Income Trust Acquisitions Boost Canadian Ownership by 50%

Abstract: The ongoing popularity of income trusts combined with asset rationalization by U.S. firms that bought Canadian companies in recent years will likely lift Canadian ownership of the energy sector above 50 percent by year end.

Analysis: Several developments indicate income trusts will soon push Canadian control of its oil and gas sector above 50 percent, reversing a recent trend of increasing U.S. presence in the Canuck oilpatch.

The still-evolving change stems from the ongoing popularity of income trusts and declining opportunities via the drill bit in Western Canada.

High gas prices two years ago helped spur a massive influx of U.S. companies. They used a stronger currency and higher stock multiples to scoop up Canadian producers faster than a Dairy Queen employee working the ice-cream counter.

The consolidation boom of 1999 to 2001 saw U.S.-based buyers spend about $25 billion for Canadian exploration and production (E&P) firms. The buying spree washed away decades-old players, including such well-known names as Anderson Exploration, Canadian Hunter Exploration, and Gulf Canada Resources.

It also resulted in U.S.-headquartered firms controlling, on a daily production basis, just over half of Canada's petroleum sector. While below historic highs of more than 70 percent recorded in the 1970s, some nationalists decried the trend, alleging the "Americanization" of the industry meant a loss of sovereignty.

The argument was specious, of course, as provincial and federal governments continue to regulate the industry. Unlike the early 1980s, when excessive and discriminatory regulation drove away U.S. producers, the increasing maturity of the Western Canadian Sedimentary Basin is causing some American firms to question their northern exposure.

A good example came this week when Marathon Oil decided to sell its remaining Western Canadian properties. The proceeds, likely to exceed $350 million, will be applied to international projects and offshore Nova Scotia, where Marathon and partners found gas with a well drilled last year.

In some ways Marathon was at the leading edge of the northward push by U.S. firms. It paid C$1.1 billion in 1998 for Tarragon Oil & Gas Ltd., a Calgary firm focused on heavy oil production.

Marathon decided heavy oil didn't fit its plans and exited the business in 2001. It is now selling all remaining Canadian production, about 4,000 barrels (bbls) of oil and 100 million cubic feet of gas per day (mmcf/d).

Marathon joins other U.S. companies, such as ConocoPhillips, Hunt Oil, and Vintage Petroleum, that are jettisoning Canadian assets.

Selling when commodity prices are strong certainly makes sense. The dispositions also show producers are looking hard at the costs of doing business in Western Canada, where finding and development expenses are rising because new fields are getting harder to find and the rewards are shrinking.

But, as proved earlier this week, income trusts are still eager to snap up properties. These firms, which pay out the majority of their cash flow to investors in monthly or quarterly distributions, have been wildly popular in Canada.

This has enabled income trusts go to equity markets to raise money or to use their own paper to finance purchases. The latter occurred this week when ARC Resources paid C$710 million (including debt) for Star Oil & Gas. ARC will issue C$320 million in debentures to United Co., a private, Bristol, Va. holding company which owns Star. The debentures are convertible under various conditions into units of ARC.

The deal will boost ARC's production by almost one-third, and it will also result in a slightly higher percentage of Canadian ownership of the oil and gas sector north of the 49th parallel. This trend will continue for several reasons.

Besides their ability to tap capital markets, differences in Canadian corporate tax rates give the trusts another tool enabling them to outbid conventional exploration and development companies when attractive properties go up for auction.

Despite some concerns about a bubble pushing up prices, investor enthusiasm for income trusts does not appear to be faltering. The lousy performance of stocks in the first quarter, with the Toronto Stock Exchange's (TSE's) benchmark index down 4.1 percent and Standard & Poor's 500 off 3.6 percent, gave investors more reason to look at the specialty investment vehicles.

A recent decision by the Ontario government should even increase their popularity. Ontario announced last week that Canada's largest province will introduce legislation to limit the liability of unit holders.

Unlike investors who buy shares in publicly traded firms, the question of unit holders' liability if a trust went bankrupt or was involved in an expensive lawsuit has not been resolved in Canada. The question has kept some institutional and retail buyers out of the sector.

The liability issue was a key reason why income trusts were not included in a recent shakeup of the TSE's benchmark index. Since many mutual funds have to buy firms that comprise the TSE's composite index, the inclusion should translate into greater liquidity and higher prices for trust units.

Other provinces, particularly Alberta where most energy trusts are headquartered, are expected to follow Ontario's lead to maintain a level playing field. The end result will be a better environment for income trusts and increased competition for all E&P firms, Canadian and American, when it comes to acquisitions.

The purchases by income trusts will result in Canadian control of the country's oil and gas sector exceeding 50 percent by the end of 2003 or mid-2004 at the latest (assuming large independents such as Talisman Energy and Nexen are still around).

More maple leafs flying at well batteries instead of the Stars and Stripes are not going to have too much influence on the Canadian petroleum industry over the long run, although it will silence the whining from nationalists. Capital discipline is the name of the game these days because of global competition for investor dollars. The declining size of targets in Western Canada will cause managers to scrutinize carefully any capital project, regardless of whether they are located in Calgary, Toronto, or Houston.