Sifting through the trust wreckage

Weaker trusts urged to clean house; financing plans being restructured or delayed; junior explorers sideswiped; cap-ex pullback

Gary Park

For Petroleum News

There is more noise than clarity when it comes to the future of Canada’s oil and gas royalty trusts — near-term or long-term — and the impact of federal government plans to end the sector’s preferential tax status.

While some pursue a rearguard action in hopes of persuading the government to exempt energy trusts from facing standard corporate taxation in 2011, others take Finance Minister Jim Flaherty at his word — “we are firm and certain in our resolve … we are not changing” — and are starting to re-evaluate where they are headed.

The first consoling thought for many investors is that trusts will continue to disperse tax-free income until 2011 and some in the energy sector are being encouraged to accelerate that process.

There is also a widespread acceptance that many trusts were in trouble anyway.

A recent analysis by Scotia Capital said the estimated 2007 payout ratios of 21 oil and gas trusts were on average 28 percentage points higher than what was sustainable over the long term.

Earlier this year, Standard & Poor’s, a respected voice in the investing world, found that when capital spending was included only 62 percent of energy trusts were generating enough cash to cover distributions — another jolt for a sector accused of not always being straightforward in its accounting.

Blunt messages for weakest trusts

Mo said the majority should simply focus on squeezing the last drops from their oil and gas assets and pass the profits on to their unit holders during the four-year grace period offered by the government.

The one-quarter of the trusts backed by strong technical teams, land bases and internal drilling programs would be best advised to revert back to conventional exploration and production roles after 2011, she said.

Gosbee estimates only five of 30 E&P trusts will still be around by 2010.

For the rest, he said they will not be able to raise the capital needed to grow their businesses.

They should use the window until 2011 to “stop spending, blow down your expenses, blow down your assets and give the highest rate of return under that tax-favorable environment to your unit holders,” he told the Financial Post.

For many, the party may already be over.

Since the government’s bombshell announcement on Oct. 31, setting off a steep decline in many trust unit prices, on top of the bruising many had already taken in a tough natural gas environment, trusts are being forced to restructure or delay plans for equity and debt issues.

The investment industry estimates that C$1.3 billion in trust-related financing plans are in limbo, of which C$565 million is believed to be on hold.

More than 10% of planned spending at risk

John Dielwart, chief executive officer of ARC Energy Trust, one of the harshest critics of the government’s action, said the sector’s essential access to “significant capital” has already diminished.

“It has become more costly, so we have to reassess the economics of some projects,” he said.

ARC itself is looking more closely at the economics of squeezing more oil and gas from mature fields, which could see revisions to its capital budgets in 2008 and 2009 and possibly by late 2007, Dielwart said.

Caught in the downdraft is Canada’s junior E&P world of companies that have carved out an existence by exploiting marginal properties, growing production to about 10,000 barrels of oil equivalent per day at which point they sold at a handsome profit to asset-hungry trusts.

Gosbee said that if the relationship between the minors and trusts evaporates over the next two or three years there could be a return to Canada’s more traditional petroleum industry of junior, intermediate, senior and integrated oil and gas companies.

What is still being debated is whether there will be any buyers for trust assets that have no appeal to larger producers — domestic or foreign — who unloaded them in the first place.

If those properties are left fallow and oil and gas commodity prices start sliding closer to break-even points (watch the mood in the oil sands change if oil again flirts with the US$45 per barrel range) there is deep concern about the impact on Canadian production.

Even now, the looming combination of capital spending by trusts and conventional producers (led by EnCana, Talisman Energy and Canadian Natural Resources) is forecast to reduce gas output in 2007 by 1.6 billion cubic feet per day or 10 percent of current volumes.