Competition for Canadian assets has become heated-some would say overheated but buyers are walking away pleased, despite paying historically high prices, and sellers, more pleased. "I haven't seen the sun, moon and stars line up like this in a long time," says Ross Kobayashi, president of Calgary-based investment-banking and divestment-advisory firm Kobayashi & Associates Ltd. Canadian royalty income trusts (RITs) as well as traditional E&P companies are continuing to experience strong access to capital. The upstream sector raised C$11.5 billion-a new record-in 2003, according to Calgary-based investment-banking and M&A advisory firm Sayer Securities Ltd. Nearly half of the total 2003 funds-some C$5.7 billion of which C$4.1 billion was from unit sales and the rest, debt-was raised by RITs, and a great deal of these proceeds were spent on producing properties and companies, totaling C$4.5 billion, Sayer reports. Traditional E&P companies raised the rest, including from C$2.4 billion of stock sales. Brent Heinz, a financial analyst with Sayer, agrees that the Canadian upstream business is under some celestial influence. "In 2003 all the stars were aligned in the financing markets for the oil industry," he says. Meanwhile, commodity prices have pushed up producers' cash flow to make cash purchases possible too. How much are investors willing to pay for western Canadian assets? Duvernay Oil Corp.'s initial public offering-for total proceeds of C$52.5 million-was so strong that shares sold at roughly the equivalent of some C$100,000 per flowing barrel of oil equivalent (BOE), Heinz notes. Duvernay is one of many Canadian junior producers that have been founded by Calgary-based E&P executives that have made a business of starting, growing and selling companies. Duvernay's founders are ex-Berkley Petroleum managers who sold Berkley to Anadarko Petroleum Corp. in 2001 for C$1.6 billion. The IPO of Duvernay at some C$100,000 per flowing BOE is a sizable premium over what the company would sell for on the street, Heinz notes. Yet, the street value of Canada's producing assets is still sizeable too-recently as much as C$55,000 per flowing BOE for some. George Gosbee, president and chief executive of Calgary-based investment-banking firm Tristone Capital Inc., says, "It's a very hungry market for Canadian properties and companies, and every subsector of producers has access to capital." A junior oil company will be able to do a C$100-million bought-deal financing when it finds the assets it wants to buy. "Around the world, Calgary is the most interesting place to be," Gosbee says. Kobayashi adds that a junior oil company he sold assets to quickly saw its C$20-million equity offering oversubscribed. "It sold out in an hour." The market influences are myriad: • The ever-hungry RITs are devouring the prolific, mature assets that come onto the market and that sometimes are encouraged onto the market. An executive with one trust says the company aims to make at least two unsolicited offers a week, close one deal a month and close one significant deal a quarter. • Meanwhile, junior producers are anxious to build bulk, starting out with private equity and production of as little as 100 BOE per day, plus drilling opportunities, for example. They tap public-equity markets and grow to 1,000 BOE per day through drilling and more purchases. At this point, they sell out to each other or continue drilling and buying. Soon, they're purchased by a large traditional producer-consolidation at the turn of the century left Canada with virtually no midsize producers. • The larger producers are tapping both sides of the market, competing with junior producers as well as trusts, as they look for both mature and nascent assets but usually with a good deal of upside too-more upside than trusts are interested in, thus won't pay as much for. • Additional pressure on the Canadian upstream market comes from RITs' need to stick to tax-free Canada-based production to uphold their business models of paying out high distributions-the equivalent of dividends under the common-stock structure. Income from outside of Canada would be taxed in the country from which it is produced, diluting distributions. Garry Tanner, senior vice president and chief operating officer of Canada's oldest E&P trust company, Enerplus, says the trusts may be forced outside the Canadian border to replace production. "You've got too many trusts, really, for the size of the sandbox in Canada. You're going to see these trusts start looking outside of Canada," he says. Movement into the U.S., however, has been stalled by a tax leakage problem that has not been solved, he adds. The tax problem goes like this: Trusts' revenues from Canadian operations are distributed to investors before taxes. Their revenues from outside of Canada would be subject to the source country's corporate and other taxes, and then also to a Canadian withholding tax when it crosses the border into Canadian coffers. A separate U.S. security could be issued for the U.S. subsidiary, but linking it back to the Canadian entity is problematic. As yet, a good solution has not been found to address the U.S. tax issue. • More stress comes from some well-funded Canadian institutional investors' covenants that require investment in Canada-based companies, and in the upstream Canadian sector there are fewer companies from which to choose. • And an added influence comes from non-North American firms that are looking to diversify their portfolios, such as BG, which wants to expand its North American natural gas story. It had a deal under way at press time to purchase El Paso Corp.'s western Canadian producing assets for approximately US$346 million. An added benefit is that the deal helps BG bring in more assets in investment-grade countries. • Meanwhile, a new Canadian securities rule, NI 51-101, has reserve-owners reevaluating their established and proved reserves based on the new definitions. "A lot of companies are going into evaluations right now and making decisions on whether to hold or sell," Kobayashi says. "And when they have an appreciation of the rule's effect on their portfolios, some will likely put assets into the marketplace." Tom Pavic, an analyst with Sayer, expects many reserves that are classified as proven may need to be reclassified as probable. The new rules will result in fewer "train wrecks that have given the industry a black eye," he adds. Producers that choose to fold will put assets on the market, and those that choose to hold will be anxious to buy them. The end result could be no net pressure on prices but contribute to an active market. Pavic expects the buyers of the nonproducing reserves that come onto the market as a result of NI 51-101 compliance will be private companies that are not affected by the new rule. • Plus, the Canadian dollar is up, thus driving more intra-Canadian deal-making, compared with 1999 and 2000 when the Canadian dollar was down and U.S. producers in particular could shop in Canada more inexpensively than in the U.S. and some other first-world countries, Gosbee adds. "The demand drivers are unbelievable," he says. "Producers are buying on all cylinders." While Calgary may be an interesting place for producers to be right now, some Canadian reserve-holders are rethinking their portfolios-U.S.-based producers. Several have already divested their Canadian assets. Others see growth of their portfolios through drilling as being relatively expensive-finding and development costs in western Canada have grown to average C$15 per BOE lately, Kobayashi says. Meanwhile, buying reserves will cost nearly C$10 per established BOE, according to Pavic. Established reserves are proved plus half of those deemed probable, before royalties. "This is the highest price recorded since Sayer Securities began publishing M&A statistics in 1988," Pavic says. So looking down that barrel, U.S.-based producers that feel their Canadian plans have foundered may have a profitable way out-take cash and retreat. Gosbee agrees. "If you're seeing frustration by some U.S. companies with their inability to grow in the western Canadian market, what better time than now to monetize these assets?" U.S. producers paid C$5 to C$6 per established BOE in 1999 and 2000 when they were rushing north of the border for quick and inexpensive growth; today, they could sell the same assets for more than C$9 per established BOE. In terms of the number of transactions, there were fewer in 2003, according to Pavic-135 deals of C$5 million or more versus 143 in 2002. Kobayashi expects more transactions in 2004. Gosbee does as well, including more selling by U.S.-based producers and even some consolidation among the smaller RITs in the second half. In 2003, RITs could afford to throw extra premiums at quality assets-at year-end their units were trading at approximately C$51,400 per flowing BOE per day of production, Pavic says. By comparison, they were able to purchase reserves in 2003 at a median price of C$30,516 per flowing BOE per day. But, Pavic expects RITs' activity will taper this year. "Early indications in 2004 are that RITs' dominance in the M&A market may not be as prevalent as it was in the recent past," he says. Traditional E&P companies were able to snag some large deals at the start of 2004-the BG's purchase from El Paso, and Canadian Natural Resources Ltd. and Penn West Petroleum Ltd.'s purchase of the Petrovera Resources partnership assets for C$701 million from EnCana and ConocoPhillips. "These deals suggest that conventional E&P companies are not totally shut out of the M&A market. This may make 2004 radically different than 2003 in terms of M&A activity," Pavic concludes. The two larger offerings on the Canadian market at press time were the ChevronTexaco and Murphy Oil divestments. The former consists of mature, consolidated assets and is being chased by the trusts, which look for prolific assets that don't require higher-risk reinvestment, Kobayashi expects. The latter's assets are scattered and have attracted the interest of traditional producers. He concludes, "There is dramatically more demand right now than there is supply." Tanner says, "There are too many buyers and not enough sellers...The Canadian marketplace is too crowded, and the trusts need to expand their opportunity set." RITs could set up shop in the U.S. even if the tax leakage problem is not solved, but their more likely course would be overseas where deals are more attractive, he adds.