While the first half of 2005 brought record prices to the Canadian M&A space, the second half didn't exactly disappoint. As companies exiting Canada finished their exits and companies selling noncore assets finished their dispositions, the lack of opportunities to pay these historical prices proved to be the disappointment. "We continue to see a reducing supply of assets on the market, which continues to increase transaction metrics," says Art Korpach, Calgary-based vice chairman and head of global oil and gas for CIBC World Markets. "For the most part, many of the U.S. companies that are going to exit Canada have already exited and a lot of large, noncore asset-disposition programs have been completed." George Gosbee, chairman, president and chief executive of Calgary-based Tristone Capital, says these factors have led to a lack of available smaller asset packages in the marketplace, a trend he expects to continue through 2006. "In past years we saw companies doing a lot of house-cleaning, getting rid of the nonoperated, higher-cost properties and keeping the jewels and the properties in their core areas," Gosbee says. "Now, everyone's house is clean, and E&P companies are not going to shed their good stuff, so junior companies are forced to grow through the drillbit or buy internationally." As asset supply dwindled, large buyers were forced to pursue assets that would have been too small for them in past years, says Mark McMurray, a principal with Calgary-based divestment firm Kobayashi Partners Ltd. "Buyer demand versus supply was overheated," he says. "Every buyer demographic in the marketplace was anxious to make acquisitions and the opportunities just weren't there. We saw buyers increasingly moving down-market to make acquisitions." For those that did buy in the second half of 2005, record-breaking prices continued to be paid. According to Brent Heinz, vice president, Calgary-based Sayer Energy Advisors, on a proven-plus-probable reserves basis, the median acquisition price paid increased from C$15.25 per barrel of oil equivalent in the first half of 2005 to C$15.91 in the second half of 2005. Production-based acquisition prices increased similarly, from C$49,312 per flowing daily barrel of oil equivalent (BOE) in the first half to C$53,596 in the second. Continued high levels of interest for properties in the oil and gas market, coupled with record cash flows and increased liquidity in the Canadian marketplace for oil and gas stocks, pushed transaction metrics higher in the second half, says Barry Munro, a Calgary-based partner, corporate finance, with Ernst & Young's Energy Center. "If I looked at the Canadian acquisition metrics compared with every other place in the world, Canada is the most expensive place in the world to buy oil and gas assets," he says. "In return, buyers in Canada experience more political certainty and a lot less risk compared to other geographies around the world." The year came to a close in Canada with six transactions that were more than C$1 billion in size, according to Tom Pavic, vice president, Sayer Energy Advisors. "In contrast, in 2004 there were no transactions over C$1 billion in size," he says. "Three of the six transactions involved were oil and gas royalty income trusts merging or being acquired, for a total of approximately C$5.8 billion." Two trust mergers worth more than C$1 billion occurred in the second half, Heinz says, including StarPoint Energy Trust's merger with Acclaim Energy Trust for C$2.7 billion and Harvest Energy Trust's combination with Viking Energy Trust for C$2.1 billion. As trusts became more popular and the marketplace became flooded with them, the combination of trusts was inevitable, according to Paul Charron, former chief executive of Acclaim and current president and CEO of Canetic Resources Trust, the result of the combination of StarPoint and Acclaim. "It's my view that you have to pick your dance partner early," Charron says. "I wanted to get out ahead of the pack of consolidating trusts. I've always been a believer in consolidation, and I could see where the market was going. I could tell there would be too many names out there, with how quickly the trust market was growing, and that we'd start to see some consolidation." Charron pursued the idea of consolidating his trust for about a year before he began talking seriously with StarPoint, which had a lot of assets in areas Acclaim wanted to pursue, and very little overlap. "In a market where there are so many trusts, you have to differentiate yourself," he says. "Investors have so many choices. They're looking to invest a large chunk in companies with size and liquidity. Before the consolidation, Acclaim was eighth- or ninth-largest in terms of production. I wanted to break out of the pack. Now, Canetic is the third-largest trust in terms of production." Charron expects the trend of trusts merging with each other to continue throughout 2006 because some trusts' management teams are not necessarily interested in running a trust for the long-term. Another notable transaction announced in the second half of 2005 was the acquisition of Burlington Resources by ConocoPhillips for US$35.6 billion, Heinz says. The deal was to close in March. "Sayer Energy Advisors estimated the value of the Canadian assets held by Burlington to be in excess of C$9 billion," he says. "This was the largest transaction announcement for the second half." Other large deals included Petrofund Energy Trust's purchase of Kaiser Energy Ltd. for C$485 million and Pogo Producing Co.'s purchase of Northrock Resources Ltd. for C$1.9 billion. Korpach says, "The sale of Kaiser Energy to Petrofund was done at more than C$80,000 per flowing production unit and Pogo's purchase of Northrock (Unocal Canada) was done at C$60,000. These were pure sales, and we didn't see many of these. We saw several trust-to-trust mergers, which were done at little to no market premiums." Another important Canadian deal done in the last six months of 2005 was Total SA's acquisition of Deer Creek Energy Ltd. for C$1.6 billion, Heinz says. "Deer Creek is focused on oil-sands development, and this acquisition follows a trend of foreign companies acquiring interests in Canadian oil-sands projects." Korpach says foreign interest in Canadian companies in 2005 is a trend just taking hold because of today's high commodity prices and technological advances. "We saw a huge increase in oil-sands activity last year," he says. "Today's pricing makes it attractive to develop these projects. Public perception that there is a shortage of oil has also stimulated the development of the projects. Technological advances are also improving the ability to develop these resources on a cost-effective basis." The oil sands are one of the few remaining areas in the world where companies can access large reserves, he adds. "The oil sands of Alberta have more resources than anywhere, save maybe Saudi Arabia. The other option for a company is to drill a bunch of conventional wells. They just aren't going to find the huge reservoirs that way anymore. The key areas of activity in Canada today are focused on unconventional assets, mainly tight gas, coalbed-methane and the oil sands." Gosbee says Total's purchase of Deer Creek was what the Canadian oil-sands needed. "I've been expecting something like that for a while, a big foreign company coming into Canada and buying an oil-sands company, showing the rest of the world that it is a good place to do business," he says. "The Total deal really put the oil sands on the map and, as a result, a lot of companies are hunting around now." Competition will increase in the oil sands in 2006 by national oil companies as they look internationally for long-lived reserves. "The national oil companies don't want to go into the Western Canadian Sedimentary Basin because the reserve life is too short," Gosbee says. "The oil sands are very long-term and they offer security of supply. The national oil companies would be crazy to even compete with the royalty trusts in western Canada because they have access to such cheap capital. Foreign companies will really only be able to compete in the large resource plays or in the oil sands." In a market that continues to experience rising transaction metrics as it finds itself increasingly starved for available deals, companies will be hard-pressed to find affordable deals in Canada in 2006. "Beauty is in the eye of the beholder," Korpach says. "We are starting to see an increase in finding and development costs, partly because of the services required, the costs of which have increased dramatically. The two are moving in tandem. It's costing more to obtain reserves through exploration and development, so buyers are prepared to pay more to acquire reserves in the transaction market." Gosbee believes good deals can still be found, depending on a company's definition of affordable. "If you have a good cost of capital you can still buy underappreciated assets," he says. "It's different than in the U.S.; it's more of a public company game in Canada. Reliance on share prices is just as important as finding oil and gas for Canadian companies." Gosbee believes trusts will continue to move south to participate in the U.S. acquisition game. "The juniors will stay clipping coupons in Canada and the seniors will start to move overseas where it's not as competitive, but I expect by the end of 2006 we'll see between six and eight trusts holding U.S. assets. We've already seen Provident Energy Trust and Enerplus Resources Fund do very well." For the trusts to acquire U.S. assets, they must find a U.S.-based corporate entity to act as their subsidiary so that the trust can purchase assets through the subsidiary, he adds. "That's a great marriage," he says. "They have to look for a corporate entity with a proven management team that is willing to stay and carry the flag under the trust umbrella. "It's a lot harder to convince someone to do that, it's a hard sell. But, it's worked out well for the Breitburn Energy guys. They've been able to enjoy monetizing their shares and having access to the capital to make acquisitions." Assets continue to fetch different prices throughout each of the provinces as the asset quality is different in all basins, Korbach says. "Each province has different metrics," he says. "Most of the hydrocarbons are in Alberta, but there are high-quality assets in every province. The difference today is the key areas of activity in Canada are focused on unconventional, mainly coalbed-methane and the oil sands. These are mainly in Alberta right now." As 2006 continues to roll on, many in the Canadian M&A space agree the year's shortage of deal supply will affect Canadian companies. "Canadian oil and gas M&A activity will increase in 2006," says John Koyanagi, managing director, Canaccord Enermarket. "Commodity-price declines and performance shortfalls will separate the winners and losers. Demand for oil and gas assets will continue to exceed supply." Korpach believes it is a unique time in Canada because the capital markets and the transaction markets are both robust at the same time, giving E&P companies a choice. "We'll continue to see entities having opportunities in the capital markets and in the transaction markets," he says. "Companies will be able to sell their business or take them to the capital markets and do initial public offerings. It is a unique period of time to have attractive alternatives in either market. Often one market is much better than the other." Competition for assets will continue to strengthen as the royalty income trust and junior E&P market grows and junior companies balance exploration efforts with the need for acquisitions, Heinz says. "There will continue to be a strong demand for assets and especially those of a smaller size-under 2,000 BOE per day-as E&P companies are struggling to find oilfield services to complete their exploration and development programs. They will access the M&A market to complement their organic growth," he says. Heinz also predicts the taxability of companies will discourage property sales and should result in numerous corporate sales, particularly private companies. A dip in gas prices early in the year has already led to companies revising their spending plans, Kobayashi's McMurray says. "There has been quite a retraction of gas prices in the first part of the year because demand has dropped from a warmer winter than normal and production has finally caught up to storage," he says. "We've been investing in gas opportunities like mad bandits. Productive capacity for gas in the North American market is ahead of demand. It's anyone's good guess as to how much storage will be drawn down this summer and how long this over-supply trend will last." McMurray predicts the transaction metrics for gas-weighted acquisitions will come down. He also sees a retreat in public markets related to shortfalls in earnings, underperformance of capital and pace of growth. "We'll see companies that can hit their targets, but you'll also see quite a few fall short of that because competition for services is driving up F&D costs, and getting the operations completed that bring on new production is taking far longer than most had planned," he says. "I think we'll also see the market peel back a bit as public investors look at quarterly performance and see a trend toward the sector underperforming earlier guidance." Lower gas prices will lead to bargain-hunting by acquirers looking to buy companies more strongly weighted to gas and increased competition for oil assets in Canada, McMurray says. He also predicts merger activity will continue throughout the year. "We are going to see differences in performance within the trusts and public-sector juniors that will cause merger activity as the strong take advantage of the weak," he says. "We'll see a rationalization where weaker companies are involved. Volume shortfalls and weak gas prices will result in a good number of companies not able to come up with the cash flow to re-invest for growth in the upcoming year. Private companies are generally dealing with more patient investors, so they'll stick to their business plan, but the public companies are under more pressure from their investors to deliver quarter-over-quarter growth." McMurray sees the fundamental reserve value of gas assets experiencing some correction because of weather and storage. However, oil reserves will remain expensive. As for M&A activity in Canada in the coming year, expect lots of activity in the mid-market trusts and small-cap public sectors after the winter drilling season wraps up. "There will be winners and losers," McMurray says. "The strong will consume the weak."