Will the US oilpatch get flooded with Canadian juniors looking to build and sell production to the new Canadian energy income trusts?  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.

Read Energy Income Trusts Part 1 here, and Part 2 here.

– Keith

Editor’s Note:  I’ll be speaking at the World Resource Investment Conference in Vancouver, British Columbia this Monday, June 6.  I’ll be sure to include some notes from the show in an upcoming OGIB Free Alert.

Want to learn more about investing in junior oil and natural gas stocks? If you have a Facebook account, just “like” this article and a hidden link to Keith’s 10 page how-to on oil and gas investing will appear:

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Editor’s Note:  Today’s story is contributed by Dennis and Eric Hoesgen of Hoesgen Investment Partners and Canaccord Wealth Management. In this Oil and Gas Investments Bulletin-exclusive report, the Hoesgen brothers reveal what could be a comeback in income trusts (investment vehicles that aim to provide steady quarterly or monthly payouts.)  Enjoy…

-Keith

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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 Parellel Energy Trust are showing.

Next story:  Oil & Gas Income Trusts, Part 2 — The ‘New Class’
Part 3:  The New Canadian Energy Income Trusts

Dennis Hoesgen and Eric Hoesgen are Senior Investment Advisors at Hoesgen Investment Partners in Vancouver, with Canaccord Wealth Management, a division of Canaccord Genuity Corp., Member – Canadian Investor Protection Fund. They can be reached at 604-643-0229 or hip@canaccord.com. The views in this column are solely those of the author. This report is provided as a general source of information and should not be considered personal investment advice or a solicitation to buy or sell securities.