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Vol. 10, No. 40 Week of October 02, 2005
Providing coverage of Alaska and northern Canada's oil and gas industry

Grappling with a genie

Canadian government slows conversions to trusts, flags impact on economy

Gary Park

Petroleum News Canadian Contributing Writer

Coincidence or not, the Canadian government has followed two blockbuster energy-related income trust transactions by slamming the brakes on one of the hottest North American investment vehicles.

In the process it has caused turmoil in the stock market by raising fears that it plans to change the trust tax regime in next year’s federal budget.

Finance Minister Ralph Goodale has made no effort to ease those concerns, explaining that he has become uneasy about the frenzied atmosphere around trusts and the impact on the wider economy.

He downplayed the lost tax revenues, which his own department estimated at C$300 million in 2004 and Toronto-Dominion Bank chief economist Don Drummond believes has now doubled to C$600 million.

In effectively freezing future deals, Goodale said he wants time to understand the “implications of a business vehicle that essentially pulls off a revenue stream, leaving little flexibility for reinvestment in future growth and development.

“There’s a long-term implication about whether or not you could be embedding a kind of sluggishness in the economy,” Goodale said.

He said the government wants to know whether there is an inherent unfairness in the treatment of conventional corporations and trusts.

No more advance tax rulings

To allow “good, solid consultations to continue” in an atmosphere of calm, he has ordered an end to advance tax rulings for companies planning to convert to trusts — a practice that is not required, but has given companies certainty regarding the tax implications of a transaction.

Federal Industry Minister David Emerson made more of an effort to placate the trust world by insisting that Ottawa has no intention of driving away investment through possible tax changes.

He told reporters Sept. 22 that neither he nor Goodale “is going to be comfortable with driving investment away,” but the Finance Department is also anxious to ensure that Canadians are not motivated “largely or solely by tax considerations,” when the loss of that tax revenue could squeeze out investment in plants and equipment.

Drummond thinks there is a 50 percent chance that Ottawa will trim the trust advantage by lowering the effective tax rate on corporate dividends before an election, expected by late winter or early spring.

Otherwise, he said it is possible the government may limit the ability of trusts to deduct interest as an expense and, finally, that it could tax trust distributions.

Other factors could underlie concern

There could be many factors underlying government concern, not least the ballooning cash flow of trusts.

Scotia Capital analysts Brian Ector and Grant Hofer estimate the free cash flow of conventional oil and gas trusts could reach C$2.7 billion in 2006 if oil prices hold steady at US$40 a barrel, climbing to C$4.8 billion at US$50 oil, C$6.9 billion at US$60 and a mind-boggling C$11 billion if ever oil hits US$80.

And that doesn’t include CanadianOilSands Trust, the largest partner in the Syncrude Canada consortium, whose free cash flow could surpass C$1 billion next year.

Although not prohibiting the formation of trusts, the government said it hopes companies will postpone conversions or spin offs.

Intended or not, the immediate response was to spook the markets, with shares of some companies that are proceeding with conversion strategies tumbling by as much as 16 percent.

“We’ve seen more than C$700 million worth of value in our company eroded,” said Stephen McPhail, chief operating officer of CI Fund Management, Canada’s second largest mutual fund company.

Shareholder pressure to convert

Over the last couple of years, E&P, pipeline and oilfield service companies have been caving in to pressure from shareholders and switching to trust ranks.

Until then they were obscure and much-scorned vehicles used by small oil and gas producers as a tax-efficient way to spread cash flow to investors.

Conventional companies distribute cash to equity holders in the form of dividends. But those dividends and the revenues are both taxable, whereas only the cash distributed to trust unit holders is taxed.

As a result, trusts in unpopular mature industries are able to raise capital at a lower cost, giving them an opportunity to expand, acquire, innovate and create jobs.

Instead of being a short-term fad, as many had predicted, the trusts have gained momentum and finally exploded this year as companies across a wide spectrum have caved in to the option of not paying taxes, building an asset class with a market value of C$170 billion, equivalent to 10 percent of the Toronto Stock Exchange’s overall value.

While Goodale has temporarily slowed the proliferation of trusts until he decides sometime next year whether to overhaul the tax system, the ban on tax rulings has spread confusion among investors and punished those companies that did not act quickly enough to convert.

Big energy deals in September

In the oil patch, the two big deals in September involved a merger of StarPoint Energy Trust and Acclaim Energy Trust which negotiated the largest trust transaction to date in Canada, with a market value of about C$4.5 billion, and the long-anticipated conversion of Precision Drilling, Canada’s largest driller with a market capitalization of over C$7 billion.

Known for the time being as New Trust, the StarPoint-Acclaim entity will produce 75,000 barrels per day of oil equivalent, placing it third among conventional trusts behind Penn West Energy Trusts at 100,000 boe and Enerplus Resources Fund at 78,000 boe.

Acclaim Chief Executive Officer Paul Charron said New Trust will be listed on both the Toronto and New York stock exchanges, giving it an edge in scooping up more mature oil and gas fields.

“Being a bigger entity will reduce the competition for larger transactions,” he said. “The reality today is C$200 million or C$300 million deals can be achieved by almost anyone, given the strength of the capital markets, but the C$1 billion deals are not so easy to do by smaller organizations.”

The merger was consistent with earlier predictions by StarPoint Chief Executive Officer Paul Colborne, who expects four years of consolidation as trust cost structures climb and producing assets decline.

“When consolidation comes, and it will, that will be our opportunity,” he predicted in May.

Colborne, described as a deal junkie, has stitched together four deals in the past five months carrying a combined value of almost C$6 billion in turning a small junior explorer into a giant trust.

Assuming the StarPoint-Acclaim merger is concluded — and the two trusts say the federal intervention does not affect their plans — Colborne will start again as chief executive officer of a new junior explorer the combined trust plans to spin off, with production of 1,000 bpd of production and reserves of 3 million barrels.

But some analysts doubt that the StarPoint-Acclaim transaction signals a wave of new deals.

Jeff Martin of Peters & Co., in a review of the sector earlier in September, said major consolidation can’t occur until oil and gas prices fall, exposing the weaker trusts.

Tax rulings freeze won’t deter Precision

Precision, with Chief Executive Officer Hank Swartout an outspoken critic of the trust impact on upstream activities, said Sept. 22 that it will not be deterred by the freeze on tax rulings.

The company said that given published Canada Revenue Agency policy and prevailing law it does not think a ruling is necessary and will, therefore, proceed with its trust conversion.

Swartout might also have helped prod the government to take action by observing that trusts have “more cash than we know what to do with.”

He also sits on the board of Harvest Energy Trust, whose annual payout to unit holders has been raised twice this year for an overall increase of 75 percent, consistent with Harvest President Jake Roorda’s view that “we are not in the business of hoarding cash. We are in the business of distributing money to our unit holders. That is our No. 1 priority.”

The trust review by Peters & Co. said the “stage is set” for higher distributions, which now average 55 percent of cash flow compared with 90 percent several years ago.

“Many of the energy trusts have not increased distributions at the same rate at which their respective underlying cash flows have been growing,” the firm said, predicting that energy trusts “will likely be forced to raise distributions to keep the underlying structure non-taxable.”

Trilogy Energy Trust, Crescent Point Energy Trust and Petrofund Energy Trust have all announced higher payouts in September and Canaccord Capital has forecast they will soon be joined by Vermilion Energy Trust, C Energy Trust, Viking Energy Royalty Trust and Daylight Energy Trust.

In addition, to sustain their oil and gas production, trusts have been forced to divert more of their cash flow from acquiring properties to spending more on exploration and development, Peters & Co. said.



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S U B S C R I B E




Government sidesteps U.S. ‘factor’

The unmentioned aspect of income trust review under way in Canada is the role U.S. investors are playing in the drain on tax revenues and whether they might become part of the solution.

When dividends flow out of Canada, the government collects only a 15 percent withholding tax.

Finance Minister Ralph Goodale tried plugging that hole in early 2004 by proposing a limit on foreign ownership.

But a furious response saw Goodale back down, allowing American investors to pick up where they left off and buy as many units as they wished.

However, Pengrowth Energy Trust took action to protect itself, offering A units to foreigners and B units to Canadians.

The A units now trade at a 40 percent premium as conclusive proof of their popularity among U.S. investors.

Although it did not follow the Pengrowth example, Enerplus Resources Fund, one of the top three trusts, recently estimated that non-Canadians own 73 percent of its units.

Senior Vice President Eric Tremblay said Enerplus has no reason to believe that Ottawa is unduly concerned about foreign ownership.

But some observers warn that it would be less painful politically for the government to discourage international investors than punish Canadians who hold small numbers of units in their retirement plans.

—Gary Park