Crude Observations

Trust me – this is a good idea!

Good afternoon everyone, an abbreviated blog this week. Why? Because this week I am coming to you remotely. Ironically from Montreal, a city that I slagged so magnificently last week.  Where in Montreal? Well I am paying a return visit to my roots, pretty much THE root, the Montreal General Hospital where yours truly was born – many, many, many years ago. And wouldn’t you know it, just up the street from here is the Trudeau family compound, and down the street is the head office of SNC Lavalin and right in between, where I’m sitting, is a major hospital renovation project that wasn’t part of the bribery and corruption scandal that embroiled SNC Lavalin.


OK, I know I promised that I would write about energy this week so I will. And I’m going to get there but first off, let’s remember what day this is. Just for fun and some pathetic attempt at a theme. No, it’s not pi day, that was yesterday, stop being irrational. And no, it’s not Saint Patrick’s Day, that’s Sunday (although I do reserve the right to have myself a green beer anytime I want).


No, today is the Ides of March and you know what they say – “beware the Ides of March”. And what pray tell does that mean? Well it refers to that wonderful day many years ago when Julius Caesar was allegedly betrayed by his cohorts and partners in imperial crime and assassinated – stabbed in the back and cast aside. So the Ides of March are all about betrayal and how one event changed the course of Roman history.


Where am I going with this? Surprisingly, not down the rabbit hole of another epic Trudeau bashing. No, this time I am reminded of another epic betrayal that I, and many others in the energy sector, experienced first hand.


Back in 2006, I was a fresh-faced M&A guy, looking to make my way in the wide, wild world of the energy sector and I left my cushy job at a big accounting firm to chase the siren song of epic riches in an energy services roll-up. Our grand plan was to aggregate a bunch of service companies and flip them into an income trust and everyone would make out like bandits. It was actually a pretty sound plan, and wasn’t going to be some weird agglomeration of unrelated businesses like some of the abominations that were being foisted on the market at the time, but, unfortunately, it wasn’t meant to be.


You see, I joined this company just after Thanksgiving 2006 and no less than two weeks later we were stabbed in the back by none other than the governing Stephen Harper Conservative government when they elected to eliminate the income trust as a corporate structure, throwing many in the market (including us) into disarray, crushing corporate valuations and investment portfolios and generally wrecking stuff for a lot of energy sector participants.


Now, before I go on with the history lesson, rest assured it worked out just fine for little old me and the company I had joined. We executed the strategy as planned on a private basis and built a great business that thrives to this day – a testament to the quality of the management team and the ownership group.


Back to the present for a minute, I was thinking about the world when that change happened as wellas the current situation and suddenly had a monumental idea.


What is that idea? Simply put, maybe it’s time to think about reviving the income trust.


Wait – what? Is he crazy you might ask yourself and you might be right. Wasn’t the trust market an example of greed run amok? An out of control corporate structure whose nadir was indeed some of the energy service abominations I referenced earlier?


Of course it was, but let’s take a step back for a minute and think about it. I mean really think about it – the good, the bad and the ugly. And explore the realm of the possible.


So, what is it about income trusts that might be interesting? Let’s explore. Born in Calgary before the turn of the millennium, in the heady days of the early 2000’s the income trust was the financing vehicle of choice for the Canadian energy sector and was part of a booming energy sector capital market that in many ways led to the rise of Calgary as a global energy centre.


Modelled after Real Estate Investment Trusts, the Income Trust structure was a tax advantaged capital program that allowed for the distribution of pre-tax free cash flow (distributable cash or distributions) to unit-holders who were then required to pay tax on it. The Income trust structure is of course not unique to Canada but it achieved its near immortal status here.


While not exactly the steady-eddie cash flow distributions prevalent in real estate, it was theorized that a stream of distributed pre-tax cash flow from producing energy assets could be similarly monetized and that a market for this yield would exist on some form of risk-adjusted basis.


The major difference of course between real estate cash flows and oil and gas cash flows is that one is based on long term lease payments while the other is based on a variable sales price of a declining resource. This meant that in order to provide the level of predictability required by investors and maintain a constant yield that oil and gas trusts had to continually raise fresh capital to maintain their production levels, encouraging capital expenditures.


While this of course has drawn comparisons to a legalized ponzi scheme, it is really no different than what energy companies do anyway, reserve replacement is critical to maintaining share prices.


In the case of income trusts, the valuations were a key feature, because you could take an oil and gas production company that was traditionally valued on the basis of its reserves and asset value and flip that valuation to a capitalized yield and, in a low interest rate environment, that yield was in fact very valuable.  The end result is a higher valuation for the producer. And the yields and the higher valuations attracted capital.


Really, this is no different than what we are seeing today in the Permian where much of the activity is debt financed. Value is being created where it previously may not have existed thanks to a cheaper cost of capital. Low cost abundant debt in the United States makes the Permian possible. Income trust yields were significantly lower than required equity returns and made a lot of companies in the Canadian energy sector possible.


To this observer, one of the more interesting aspects of the income trust market was how it facilitated the growth of small and intermediate producers.  These companies typically would raise capital to execute exploration programs and once they achieved a critical mass of production, they would flip those producing assets into an income trust and pay distributions. Because the demand for yield is ever-present in the investment world, these trusts were very much in demand and were ultimately a remarkably efficient way to raise capital at elevated valuations. As a high yield instrument it was really a win-win for companies and investors.


Unfortunately, as with anything of this nature, the pendulum swung way too far and in true Canadian fashion, we overdid everything and ruined the party for everyone. I guess we’re just not allowed to have nice things..


The reason we ruined it was because while the trusts were great for investors and companies, they were far less of a win for government. Part of the problem was the proliferation of questionable income trusts in the energy services sector and leakage into weird industry verticals such as check printing companies, mattress companies, yellow pages and subscription based businesses and, eventually, telecoms. This allowed the market to get too big too fast, drew unwanted attention from various levels of regulatory agencies and ultimately provincial and federal governments discovered they were losing out on an important source of tax revenue.


You see, as long as the attribution of taxes on the distributions worked, it was all A-OK, because personal tax rates, being higher than corporate tax rates, would make up for reduced corporate taxes. Unfortunately, Canadians loved to hold these investments in pension funds and RRSP’s because in these registered investments, both the distributions and the capital gains were tax deferred. What government came to realize was that left to its own devices, the income trust market would run so far ahead of itself that government might find its cash flows severely impacted.  This was because not only were the corporations paying minimal taxes, the unit-holders weren’t either. Which of course we all know is bad. Especially if you are a government. So as the income trust sector got bigger and bigger, the problem became more acute and as larger and larger companies started exploring the structure the government of the day was really left with no choice.


So, full circle, there we were at the end of October 2006, the hammer dropped on the income trust market in Canada, marking a turning point in the capital market history of Canada’s energy sector – a blow from which a good case can be made that the market has still not recovered.


And now here we are, more than a dozen years later.


The capital markets for energy companies in Canada are for all intents and purposes closed. Exploration activity for small and intermediate companies is muted and the average Canadian energy company trades at a steep discount to asset value and has free cash flow yields typically in excess of 20% or more. Capex in Canada is expected to decline between 5% and 10% this year as we continue to wait for pipelines, egress and someone to pay attention to us. The lack of interest in the sector is mind-boggling. Even if some enterprising intermediate wanted to launch an aggressive exploration program, the capital is scarce.


So the Canadian energy sector needs a shot in the arm. A way to jump-start valuations, attract capital and spending back to the market and find a way differentiate Canada from the United States as a destination for energy investment aside from the usual ways.


I guess one way to do this would be to cut royalties or provide similar incentives, but I don’t think that has enough juice. We have the incentives and we are already have competitive royalties, so doing more along those lines is just carving into the government rents that an indebted provincial government is relying on.


No, what we need to do is bring back the income trust for energy companies. Not every company, just energy. And not just oil and gas – any and all energy producers.


I would like to see a version of the structure revived that provides all the tax advantages to corporations and individuals of the historic income trust and allows energy producing companies to raise capital, distribute cash flows and benefit from growth capital and valuation bumps that come from a yield oriented financial structure.


The investing public will love the yields in the current low interest rate environment. Energy producers will convert, grow production to maintain yields and otherwise invest capital. The provincial and federal governments will reap the rewards of new capital investment, service company activity and increased royalties.


How do you avoid the excesses of the prior period? I don’t know. It’s hard to police the free market. But if you follow my proposal to limit it to pure-play energy producers, I think you can have many of the benefits and avoid the worst of the downside. Perhaps there might be consideration to a market capitalization test to prevent the structure being abused by significantly larger players, but that might be going too far.


Don’t believe me that it would work? Look no further than the current valuations ascribed to Canada’s energy companies. A few examples.


Consider MEG Energy. MEG Energy has a current market cap of about $1.5 billion, debt of $3.5 billion, low decline production of 87,000 boepd and generated operating cash flow of $180 million in 2018 which was down by 50% from 2017 due to raging pricing issues from the temporary blow out in price differentials.


Assuming an 8% required yield for an income trust and even a halfway return to prior year cash flow (call it $270 million), the estimated market cap for the MEG trust would be in excess of $3 billion. Double.


What about natural gas. Let’s see what’s up with Peyto. Peyto has a current market cap of $1.25 billion and funds from operations of $474 million IN ONE OF THE WORST YEARS FOR NATURAL GAS IN MEMORY!!! Absent AECO prices doubling, their share price is permanently stuck in the basement. But apply the same required yield to their distributable cash and you get an implied market cap $6 billion.


Prefer your energy cleaner? OK, let’s contemplate a large scale solar installation that sells its power under a long term PPA to a provincially regulated utility. Are you telling me there is no market to create a trust for this energy producing asset? You want to lower the cost of renewable energy? Allow a structure where the required rate of return on the capital going into that asset is cut in half. Same goes for wind power, hydro projects, you name it.


See where I’m going with this?


Am I on to something? I think so. Will it ever happen? Not a chance.


Well certainly not if no one is talking about it. So maybe we should be talking about it. It’s an idea. It’s better than sitting on our hands.


Seriously, we do need something different. We can’t just put all our eggs in the Trudeau pipeline basket and completely overlook the financial incentives that could be created with this.


Come to think of it, I may need a new letter to Justin on this. After all, this SNC thing is killing him. He needs to change the conversation, rescue the oil patch and get some positive mojo going in his favour – there’s an election coming after all.


So Justin, bring back the income trust. For energy companies only. Renewable and Fossil.


It’ll work.


Trust me. When have I ever steered you wrong?


Who’s with me?


Prices as at March 15, 2019 (March 8, 2019)

  • The price of oil was up this week on lowered production and supply concerns.
    • Storage posted a decrease
    • Production was down
    • The rig count in the US was down marginally
  • Withdrawals from storage were much higher than anticipated for natural gas. The market was unmoved
  • WTI Crude: $58.36 ($55.96)
  • Western Canada Select: $47.69 ($45.05)
  • AECO Spot *: $2.70 ($3.40)
  • NYMEX Gas: $2.790 ($2.858)
  • US/Canadian Dollar: $0.7500 ($0.7434)



  • As at March 8, 2019, US crude oil supplies were at 449.1 million barrels, a decrease of 3.9 million barrels from the previous week and 18.1 million barrels above last year.
    • The number of days oil supply in storage is 28.2 compared to 26.9 last year at this time.
    • Production was down for the week at 12.000 million barrels per day. Production last year at the same time was 10.381 million barrels per day.
    • Imports fell from 7.001 million barrels to 6.746 million barrels per day compared to 7.585 million barrels per day last year.
    • Exports from the US fell to 2.546 million barrels per day from 2.803 million barrels per day last week compared to 1.487 million barrels per day a year ago
    • Canadian exports to the US were 3.553 million barrels a day, up from 3.047
    • Refinery inputs rose during the during the week to 16.020 million barrels per day
  • As at March 13, 2019, US natural gas in storage was 1.186 billion cubic feet (Bcf), which is about 32% lower than the 5-year average and about 23% less than last year’s level, following an implied net withdrawal of 204 Bcf during the report week
    • Overall U.S. natural gas consumption fell 19% during the report week
    • Production for the week was flat. Imports from Canada decreased 11% from the week before. Exports to Mexico decreased 1%
    • LNG exports totaled 39.4 Bcf
  • As of March 15, 2019, the Canadian rig count was down 28 at 161 (AB – 116; BC – 15; SK – 27; MB – 2; Other – 1. Rig count for the same period last year was 219.
  • US Onshore Oil rig count at March 15, 2019 is at 833, down 1 from the week prior.
    • Peak rig count was October 10, 2014 at 1,609
  • Natural gas rigs drilling in the United States remained flat at 193.
    • Peak rig count before the downturn was November 11, 2014 at 356 (note the actual peak gas rig count was 1,606 on August 29, 2008)
  • Offshore rig count was unchanged at 22.
    • Offshore peak rig count at January 1, 2015 was 55

US split of Oil vs Gas rigs is 80%/20%, in Canada the split is 68%/32%

Trump Watch: First veto of his presidency to support his border wall! Very exciting. Oh, and a pretty brutal budget.

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