The New Canadian Energy Income Trusts
Keith Schaefer, Editor
Oil & Gas Investments Bulletin
June 8th, 2011
Will the US oilpatch get flooded with Canadian juniors looking to build and sell production to the new Canadian energy income trusts? Trusts are now allowed in Canada again – but with foreign assets.
After all, energy income trusts in Canada completely transformed the way business was done in the junior markets – enriching management teams and shareholders greatly.
Canadian trusts almost always had high valuations, and could buy lower-valued juniors with only 1000 boe/d production (barrels of oil equivalent) at very accretive prices.
This turned into a cookie-cutter business model where management teams and investment bankers set up company after company with the goal of only getting to a few thousand boe production from one area – and then get bought out. It was a quick and easy exit strategy.
Because trusts need reliable cash flow, they do very little exploration. They can’t afford misses – if they ever have to cut their monthly payout, their stock gets crushed. So they buy production and low risk PUDs – Proven Undeveloped reserves – from the juniors. Trusts-buying-juniors was a cash cow for years for industry insiders AND investors (wasn’t that novel?).
“I do not see a massive rush of people going down to the U.S. and building up companies to sell to the new trusts – it’s too different, too tough,” says Richard Clark, CEO of Eagle Energy Trust. “The US oil business is different. In the US a lot more oil assets are held privately. In Canada, it’s something like over 90% of reserves are held in public companies. It’s not like that in the U.S.”
Clark says land ownership isn’t the only thing more private in the U.S. – good information is as well.
“There is much less transparency as to who owns what,” in the U.S., he says. Canada is the gold standard in the world when it comes to publicly available data.
What that means is that it’s much harder to acquire big land packages in the U.S. In Canada you first need a computer and cash to get packages, whereas in the U.S., Clark says, you need a big team of landmen. They visit individual landowners, and then spend countless hours in the basement at county courthouses confirming mineral rights.
Dennis Feuchuk, CEO of Parallel Energy trust, says the difference, though, can create opportunities.
“It’s just a different type of deal flow. There are opportunities to acquire (land packages) as family ownership turns over.”
Clark says, however, that he is seeing some interest in creating new trusts in Calgary. “The national banks are already out there getting people they know who have the capability to put teams together.”
Both CEOs pointed out that the US has Master Limited Partnerships, or MLPs, that are structured similarly to the Canadian energy income trusts. They pay out tax-advantaged distributions to shareholders on a regular basis from the cash flow they get from their producing properties. And there has never been a “feeder system” like the juniors created here in Canada for the US MLPs.
Robert Mullin is the Managing Partner at RAIF LLC in San Francisco, which manages a natural resource equity income fund, and has invested in MLPs. He agrees that the feeder system for MLPs in the US has always been different than the Canadian trust model.
“The majority of big upstream MLPs haven’t been buying assets off E&P juniors,” says Mullin. “They buy boring assets of the large independents and the majors – the Apaches, Anadarkos, Devon etc. The large independents think they get better valuation for exciting exploration plays – the shale plays, the offshore plays that they think drive a premium multiple for them.”
Most of the MLPs in the US are on the infrastructure side of the energy business – pipelines for example. But there are a few upstream (energy producers) MLPs, and I asked the two CEOs if they thought those MLPs would be strong competition for the new Canadian trusts.
“I think there will be some competition, yes,” says Feuchuk. “From our point of view, it will be tied to what are we willing to pay for the part of the assets that aren’t PDPs. Maybe we’re willing to pay more for PUDs and probables that the MLP’s won’t put value on.”
PDPs are Proved Developed Producing reserves – basically, wells that are flowing or producing now. PUDs are Proved Undeveloped Resources, which are drill locations that an independent reserve engineer says will produce oil when they get drilled in the future. Between seismic and nearby drilling they have a strong comfort level that those locations will produce oil or gas.
Clark agreed that MLPs have wanted assets that have more PDPs, but recently have done deals with much lower PDP components. Clark also noted a couple other differences to the MLP business model: “Their leverage model is different. We want to stay under 1.5:1 debt to cash flow, and most MLPs use a lot more leverage, and longer term leverage as well. The MLPs also hedge most of their production, in order to facilitate their use of very long term debt. We will never hedge more than 50%. We’re trying to give our unitholders exposure to commodity prices without too much risk.”
The new trusts are in their infancy. But with very high demand for yield, I expect that starting this autumn, the market will see one a month. Despite the structural differences between the energy industry in the two countries, it will be interesting to see how Calgary junior management teams respond to this new exit strategy.
The service we endeavor to provide is to analyze and clarify the nature and potential of certain North American junior oil and gas producers, and identify those situations where the market either misunderstands the nature of the company or assigns unduly optimistic or pessimistic success odds to the company. Keith Schaefer is not a registered investment dealer or advisor. No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer to buy or sell the securities mentioned, or the giving of investment advice. Oil and Gas Investments is a commercial enterprise whose revenue is solely derived from subscription fees. It has been designed to serve as a research portal for subscribers, who must rely on themselves or their investment advisors in determining the suitability of any investment decisions they wish to make. Keith Schaefer does not receive fees directly or indirectly in connection with any comments or opinions expressed in his reports. He bases his investment decisions on his research, and will state in each instance the shares held by him in each company.
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