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Canadian energy trusts under the gun CIBC says tax pools hold key for trusts deciding to join corporate ranks before tax changes; Pengrowth determined to stay course Gary Park For Petroleum News
Investors looking for a clear, common signal from Canadian oil and gas trusts about their future direction once the federal government imposes new tax rules in 2011 must be left scratching their heads.
But a recent review of 22 trusts by the banking firm of CIBC World Markets offered some clarity, suggesting some will trim cash distributions to unit holders — once the bread and butter of the sector — while others may hike their capital budgets to ease the tax burden.
The study by five analysts concluded what has increasingly become apparent over the past year — some trusts will be better able to absorb the tax changes than others, especially those backed by large tax pools, which will be positioned to keep growing reserves and production. The greatest challenge will be faced by trusts with fewer or lesser-quality tax pools.
But the report was emphatic on one point: There will be no tax benefit to remaining a trust after 2010. In fact, in the bulk of cases, the result will only be higher taxes, according to those trusts that candidly discussed their plans with CIBC World Markets.
Majority expected to switch Brad Borggard, one of the five CIBC analysts, said that barring a change of government at the federal level the vast majority of trusts will switch to corporate ranks.
To trusts investors, the report said “it is highly probable that the majority of monthly (cash) distributions will be reduced, particularly for trusts with a limited tax pool base.”
It also concluded that paying taxes to the Canadian government will deplete the cash reserves of trusts and capital spending will be prodded by a need to generate tax pools.
The firm said that leaving cash payouts unchanged from current levels would be among the least effective strategies for trusts, given that capital spending, whether earmarked to sustain or build production, is almost sure to rise after 2010.
The CIBC firm warns that some trusts, notably those with limited tax pools, could face tough times when it comes to establishing cash distributions as they and their successor companies try to sustain or increase production.
Simply boosting the capital outlay will not be an easy matter after 2010 because assets vary so widely from trust to trust, other analysts have suggested.
Some geared to raise spending Darren Engels, an analyst with FirstEnergy Capital, said trusts such as Penn West ARC are geared to raise spending after 2011 by taking advantage of their large land bases and legacy assets.
The CIBC report said income trusts currently benefit from distributing their cash flow because the payments remain tax-deductible, but after 2010 trusts will have to rely on their tax pools that are developed through capital spending to cut taxable income.
Trusts that switch to corporate ranks will have greater incentive to keep and invest cash, both to build output and generate the tax pools they will need to survive.
But the study said the traditional building block for trusts — growth through the acquisition of mature oil and gas properties — may not be as successful under the corporate structure.
The CIBC analysts forecast capital spending by trusts will climb after 2011, reducing the cash flow that is available for distributions, compounded by the trusts’ new requirement to pay taxes.
The CIBC model predicts that starting in 2011, trusts converting to dividend-paying companies will reinvest an average 50 percent to 70 percent of pre-tax cash flow, while paying 6 percent to 11 percent in taxes, leaving about 30 percent for dividend payments.
Drop in monthly distributions by average trusts expected In contrast, average trusts would be forced to trim their monthly distributions by 23 percent in 2011, based on current payouts, and by a further 3 percent in 2012, followed by modest increases.
As decision-making time draws closer, Pengrowth Energy Trust said it will maintain its current structure post-2011, with Chief Executive Officer Jim Kinnear estimating the trust will be able to employ about C$3 billion worth of tax pools to shelter distributable income until at least 2013.
“We believe there will remain strong demand for yield-based investments,” he told analysts. “These pools can be used to either shelter income from the tax and can also be used to mitigate impacts to our unit holders beyond 2011.”
Pengrowth, which produces about 81 barrels of oil equivalent per day, paid C$168.2 million to its unit holders in the second quarter, representing 63 percent of its cash flow, despite losing C$118.7 million on the heels of a C$352.6 million hedging loss.
Borggard said it might make sense for some trusts like Pengrowth to maintain their existing structure for as long as they can if oil prices remain strong.
ARC reported a second-quarter net income of C$57.3 million, down from C$127.6 million in the same period last year despite a C$94 million increase in cash flow from higher oil prices and production.
Its cash flow per trust unit was estimated at C$128, well ahead of most forecasts ranging from C$1.09 to C$1.18.
ARC Senior Vice President David Carey said the fact that his trust can grow production 4 percent over the year through the drill bit while distributing the bulk of its cash is a “significant achievement. … One of the things lots of people point at with trusts is that they are only cannibalizing themselves … they’re not able to grow. Well, we’ve proven we can grow.”
ARC output is expected to average 64,000-65,000 boe per day this year and the capital budget has been raised C$155 million to C$550 million, mostly aimed at the Montney shale gas play in British Columbia.
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