The outlook for the sustainability of the Canadian energy royalty-trust sector-which controls some 20% of the oil and gas production in the Western Canadian Sedimentary Basin-remains positive within the framework of current commodity prices. This is the view of the energy research team at FirstEnergy Capital Corp. in Calgary. That team is forecasting oil prices of $68 and $63 for 2006 and 2007, respectively, and corresponding Nymex natural gas prices of $10.75 and $9. Given these price assumptions, the researchers expect oil and gas royalty trusts in Canada to achieve an average payout ratio of 52.6% this year. This estimate, however, is substantially lower than their year-earlier outlook of 74.1% in 2006. "We believe that [oil and gas trust] distributions will be subject to higher volatility due to the limited ability of the trust model to shelter cash flows going forward," says analyst Jill T. Angevine. She points to the continued pressures on cash flows and the increased tension in the business model as it relates to cash sources (cash flow from operations) versus cash uses (capital expenditures and unit-holder/debenture- holder financing charges). "In an environment of rising costs, we recommend investing in strong management teams with internal prospects in which they have a high working interest or over which they have control," says Angevine. Fellow analyst William J. Lacey adds that, in light of accelerating costs structures, it will be imperative for oil and gas trusts to have balance-sheet strength to weather any potential weakness in commodity-price or production shortfalls. He adds that, "while we do not advocate scale of production on an absolute basis, having the critical mass to keep rigs active has become more of a topical issue." In addition, hedging to protect distributions and underpin cost structures should play a more prominent role, he says. Based on their evaluation of Canadian oil and gas royalty trusts, the analysts remain positive about the group based on their current commodity-price outlook. Progress Energy Trust is their top pick in that sector. Rated as Outperform are ARC, Baytex, Canetic Resources, Crescent Point, Paramount, Penn West, Petrofund and Peyto.