For all their volatility, predictions of a value correction and widely anticipated round of consolidations, energy income trusts show little sign of veering from a relentless growth path in Canada.
But investment banking firm Credit Suisse First Boston has warned that trusts are “unstable investments” faced with a course correction as capital spending and cash flow head in opposite directions.
The group of 29 operating trusts posted breathtaking numbers in 2004 and built on that performance in the first quarter.
The active producers logged production of almost 711,000 barrels of oil equivalent per day, 100,000 boe per day ahead of 2003 and 340,000 boe per day above 2001 when the sector had 19 trusts.
Net earnings climbed to C$2.4 billion from C$1.98 billion in 2003; cash distributions to unit holders increased to C$3.55 billion from C$2.7 billion, although per unit payouts dropped to C$2.7 from C$2.01; cash flow made a 31 percent gain to C$5.3 billion.
The production breakdown showed oil and liquids at about 380,000 bpd and natural gas at 1.97 billion cubic feet per day — a combined total that represented about 15 percent of Canada’s total output.
Trusts acquired and drilled
It was a year when trusts demonstrated that they have no intention of resting on their laurels.
They resorted to both acquisitions and the drill bit and took the first steps towards buying assets outside Canada to build reserves and sustain production.
The sector added 571 million boe of reserves through acquisitions in 2004, added another 57 million boe from exploration, of which 80 million boe were proved.
Almost two-thirds of last year’s output of 247 million boe was replaced through drilling, although less than one-third of that consisted of proved reserves.
Entering 2005, the 29 trusts claimed proved plus probable reserves of just over 4 billion boe, a gain of better than 478 million boe from a year earlier.
The latest count puts the trust ranks at 35, with investment dealer Peters & Co. reporting 13 transactions in the first three months of 2005, carrying a combined value of C$2.1 billion for 143 million boe of proven reserves and 50,000 boe per day of production.
Trusts looking beyond Canada
On the horizon is at least another 105,000 boe per day when Penn West Petroleum converts to a trust.
Typical of the new breed, it had a lively 2004, taking over Olympic Energy and Viracocha Energy and buying out BreitBurn Energy of Los Angeles to become the first Canadian trust with significant holdings in the United States.
Provident Chief Executive Officer Tom Buchanan said the “balanced portfolio strategy” has given his firm three distinct business units — midstream services, and both U.S. and Canadian oil and gas production, currently about 31,000 boe per day.
In doing so, he said Provident has strengthened the stability of cash flow and positioned the trust for “growth outside the Western Canada Sedimentary basin.”
Acclaim Energy Trust is also starting to look beyond Canada, certain that “trusts are morphing into active E&P companies with a strong emphasis on paying out big dividends,” said President and Chief Executive Officer Paul Charron.
So far, Acclaim is delivering results, with production at a minimum 41,000 boe per day for three quarters and distributions kept at a flat level for 31 successive months.
Having acquired Western Canadian assets from ChevronTexaco for C$434 million a year ago, Acclaim is on the lookout for more deals.
Charron said he has “never seen so much property on the market as right now,” but because competition is so hot and prices are so high, his management team is searching for overseas opportunities in the United States, Europe and Australia.
The United States is an attractive hunting ground because trusts there are prevented from acquiring new assets, he said.
First Boston: sector headed for shake up
Not everyone views the sector with unrestrained optimism.
In rating trusts as “unstable investments,” First Boston warned the sector is headed for a shake up as the need for higher spending collides with tightening cash flow.
It said Canadian trusts have doled out cash distributions that have exceeded their cash flow, after accounting for capital spending, and are now relying on equity issues or debt to satisfy investors.
Because of the new units issued, the trusts will need greater cash flow just to hold the line on their distributions and free cash flow is expected to shrink because of higher cost properties and the risk of lower commodity prices, First Boston said.
In a 50-page report covering 20 trusts (with a market capitalization of about C$36 billion), the firm said it expects the “sector to evolve through three distinct phases: collapse, consolidation and finally restructuring (possibly as conventional E&P companies).”
“Trusts have declining production, are at the high end of the cost curve and have corresponding low returns and high leverage (to the commodity),” the report said, noting that while production has grown four-fold the value of shares outstanding has risen eight-fold.
It predicts that capital spending by trusts will grow as a percentage of cash flow over the next few years, while distributions decline as a percentage of cash flow.
Peters & Co. said five “outstanding” years for trusts will likely see more conversions by producers, but the outlook for the sector depends on the “timing and severity” of any commodity price decline.
Adding another element to the trust debate, Jack Mintz, president of the C.D. Howe Institute, a conservative think-tank, has called for changes to tax rules relating to trusts.
Currently, the rules require trusts to distribute most of their profits to unit holders, or face heavy tax penalties.
Mintz said he is concerned that the tax system denies the trusts access to the capital they need to “grow their businesses.”
