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November 2007

Vol. 12, No. 45 Week of November 11, 2007

Trusts heed analyst’s advice

Penn West, Canetic create North America’s largest conventional trust, eye on global growth; CEOs spurn ‘rocking chair’

Gary Park

For Petroleum News

The future of Canada’s energy income trusts was given shape on Oct. 31, the exact anniversary of the federal government’s Halloween bombshell that blew the sector apart.

It was resounding confirmation of a message from most analysts who say the sector has two choices: Go big, or go home.

Penn West Energy Trust pulled off a C$5.2 billion cash, shares and debt agreement to take over Canetic Resources Trust, creating a new trust with a market value of C$15.3 billion and the largest conventional oil and gas trust in North America, with production of about 210,000 barrels of oil equivalent per day.

Assuming unit holder and regulatory approval, the entity, which will keep the Penn West name, will be positioned to embark on even more aggressive expansion beyond North America and to enter the next generation of resource development in the oil sands, coalbed methane, shale gas and enhanced oil recovery.

Only oil sands trust larger

Only the Canadian Oil Sands Trust, a 36 percent owner of the giant Syncrude Canada oil sands consortium, exceeds the new Penn West in enterprise value at C$16.5 billion.

Cristina Lopez, an analyst at investment banker Tristone Capital, said the transaction will produce a royalty trust that is “competitive on the acquisition front,” domestically and internationally.

The deal gives full weight to talk of a consolidation trend, which started in May with the merger of PrimeWest Energy Trust and Shiningbank Energy Income Fund to create a C$2.5 billion operation that lasted barely three months before the Abu Dhabi National Energy Co. (better known as TAQA) acquired PrimeWest for C$5 billion.

In the 12 months since the Canadian government reversed a promise and announced trusts would lose their tax-preferred status in 2011, saddling them with a 31.5 percent tax on their cash payouts, the sector has been in disarray.

Some have doggedly tried to force the government to change its mind — a campaign most now concede is wasted effort — while others have pondered their options.

Trusts building mass

The message from Penn West and Canetic chief executive officers, Bill Andrew and Paul Charron, is clear.

They have decided to take advantage of the remaining three years of their tax holiday to build a critical mass and prepare the way for conversion to a growth-oriented corporation in 2011 or later.

“As I have stated many times in the past, sitting still in today’s dynamic market is not an option,” Charron said.

Backed by tax pools worth C$5.5 billion, Penn West will be armed to “consolidate” even further in the Western Canada Sedimentary basin by issuing equity between now and 2011 without breaching the “safe harbor growth” rules Ottawa has established.

“The past year hasn’t been a lot of fun in the sector,” Andrew told reporters. “We’ve seen a loss in our ability to raise capital, a loss of some shareholder interest and we’ve looked for ways to work against that.

“One way is to head to the rocking chair and look for someone to buy you out.”

But he and Charron assured analysts that neither of them has a rocking chair in his immediate future.

The best alternative, Andrew said, was to grow, rebuilding some of the strengths Penn West had as an E&P company before converting to the trust in 2005 by adding some muscle to the exploration team and asset base.

“We’re making a very large step towards that,” said Andrew, who will remain CEO, while Charron will be president.

Explaining the logic behind the strategy, Charron said size “enhances liquidity in (the Toronto and New York stock exchanges), increases weighting on the indices and attracts more attention from equity and income markets around the world.”

Acquisitions will proceed

To underscore their growth ambitions, the two trusts will proceed with acquisitions already under way: Penn West’s takeover of Vault Energy Trust for C$380 million and Canetic’s purchase of Titan Exploration for C$98 million.

Although Andrew said the initial goal of the merger is to build the “dominant light oil producer” in the Western Canada Sedimentary basin, the larger purpose is to “create an aggressive Canadian player in the global markets.”

Charron said Canetic tried unsuccessfully last year to make sizeable acquisitions outside Canada, including a bid for Houston-based Pogo Producing, which is now turning into a master limited partnership.

Undeterred by those setbacks, he said Canetic has assigned two employees to scout for opportunities in Western Europe, Australia, New Zealand and more stable South American countries.

UBS Securities Canada analyst Grant Hofer, in a prescient note to clients the day before the Penn West-Canetic announcement, said he believed “most trusts are evaluating merger opportunities with their peers, primarily … to better themselves to compete for future capital and acquisitions.”

He said that although there is “no observable correlation between size and valuations (today), we agree that trusts will likely need greater size to attract investor interest beyond 2011.”

Pointing to the weakness in the trust sector, Hofer said only five of the 28 trusts he follows have generated positive returns in the past year and neither Penn West nor Canetic was on the list.

UBS estimates unit prices for oil and gas trusts are down 27 percent from a year ago.

While the Standard & Poor’s/Toronto Stock Exchange composite index has climbed 17 percent, the capped energy trust index has tumbled 16 percent.

Bulk prefer tax advantages

But Calgary attorney Ross Freeman told a recent Montreal conference that despite troubles stemming from low natural gas prices and problems trusts face in attracting funds, the bulk of trusts prefer to continue reaping the tax advantages available to them rather than jumping prematurely into the corporate world.

John Dielwart, chief executive officer of ARC Energy Trust and the most outspoken critic of the federal government’s tax decision, said further clarity is being awaited from Ottawa.

“Whatever they hoped to achieve from this, it won’t happen,” he told the Globe and Mail. “You will either see our sector sold to other interests that can duplicate the exact model they were trying to get rid of, or it will fall into the hands of foreign investors,” he warned.

In the meantime, “we believe we can continue to create value in our current trust structure,” Dielwart said.

But he conceded that ARC must eventually choose between remaining a trust or switching to a more tax-efficient structure and paying less tax.

Gordon Kerr, vice-chairman of the Coalition of Canadian Energy Trusts — the lobby group formed to challenge the government — and chief executive officer of Enerplus Resources Fund, said the unintended fallouts from the tax move “continue to be felt throughout Canada, not to mention the devastation being felt by energy trusts and investors.”

“The federal government’s lack of consultation with energy trusts compounds the growing uncertainty investors face with doing business in Canada,” he said.

Bill Holland, chief executive officer of CI Financial Income Fund, said the decision by Prime Minister Stephen Harper’s government was “beyond absurd (and) reckless,” setting the stage for foreigners to buy up cheap Canadian assets, resulting in the “hollowing out” of corporate Canada.

John Bitcover, chief executive officer of Priszm Canadian Income Fund, said it’s not too late for the government to reconsider.

Unlike the United States, Canada has limited ways to finance a business and the trust sector is one way to let the average Canadian own different operating businesses and share the profit, he said.






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