that, while times are very hard for natural gas producers now, "this famine could be followed by a stunning feast once the next heating season begins." Even as we watch a potential bust unfold, the FT sees the following factors setting up for a future boom:

• Investment in new wells has been "slashed" (and rig counts are falling).
• Many new fields are only profitable at higher price points.
• As older fields decline with new investment curtailed, electricity prices could spike.
• Hurricanes, heat waves and competitive pricing with coal are all "X" factors that could create a surge.

So what we have in natural gas is a commodity that is getting very close to its rock-bottom value. The longer that prices stay down here, the more that production will be cut back. And with pessimism the order of the day, there are a number of hidden "surprise" factors that could cause prices to rise.

All in all, that sounds like a good backdrop against which to buy an insanely cheap high-yield play that will "pay us to wait" as the natural gas market slowly heals itself.

So now we'll look to the play…

A First-Class Producer With a 20%+ Yield

Peyto Energy Trust (PEY.UN:TSX) is a Canadian producer focused on "approximately 100% natural gas and natural gas liquids." It is also one of the most well-managed and best-positioned outfits on the continent.

The chart is ugly, but that fits with what we've already discussed in regard to energy prices and "mark-to-mayhem" stock market values in general. Thanks to investors' overly dire outlook in natural gas and elsewhere, we can now scoop up shares in beaten-down Peyto for a better-than-20% yield! (We'll talk more about that in a minute...)

Peyto's focus is on the Alberta Deep Basin in Western Canada. According to Peyto, "the Deep Basin is considered Alberta's premier exploration area for high quality long life gas reserves."

Three key areas that separate Peyto from its peers are long reserve life, low operating costs and high ownership. Peyto also has a long and reliable history of paying out monthly distributions through thick and thin. Let's look at each of those factors in turn...

Long Reserve Life

A number of natural gas energy trusts are focused on short life reserves, as opposed to long life reserves. The advantage of short life reserve projects is that they are easier to develop. You can get started faster and turn a profit faster with short life reserves. The trouble is, the reserves don't last that long... shallow wells where the gas is relatively easy to extract also tend to run out in a shorter period of time.

Peyto, in contrast, focuses on long life reserves — wells that take more care and effort to develop, but produce for many long years before running dry. Peyto is also a firm believer in "growth by the drill bit." They prefer to develop their own sites rather than buy capacity from others. This discipline helps them maintain high-quality levels and high returns on capital.

Low Operating Costs

In this tough natural gas environment, many high-cost producers find themselves slashing production and even shutting down fields that no longer turn a profit. In the long run this is good for the natural gas price, but obviously it isn't good for the producers who can't keep making money.

Peyto Energy Trust has a real advantage here in terms of low operating costs. The lower your costs, the easier it is to keep rolling along — and making profits — while your competitors are sucking wind.

Peyto really shines here. On a C$ per BOE (barrels of oil equivalent) basis, Peyto's costs are roughly one-third the average costs of its energy trust peers!

Those low operating costs show up in profit margin too... Peyto has the highest profit margin among its peers thanks to its low costs. That combination of high profit margin and low cost gives real staying power.

Smart Management, Steady Payouts

In part, Peyto is well-run because management has a big stake. The trust has no management fees, and employees are rewarded based on unit price (share price) performance and overall growth in proven producing reserves. The system works: Peyto has seen an average 24% return on capital and 49% return on equity over the past eight years.

Peyto has also paid out steadily increasing dividends, every single month, for over many years. The amounts paid steadily rose, from July 2003 through December 2008, doubling from 7.5 cents to 15 cents per unit during that time.

In 2009, Peyto announced a reduction in the dividend for the first time in more than five years, from 15 cents to 12 cents per unit.

This was done not as an emergency measure, but as a matter of prudence. Management is focused on making sure Peyto's yield remains safe and steady over time, which also means preserving a cash-flow stream for long life reserve growth.

But here's the thing about that drop to 12 cents... as of this writing, Peyto is trading at less than C$7 per share. That means that a 12 cent monthly (not quarterly) payout, on an annualized basis, works out to a better than 20% yield — and that's after conservative measures were taken.

So again, to roughly sum up, here is why we want to buy Peyto now:

• Natural gas prices have been hammered so low, there isn't a whole lot of downside left.
• There are a number of "X" factors that could turn things around for natural gas in the medium term.
• Peyto Energy Trust is one of the best-run, lowestcost natural gas producers on the continent.
• As other higher-cost producers feel the he.at (and partially shut down), Peyto should benefit.
• We can buy Peyto now for a yield in the 20% range — and sit back to wait for a double or a triple.

Action to take: Buy Peyto Energy Trust (PEY. UN:TSX) for up to C$8 per share.

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Other Related Topics: Alternative Energy , Justice Litle , Natural Gas , Safe Haven Investor

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