NORVAL SCOTT
www.globeinvestor.com - Thursday, October 25, 2007
CALGARY -- Energy trusts are still uncertain about their future course, in an oil patch that has become a very different place since the Harper government's about-face on income trusts just one year ago.
The sector has also been hit by weaker natural gas prices, higher costs, a stronger dollar that has driven down the value of exports and, perhaps most importantly, the tremendous uncertainty and anxiety about proposed increases in Alberta's energy royalties. The government, which has been weighing a panel's recommendation for sharply higher payments that the industry says could be catastrophic, will announce the details of its decision on the levies today.
"This is one of the most challenging times to hit the industry for two decades," said Harvest Energy Trust chief executive officer John Zahary. "You don't have to go very far outside the bubble that is Calgary to discover that nobody is really working at the moment." The tentative strategies being mapped out by trusts could lead to an oil and gas sector that is once more populated by intermediate-size firms as trusts convert back to corporations, or even the wholesale disappearance of the trusts as they are swallowed up by private equity funds or foreign suitors.
Mr. Zahary, for one, warned there will be "few if any" trusts remaining by the end of 2010, just before the tax regime for trusts changes dramatically.
"The market knows we have to do something, and there will be divestments, consolidations, and at some point somebody will morph into something else," he said.
Last Halloween, Finance Minister Jim Flaherty unexpectedly announced that, contrary to a campaign promise, income trusts would be taxed like corporations from 2011.
Marcel Coutu, CEO of Canadian Oil Sands Trust, the main shareholder in Syncrude Canada, acknowledged the trust sector has been buffeted by several factors, but "being hit with the trust tax is like being hit by a tornado, while the others are tropical storms."
That decision alone, he said, affected the trust's unit price by between 15 and 30 per cent, in turn boosting its cost of financing by about 2 per cent, a problem for companies that rely on capital for acquisitions.
"That one change basically moved the whole sector from being competitive and growing healthily to one that is now in a weak, defensive mode, struggling to continue to do business," Mr. Coutu said.
Canadian Oil Sands, he said, is now less likely to be in a position to acquire any stake that might become available in Syncrude, Canada's largest oil sands project. Indeed, the company is now looking over its shoulder to some extent.
"Yes, we're large but our price is down, and there are way bigger players out there," Mr. Coutu said. "This has increased our vulnerability to hostile takeovers, and that's never a good thing for any Canadian company, as most of the takeover world is not Canadian."
He pointed to the $5.8-billion sale of Western Oil Sands to U.S.-based Marathon Oil Corp. as an acquisition he would have liked to pursue, but felt hamstrung by the tax decision.
Some trusts, such as Pengrowth Energy Trust and Paramount Energy Trust, were forced to cut distributions to unitholders, which occurred partly because of the downturn in natural gas markets but was also directly attributable to the tax decision.
Paramount was not able to access the capital markets to help weather the cyclical gas price weakness, CEO Sue Riddell Rose said.
"We're in a situation where investors have been directly impacted, and yet the government doesn't think we should have a conversation about finding the best solution, and there wasn't any consultation before or after," Ms. Rose said.
The trust model has been relatively ill-suited for supporting costly and unpredictable exploration activities but has proved a good fit for trusts that stuck to property acquisitions and drilled existing fields known for their reserves.
That led to an oil patch that basically consists of the oil and gas trusts, large corporations such as EnCana that pursue major developments and sometimes sell maturing assets to the trusts, and juniors that seek to grow rapidly before selling their assets to a trust.
The energy trusts believed they had demonstrated a model perfectly suited to tapping the province's mature oil and gas fields, producing as much as 20 per cent of Canada's crude output. But they are uncertain as to what's next.
That uncertainty is partly over a government guarantee that their conversion into corporate form will be a tax-free move. The trusts say it's not clear how that would work, and most are unwilling to be the first to test the waters.
"Do we know the rules?" Ms. Rose said. "No. I haven't yet heard anything back on the details."
Until this week, among oil and gas producing trusts, only True Energy Trust had tried to convert back into a corporation, although that was shot down in March by investors who not only believed that there was no advantage but also were unhappy with a proposal to award new share options to the board of the company, the worst performing among the 35 on the S&P/TSX energy trust index over the past year.
Few trusts have since gone public with their future plans, although there have been a number of mergers and acquisitions. Mature oil and gas fields typically accumulated by trusts don't support the growth necessitated by a conventional corporate structure, while their staffs often are not well suited to chasing exploration and production targets, leaving them loath to leave the relative safety of their tax structure too soon - especially as the federal Liberals have said they will implement a lower rate of tax on the sector if they regain power.
Earlier this week, Fairborne Energy Trust, one of the sector's smaller players, said it will look to convert to a corporation, and unitholders will vote on the proposal in December. Its conversion looks to have a greater chance of success, not least because it has also arranged substantial financing with a U.S. private equity fund that backstops future growth plans.
While the move could be too early to set off a wave of similar conversion attempts, companies will doubtlessly be looking closely at the market reaction to Fairborne's initiative as they weigh their own options, said Grant Hofer, a Calgary-based analyst at investment bank UBS.
"The trust sector is now a really tough market to raise capital in, and while companies can see where the economic value is in remaining a trust until 2011, they also understand they will be financially crippled in the interim," he said.
Conversion isn't the only option. One potential, if untried, course of action is becoming a corporation that pays a high dividend to investors, a structure that doesn't really exist in Canada's capital markets, but which would be fairly similar to trusts' existing format.
Companies are also eyeing more controversial alternatives, such as selling out to suitors that might be foreign- or privately owned, or both.
Another contentious solution is to emigrate to the United States and become a master limited partnership (MLP), an investment vehicle that, like trusts, passes the requirement to pay corporate tax down the chain to investors.
Calgary-based Provident Energy already has a direct ownership in an MLP, Breitburn Energy Partners. While Provident struggled to raise $508-million earlier this year to acquire Capitol Energy, Breitburn was able to make a far larger acquisition, paying $1.44-billion (U.S.) last month for natural gas properties in the U.S.
"With any business, you need a low cost of capital to compete and grow, but we can't compete in the U.S. any more if our smaller subsidiary is able to do deals larger than we can," Provident CEO Tom Buchanan said. "Something's gone wrong with our picture, while the MLP market is evolving rapidly."
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