Oil & Gas Income Trusts

The "New Class" in an old, popular investment vehicle
 
Part 1:  A Comeback in the Making?
 
The income trust game is back - just in a different form.

Canadian Finance Minister Jim Flaherty killed these high-yield, tax sheltered public companies on October 31, 2006 - not so affectionately called the "Hallowe'en Massacre" by the millions of investors who were enjoying 10%+ payouts annually.

Canadian companies had until January 1 2011 to convert back to a regular corporation or face new taxation that essentially reverted them back anyway.

But the market has found a loophole that may allow for many new trusts - especially in the energy sector:

Don't use Canadian assets.

Two new income trusts have listed on the Toronto Stock Exchange (TSX) recently. Last year, Eagle Energy Trust (EGL.UN) went public on the TSX, which was the first Canadian-listed oil and gas trust to launch since Flaherty's Halloween surprise in 2006.

The company holds only foreign oil-producing assets - 1269 bopd of light oil production in Texas - a loophole that excludes it from the new Canadian tax regime. The founders of Eagle Energy believe this new structure will serve as a template for other oil and gas companies.

They raised $150 million in their initial public offering at $10/share last November with an additional $20 million as well via a concurrent sale of securities to their vendor.

The company quickly followed up with their first distribution declaration a month later of $0.1064 per trust unit or 10.64% if you were lucky enough to have participated in the IPO. The company is currently trading at $11.50/share as we write this, with an all time high of $12.10/share.

Parallel Energy Trust (PLT.UN) is the second new energy trust out, debuting in April 2011 on the TSX as well, after having completed a $342 million initial public offering at $10.00/share and also closing on a $51.3 million over-allotment option earlier this month. The company plans to offer an initial yield between 8.5%-9.5%.

Parellel is producing 2900 boe/d of natural gas - again from Texas - though in their prospectus they say it is 67% Natural Gas Liquids, which get a higher price than straight dry gas.

The need for income has not gone away and we feel investors looking for a reliable source of investment income will begin to favour new oil and gas trusts. It took about a decade before the trust market really took off last time.

This time around, with a new structure in place, and new rules to comply with, it could take much longer but the performance of Eagle and Parallel is certainly an indication the investor demand for this type of vehicle is there.

On the negative for investors, Canadian companies operating in foreign jurisdictions also offer a potential higher level of risk than that of a company whose assets are in Canada.

On the positive for the companies, Canadian companies have an advantage when they operate in the United States for example, since smaller energy companies can get access to capital more cheaply in Canada than south of the border.

Background on Income Trusts
 
Since their debut in the 1980s, income trusts were madly popular with investors who loved their juicy quarterly or monthly payouts. These vehicles were special in that they paid no corporate taxes but rather passed their profits on to unit holders who were then taxed.

Seniors, in particular, loved them for their ability to provide steady income at yields that were consistently better than that of traditional dividend-paying investments.

By the turn of the millenium, they had become the talk of Bay Street and any well-informed investor was not without at least a portion of their hard - earned portfolios allocated to Income Trusts. In fact, by 2006, they became so attractive that telecom giants Telus Corp. and BCE Inc. were considering converting themselves from the traditional corporate structure into income trusts in order to reduce their tax burden.

The government stood by and watched for years while tax dollars fell by the wayside. It was not until Gord Nixon, CEO of the Royal Bank of Canada, commented publicly about the possibility of converting the biggest bank in the country into an income trust that Ottawa finally took action.

On Oct. 31, 2006, Jim Flaherty, Canada's Finance Minister at the time, announced his own "trick" but no "treat", on a Halloween Tuesday unit holders will never forget. He announced income trusts, with the exception of real estate investment trusts that adhere to strict rules, would be subject to tax on trust distributions -- effectively, making them treated the same as corporations. This announcement forced the stock-market value of these vehicles down by at least 15 per in reaction to the news. Some were way worse.

The number of energy income trusts has fallen dramatically since then. At that time, the Toronto Stock Exchange boasted 32 energy trusts with a combined market capitalization of $83.9-billion. In the last four years, that shrank to 13 with a total value of $57.2 billion. The gap is even wider for all Canadian income trusts, which have tumbled from $209-billion in value to $140-billion.

Under the new rules, all new trusts from that date forward would be subject to the new tax regime, but Flaherty gave existing trusts (of which there were 255 on the TSX at the time, collectively worth more than $200 billion) until the then-far-off date of Jan. 1, 2011 to meet the new requirements.That deadline has come and gone and while the sector is not what it was years ago, the good news for investors seeking income is that the income trust could be making a comeback, as Eagle Energy and Parallel Energy Trust are showing.

Part 2:  The "Ideal Yields" in this new asset class
 
Investors in the new wave of energy income trusts won't notice any difference from the old ones -- except a slightly lower yield, says Richard Clark, CEO of Eagle Energy Trust (EGL.UN-TSX), the first NEW energy income trust to go public since the Canadian government changed the tax rules on trusts in 2006.  All Canadian trusts had to convert to regular, tax-paying corporations by December 31, 2010.

"The payout ratios probably were too high" on the old trusts -- some were 100% of cash flow," Clark says. "Perhaps this resulted in more risk for the asset class than was ideal.  And in returning more capital to their unitholders more quickly, the old trusts perhaps overly benefited those early investors.  The taxable component of the distributions was around 20% in the late 1990's, but by 2006 it was over 80%."

He said the original trusts - somewhat unintentionally - did some things that he wouldn't necessarily do again, with a view to keeping trusts more sustainable.

Prior to the Canadian government's announcement on October 31 2006 that income trusts with Canadian assets would no longer be allowed (the Halloween Massacre), the oil & gas trust sector had an average yield of ~12% (compared to 5% from oil & gas corporations today), says Kelly Nichol, CEO of North American Oil Trust, a private company.

Whereas Clark says, "The ideal yield for this new asset class may be more like 7-10%."

I agree with Clark but would add two points - one in favour of a lower yield, and one not.  One factor favouring lower yields - which can also mean higher stock prices - is what is called "yield compression."  This happens when there is so much appetite for high-yielding investments that the market is willing to bid up the share price of a stock to accept a lower yield.

Eagle Energy itself jumped 20% in the first three months after its $10 IPO in November 2010, with no change in its payout, as investors were willing to take a lower yield.  The previous trusts had to limit the amount of non-Canadian shareholders to 50%, but this new class of trusts has no such restrictions.  This means Americans, who have basically zero interest rate in their home country, can own 100% of these new trusts - creating a much larger demand pool for the stock.

Just to illustrate, Eagle Energy is paying out $1.05 a year in its first year to shareholders.  At $10 per share, that's a 10.5% payout.  At $12 per share it's an 8.75% payout.

But the second point is this - Investors cannot underestimate the greed of the market.  The trusts were VERY popular investments vehicles - oil trusts made up $60 billion in market cap in 2006, vs. $600 million today (that's a 100:1 ratio, by the way) - and the oil patch executives and investment bankers were able to raise equity easily to make up for any shortfall in cash a high payout ratio might cause.

I believe Clark's pioneering efforts in creating these new trusts will become a huge new industry again, very quickly.  And human nature says that high-payout-raise-equity game could happen again.

Clark was previously part of the senior management team at Shiningbank Energy Income Fund, a heavily natural gas weighted income trust that was bought by PrimeWest Energy Trust.  So he has been intimately involved in the sector before and after the Canadian government ended the trust game.  Clark says Eagle Energy Trust will be different in a few key ways.

"Our payout ratio is targeted at 50%, lower than most of the old trusts. This will go part of the way to reducing the projected yields to under 10%.  Our return of capital component is also targeted to be much lower than was the case in most of the old trusts.  Eagle is also targeting assets with more conventional upside, and so ultimately, hopes to hit a balanced growth and distribution strategy that is sustainable."

"We want to make the return OF capital as low as we can make it, like 35-40%.  And we want to get land where PDPs (Proved, Developed and Producing drill locations) make up less than 40% of the package.  That makes for a more balanced income and growth approach - which I believe is sustainable."

For the past five years, Clark has made it a mission to re-invent the energy income trust in Canada - because in 2006 the government actually made it very clear the trusts could continue, they just had to use foreign assets.

If it was that simple, why did it take four years for the first new trust - Clark's Eagle Energy Trust - to get listed?

"A lot of people understood the essence of the rules, but they were accountants, not entrepreneurs," says Clark, adding that new Canadian rules surrounding foreign asset trusts came out in "dribs and drabs" right up until 2010, making it difficult to move before then.

Other factors, he said, included:

•   It was not until 2010 that the market finally focused on all the companies that were LEAVING the energy trust sector, making it difficult to get traction with investors on new companies ENTERING the trust space.

•   In the oil patch, there are the "trust guys" and there are the high growth "exploration guys," and these two groups have somewhat different technical and business skill sets.  Very few of the "trust guys" had oil and gas operating experience outside of Canada.  And the U.S. has some key differences in how the oil and gas industry is structured, and in taxation, that require a strong knowledge of the U.S. energy patch.

•   Many people believed that the MLPs in the US - Master Limited Partnerships - already have this market covered.

Part 3:  How Energy Income Trusts compare with another popular yield play: Master Limited Partnerships (MLPs)
 
Will the US oilpatch get flooded with Canadian juniors looking to build and sell production to the new Canadian energy income trusts?

As I said, trusts are now allowed in Canada again - but with foreign assets.

After all, energy income trusts in Canada completely transformed the way business was done in the junior markets - enriching management teams and shareholders greatly.

Canadian trusts almost always had high valuations, and could buy lower-valued juniors with only 1000 boe/d production (barrels of oil equivalent) at very accretive prices.

This turned into a cookie-cutter business model where management teams and investment bankers set up company after company with the goal of only getting to a few thousand boe production from one area - and then get bought out. It was a quick and easy exit strategy.

Because trusts need reliable cash flow, they do very little exploration. They can't afford misses - if they ever have to cut their monthly payout, their stock gets crushed. So they buy production and low risk PUDs - Proven Undeveloped reserves - from the juniors. Trusts-buying-juniors was a cash cow for years for industry insiders AND investors (wasn't that novel?).

"I do not see a massive rush of people going down to the U.S. and building up companies to sell to the new trusts - it's too different, too tough," says Richard Clark, CEO of Eagle Energy Trust. "The US oil business is different. In the US a lot more oil assets are held privately. In Canada, it's something like over 90% of reserves are held in public companies. It's not like that in the U.S."

Clark says land ownership isn't the only thing more private in the U.S. - good information is as well.
"There is much less transparency as to who owns what," in the U.S., he says. Canada is the gold standard in the world when it comes to publicly available data.

What that means is that it's much harder to acquire big land packages in the U.S. In Canada you first need a computer and cash to get packages, whereas in the U.S., Clark says, you need a big team of landmen. They visit individual landowners, and then spend countless hours in the basement at county courthouses confirming mineral rights.

Dennis Feuchuk, CEO of Parallel Energy trust, says the difference, though, can create opportunities.
"It's just a different type of deal flow. There are opportunities to acquire (land packages) as family ownership turns over."

Clark says, however, that he is seeing some interest in creating new trusts in Calgary. "The national banks are already out there getting people they know who have the capability to put teams together."

Both CEOs pointed out that the US has Master Limited Partnerships, or MLPs, that are structured similarly to the Canadian energy income trusts. They pay out tax-advantaged distributions to shareholders on a regular basis from the cash flow they get from their producing properties. And there has never been a "feeder system" like the juniors created here in Canada for the US MLPs.

Robert Mullin is the Managing Partner at RAIF LLC in San Francisco, which manages a natural resource equity income fund, and has invested in MLPs. He agrees that the feeder system for MLPs in the US has always been different than the Canadian trust model.

"The majority of big upstream MLPs haven't been buying assets off E&P juniors," says Mullin. "They buy boring assets of the large independents and the majors - the Apaches, Anadarkos, Devon etc. The large independents think they get better valuation for exciting exploration plays - the shale plays, the offshore plays that they think drive a premium multiple for them."

Most of the MLPs in the US are on the infrastructure side of the energy business - pipelines for example. But there are a few upstream (energy producers) MLPs, and I asked the two CEOs if they thought those MLPs would be strong competition for the new Canadian trusts.
"I think there will be some competition, yes," says Feuchuk. "From our point of view, it will be tied to what are we willing to pay for the part of the assets that aren't PDPs. Maybe we're willing to pay more for PUDs and probables that the MLP's won't put value on."

PDPs are Proved Developed Producing reserves - basically, wells that are flowing or producing now.  PUDs are Proved Undeveloped Resources, which are drill locations that an independent reserve engineer says will produce oil when they get drilled in the future.  Between seismic and nearby drilling they have a strong comfort level that those locations will produce oil or gas.

Clark agreed that MLPs have wanted assets that have more PDPs, but recently have done deals with much lower PDP components.  Clark also noted a couple other differences to the MLP business model:  "Their leverage model is different.  We want to stay under 1.5:1 debt to cash flow, and most MLPs use a lot more leverage, and longer term leverage as well.  The MLPs also hedge most of their production, in order to facilitate their use of very long term debt.  We will never hedge more than 50%.  We're trying to give our unitholders exposure to commodity prices without too much risk."

The new trusts are in their infancy. But with very high demand for yield, I expect that starting this autumn, the market will see one a month. Despite the structural differences between the energy industry in the two countries, it will be interesting to see how Calgary junior management teams respond to this new exit strategy.

By. Keith Schaefer