Analysis:Aside from the usual uncertainties about commodity prices, weather and the health of the U.S. economy, the fate of income trusts is a big question hanging over the Canadian oilpatch in 2003.
Just in case anyone missed it, income trusts of all kinds in Canada were hotter in 2002 than Bey-Blades for young kids at Christmas. The numbers for the year have not been fully compiled, but one study found 94 percent of all money raised through IPOs in Canadian equity markets in the first half of 2002 went to income trusts. The stampede has not halted, evidenced by a C$34.5 million IPO for Harvest Energy Trust completed last month.
The merits of the numerous trusts can be debated endlessly by money managers, especially on the subject of whether a bubble has formed. Let's leave that discussion to another day and focus on the practical implications of energy trusts on the Canadian oil and gas industry.
The tax advantages of income trusts, which transfer the government's bite to unit holders and away from the corporation, plus a deep well of capital that shows no sign of emptying have permanently altered the exploration and production sector north of the 49th parallel.
The days of building a junior into a mid-sided or senior producer are as dead as Al Gore's 2004 election campaign. Now the goal seems to be to build a producer up to around 10,000 barrels of oil equivalent per day, about the point where growing production while staying ahead of decline curves really starts to pinch, sell out to an income trust and start all over again. The best example of this pattern is demonstrated by the recent experience of the former executives of Poco Petroleums.
Craig Stewart, the former chief executive, and his management team built Poco into one of the largest independent producers in Canada when it was sold to Burlington Resources in late 1999 for C$3.7 billion. After taking a few months off, Stewart and his colleagues took over Meota Resources, a junior producer. Meota was recently sold to Provident Energy Trust for C$340 million, and the ex-Poco executives have moved over to take the reins at Rider Resources.
With interest rates low and investor interest high, trusts are trading at between six and eight times this year's estimated cash flow while many E&P firms are stuck at multiples between three and five.
A list of firms that have either sold the majority of their properties to an income trust or converted some/most of their assets into the specialty vehicles in the past 12 months includes Best Pacific Resources, Elk Point Resources, Ketch Energy, KeyWest Energy, Meota, Paramount Resources, Storm Energy and Vermilion Resources.
Energy trusts have also been among the most active in the corporate acquisition market, particularly for bigger deals. For example, PrimeWest Energy Trust paid C$206 million for oil and gas properties located in Alberta, while Pengrowth Energy Trust anted up C$388 million for B.C. oil and gas properties.
Steve Bjornson, vice-president of finance and chief financial officer at Vermilion, which started in 1994, says increased competition from trusts had a significant impact on his company's strategy. The ability to grow by acquiring properties and drilling up underexploited land or bypassed pay has all-but-disappeared since income trusts can offer more cash or stronger paper to sellers than a producer.
"Did I ever think we would do this conversion a few years ago? No, but it's what investors are looking for. If you look at the fundamentals for the business, the big guys (in Canada) are going to be the income trusts and the small ones are going to be the producers."
The prediction has some serious implications for other parts of the petroleum business in Canada.
Drilling and service companies are going to have to adjust to reduced expenditures since several billion Canadian dollars of cash flow are going to be sucked out of the industry every year for distribution to investors.
For brokerages, the rise of the income trusts has been a badly needed revenue generator since equity markets for energy producers have largely disappeared in the last two years, especially in post-Enron days.
For the income sector, the reaction in 2003 by professional money managers could have a big impact on their operations. While retail investors have tucked into trusts like starving guests chowing down a turkey dinner, institutional investors have been less enthusiastic.
One reason for the foot-dragging has been the issue of the liability carried by unit holders in case of bankruptcy or a catastrophic lawsuit. The unresolved question is a major reason why income trusts were not included in a recent shakeup of the benchmark index on the Toronto Stock Exchange.
The situation may be resolved later this year. The provincial government of Ontario, home to the TSE and the powerful Ontario Securities Commission, has been asked to define in legislation that unit holders enjoy the same protection as ordinary shareholders. Such a situation already exists in at least nine states.
Besides liability, some institutional buyers have avoided income trusts because of concerns about their fees and corporate structure. This distaste has resulted in some income trusts eliminating fees for arranging acquisitions and dispositions.
In addition, a number of trusts have internalized their management structures, directly employing senior executives rather than contracting them through a separate company. The process is not cheap for shareholders, with the bill totaling C$55 million for unit holders of ARC Energy Trust and C$21 million for investors in Shiningbank Energy Income Fund.
The cost of buying out management is one reason why consolidation has not reduced the roughly 20 income trusts focused on the Canadian energy industry. According to a report by brokerage TD Newcrest, the firms have a combined market capital of about C$12 billion and control production of 370,000 barrels of oil equivalent per day, close to 10 percent of country's daily output.
There's no reason for that many income trusts to exist. If the liability question is resolved in favor of trusts, expect to see institutional investors press for consolidation to create larger and more liquid companies.
A drop in commodity prices, particularly if oil loses its war premium after U.S. military action against Iraq, could be another factor that drives consolidation this year. Low oil prices knocked 20, 30 and even 50 percent off the value of energy trusts in 1998 and led to some consolidation in early 1999, when ARC acquired Orion Energy Trust and Starcor Energy Royalty Fund.
Whether one or 10 income trusts merge in 2003 won't change one factor -- income trusts have fundamentally changed the face of the Canadian oil and gas industry by basically eliminating second tier producers. American investors need to study and understand the risks and rewards of these specialty investments, particularly since the tax treatment of cash distributions is different in the U.S., unless all they want to play is small and large E&P companies.
CORRECTION: In the December 20, 2002 article NEB Study Confirms Canadian Gas Production Declining, Will Encourage LNG Renaissance in U.S. - the corrected EIA forecasts LNG imports will hit about 900 billion cubic feet per year by 2010, not 900 million per day as originally stated.
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