Maple Leaf trusts must convert to conventional corporate form by year-end. That frees up capital for acquisitions, especially in the shales.

The Canadian oil patch called it the Halloween massacre when Finance Minister Jim Flaherty startled investors and energy executives with his October 31, 2006, decree that income trusts would be treated as corporations and taxed as of January1, 2011. That meant energy trusts would have to convert from the trust structure to conventional exploration and production companies.

As the witching hour approaches, the cauldron of shock and horror has boiled dry. Energy trusts are adapting to their shifting paradigm with inquisitive and acquisitive optimism. Freed of the need to distribute gains, they will have more capital to make acquisitions, and they have their sights set on unconventional resources. Although the results of the energy-trust conversion are as yet unclear, in many cases they may prove to be positive.

Thus it is, and ever shall be, in the topsy-turvy world of oil and gas. Regulatory upheaval and legislative overhaul only add to perennial industry challenges such as volatile commodity prices, environmental issues, global economic uncertainty and geopolitical saber-rattling.

“Like everything, the industry adapts,” says veteran investment banker Michael Tims, chairman of Peters & Co. Ltd., Calgary.

Since the conversion announcement, distributions have been cut, with some trusts slicing more than once. “They took the opportunity to cut distributions,” notes Cristina Lopez, senior vice president of Macquarie Bank. “They have additional capital to reinvest, which they wouldn’t have had when there were higher payout ratios.”

In their initial incarnation, the majority of trusts dedicated between 60% and 80% of cash flow to payout. Now, it’s typically 50%, with the remainder returned to operations, exploration and production, and asset acquisition.

“Going forward, the trusts will continue doing what they are doing today, which is paying dividends plus drilling wells,” says Lopez. “Once December rolls around, we won’t see much change. January 2011 will be largely a nonevent.”

In most cases, it’s the legal structure that is changing. The old trust model appealed primarily to individual and non-taxable investors. After the announced change, a number of individual investors sold their shares in trusts that converted early, only to buy those that hadn’t yet done so.

Financial sustainability is often measured by a company living within its cash flow, which is determined with a cash-use to cash-flow multiple of 1.0x or less. Those companies on the lower left show a more inexpensive value versus the group, while also having a lower cash-use to cash-flow metric.

“That phenomenon has ended, because almost every trust now has to convert,” adds Tims. “Clearly, a number of entities would have preferred to stay as trusts. Yet overall, most of them have adapted extremely well. That’s a good sign. We’re going to morph from an emphasis first on income and preservation of reserves and asset base, to more of a hybrid model.”

That hybrid model for growth and income would result in strong companies paying good dividends, just not as high as their former entities paid. The amount will depend on the growth model, but analysts expect dividends ranging from 5% to 7%, with a few exceptions. Astute managements will gravitate between the pull of capital expenditures and the allure of shareholder yield as they portion out cash flow. Since most trusts are significant in size, they have economies of scale and should emerge relatively unscathed.

Growth or Income?

“On a go-forward basis, are they going for growth or for an income strategy?” asks FirstEnergy Capital’s Jill Angevine, vice president and director, institutional research. “If they’re going to grow, they need to put more capital in the ground. Where will that capital come from—more debt or decreased distribution? Investors need a guide.”

The traditional E&P trust was modeled on asset aggregation. Trusts bought mature assets from conventional energy companies shedding uneconomic properties. The properties had lower rates of decline, which translated into lower maintenance costs. The trusts were able to unlock value as they pushed out production without investing cash flow into further drilling and production. Instead, cash flow went directly to the unitholders and to asset acquisition. There was minimal development, and trusts didn’t need to manage the properties they bought.

All that has changed in the transition to operational companies. Trusts must reinvest capital rather than simply deploy it into dividends and asset acquisition. To be competitive, the trusts must determine what assets they need and how they must change their portfolios.

As a consequence, the former trusts are much more selective about acquisitions and are no longer necessarily the obvious asset buyer of choice. While company consolidation continues, acquisitions must focus on quality.

“This industry has constantly gone through waves of acquisitions and I think that hasn’t ended,” says Tims. “We will see continued consolidation in the industry with the same sort of spirit that’s always been there.”

Yet the “have” companies don’t want “have-nots.” That means that the vulnerable trusts are those with the lowest valuations traded. Since they don’t always have the requisite asset base, they won’t have the heft to grow.

“Those that were seen as being most challenged have been consolidated,” adds Lopez. “We’re left with a high-quality group.”

Since June 2007, when the draft legislation was enacted, energy trusts have had plenty of time to contemplate their strategies and convert. Peters & Co. pointed out in a winter 2010 investment report that only 14 of 36 energy trusts have survived the Halloween scare after mergers, sales and early conversions.

Some trusts bit the bullet early, like Fairborne Energy Ltd., which isn’t paying dividends but is putting its money into the ground using new technologies. The company is drilling horizontal fractured wells in the Marlboro area of the Alberta Deep Basin.
When Advantage Oil and Gas converted to a producing company, it limited dividends to become a high-growth player, concentrating on its burgeoning Montney property in northwestern Alberta. The Montney tight-gas play straddles the Alberta-British Columbia border and stretches into northeastern B.C.

Bonterra Energy Corp. and Crescent Point Energy Corp., both Calgary-based, also converted quickly, but do pay dividends. Crescent Point has a high payout and impressive assets. With its purchase of Shelter Bay Energy, the company is dominant in the Bakken shale-oil play in Saskatchewan. Bonterra’s strength is in the Pembina Cardium oil field. And gas-rich Paramount Energy Trust continues to pay a dividend since its July 1 conversion to Perpetual Energy Inc.

Unconventional Advantage

The competitive companies on the front end of the curve are those that shifted from buying conventional to unconventional assets, with exciting new growth opportunities in shale gas and the oil sands.

“It’s the unconventional assets providing growth and the continued application of newer technologies like horizontal fractured drilling,” adds Angevine. “Productivity, reserve capture and capital-efficiency rates are all higher.”

During the conversion-window timeframe, industry technology has morphed dramatically, with drill bits boring much deeper than before. The Canadian oil patch traditionally relies on new technologies to capture hidden value. Horizontal wells, multifrac technology and 3-D seismic surveys are giving tired assets a new lease on life. Applying innovative mapping technology has also helped to lower finding and development costs. Successful conversions to conventional producers will be those trusts with technology know-how, lower costs and enviable suites of exploitable properties.

Angevine notes that ARC Energy Trust, for example, is already shoring up its position in the Montney shale in northeastern British Columbia. With plans to convert to a conventional E&P at year-end 2010, ARC’s quest for growth prompted chief executive John Dielwart to buy Storm Exploration for C$680 million this past June. The deal positions ARC to take advantage of more unconventional-gas potential in the Montney. (For more on the Montney shale, see the March 2010 issue of Oil and Gas Investor, and OilandGasInvestor.com.)

The hallowed path of unconventional assets, sophisticated technology and a strong management team is similar to that followed by Crescent Point Energy. In May 2010, Crescent Point purchased the remaining 79% of Shelter Bay Energy that it didn’t already own, for C$1.1 billion. While still a trust, Crescent Point had created the private Shelter Bay in 2008 to house Bakken opportunities in southeastern Saskatchewan. (The play extends into Manitoba, the Dakotas and Montana.)

FirstEnergy Capital expects most of the trusts to offer a combined growth and income component in the 8% to 15% range.

“From our perspective, Shelter Bay was a great success for both Crescent Point and Shelter Bay shareholders,” Scott Saxberg, president and chief executive officer of Crescent Point, said in a statement. “Under the constraints of the Safe Harbour growth rules, without Shelter Bay we could not have captured and consolidated the Bakken and Lower Shaunavon plays as completely as we did. At the same time, Shelter Bay shareholders received strong returns, despite the financial downturn in late 2008 and early 2009.”

After converting in July 2009, Crescent Point was no longer hampered by growth-inhibiting trust legislation. The total deal included C$900 million in tax pools.

Tax pools are valuable commodities, with owners holding them close. Since trusts aren’t taxable, any tax pools that accompany acquired assets sit on the company books. Because they haven’t been used up, protected tax pools can ease the pain of trust conversion. They also whet the appetite of potential buyers.

Restructuring

Some of the older trusts that have followed income-distribution models, such as Pengrowth Energy Trust, have had to transition.

“They’ve internally restructured, and are expected to significantly change their asset base towards resource-type plays to provide growth,” says Angevine.

In September 2009, Pengrowth founder and chief executive Jim Kinnear resigned and was replaced by oil-patch veteran Derek Evans, who brought in Bob Rosine as executive vice president in charge of business development and, later, Brent Defosse as vice president, drilling and completions.

“Peeling back the layers of the onion, we asked, what are the opportunities on our own land? We went out and tried newer concepts in our Deer Mountain area and got some strong results,” states Evans. “This team can find and execute on those new opportunities.”

Pengrowth posted a dramatic drop in net profit from 2008 to 2009—from C$395.8 million to C$84.8 million—the result of shrinking commodity prices. That slide stopped in 2009, with the company’s first-quarter net profit jumping from C$54.2 million to C$108.8 million in first-quarter 2010. The rebound was propelled by commodity-price increases and aligns generally with the industry average. In 2009, West Texas Intermediate oil fell 38% from 2008 average levels while natural gas prices plunged more than 50%.

“The first quarter demonstrated that we could operate cost effectively and efficiently and we did that with our shallow-gas costs,” notes Evans. “It’s critical to show that we have the same cost structure as E&P companies.”

Pengrowth’s sustainability model will stick to existing cash flow with a balance between growth and income, built on an ultimate strategy of growth. As Pengrowth transforms to a growth-focused oil and gas company, its new model is to maximize returns through the drill bit, says Evans. That means taking advantage of opportunities both within its own asset base and beyond.

“The new strategy is 50% to the capital program and the other 50% primarily to distributions,” says Evans. “As we grow and go from a conservative and financial operation to value creation through the drill bit, our focus will be on unconventional assets, cost control and opportunity identification.”

Like many trusts, Pengrowth’s C$2.8 billion in tax pools stretches four to five years beyond 2011, leaving the company with the luxury of little material impact from the new tax status. Ultimately, of course, taxation will be an issue, just as it is for every company. That’s another reason acquired unconventional assets with multimillion-dollar tax pools are so attractive, especially for former nontaxed trusts that are gas-heavy.

Lopez notes that most trusts don’t expect to pay taxes until 2013 to 2014. Even then their tax rates will be low, with the highest in the mid-teens. Angevine expects minimal corporate taxes for the next three to five years.

New Intermediates

The evolution from trust to conventional has been steady, slow and largely anticipated for the companies. What the energy-trust conversion has done to the oil patch is add an intermediate class to the playing field. These intermediates produce more than 25,000 barrels of oil equivalent per day. (In contrast, the majors are upwards of 500,000 barrels of oil daily.) This new class gives investors an additional tool in comparing peer groups, especially when debt levels creep up and equity values are hammered. With such diversity in market capitalization, daily production is a way to compare within peer groups.

Small producers have less than 10,000 barrels of oil equivalent per day, while the mid-caps yield between 10,000 and 25,000 barrels equivalent daily. Previously, there was a clear market gap between junior producers and the integrated and large-cap producers, but now trusts make up the intermediate and mid-cap universe.

As trusts fly from their financial cocoon into the operational maelstrom, their best friend forever will be technology. A drilling and completion revolution is taking place with deep wells, horizontal wells and multistage fracturing. Armed with assets that traditional operators didn’t want or need, the converting companies are able to exploit new plays in novel ways.

The biggest issue facing former trusts is commodity prices. Many trusts are waiting until later in 2010 to see where oil and natural gas prices stand. By weighing commodity prices, management can determine what makes most sense in delivering value. Those with astute hedging plans are already ahead of the game, but there is no failsafe method. Trying to capture price upside while derailing the downside tests the most able veterans. The best err on the side of caution.

Industry executives are used to the extreme commodity-price volatility of the oil patch, and the remaining energy trusts have revised business plans, hired operational management and embraced their legislated conversion. With strong leadership, a nimble hedging strategy and a sophisticated approach to assets and technology, many converts are already ahead of the game.

For investors, the trick that was the Halloween massacre may actually prove to be a treat.